Evaluating Risk in an Uncertain Market

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Text transcript

John Goetz. I’m the co-chief investment officer at Pzena Investment Management in New York.

In the current market, because of the high level of uncertainty in the economic outcome, I’ll just say, the degree of the recession: Is it a minus 10% GDP? Is it a minus 4% GDP move? These are things that we haven’t had to deal with for decades in the investment community.

I think it highlights a very important aspect of how to look at risk. Clearly, the volatility in the market, particularly in March, went to record levels — levels of volatility that hadn’t been seen since the Great Depression, actually, which is a good way of saying fear reached levels that we hadn’t seen since the Great Depression. And with good merit, because the GDP drop and the impact on the global economy was something that is so large that we wouldn’t have seen it since the Great Depression.

Now, as an investor, what’s important is, how do you look at risk? Do you look at risk as the volatility in the stock price, or do you look at risk as the probability of losing the value of the business? And there, I’m talking about permanent capital impairment. Many of you have probably seen that many travel-related industries, including the industry that does the big cruise vacations like Carnival, they’ve been really hard-hit and they’ve already gone to the market to raise capital, both equity and debt, because their cashflow is so bad.

So, we would look at being in industries that go bankrupt or need to do massive capital raises as potentially permanent capital impairment, as the new equity squeezes out historic equity players. We are very, very careful in looking at the range of outcomes [for] each of the companies that we’re looking to invest in to make sure that they have the liquidity and the capability to survive a very significant economic shock. We call this downside analysis.

So, it isn’t necessarily that we expect the stay-at-home orders to continue. In fact, as of the end of May, it looks like many economies are opening up in June and the months of this summer, so we’re not making an economic forecast that will either stay at home longer or stay at home shorter; we’re just looking at each business from an analysis standpoint of saying, “What is a downside case?” And that would look like longer shut-ins, maybe a second wave of the coronavirus, and understanding the impact to the cashflow and liquidity of the business.

This is a critical part of managing risk right now in our portfolios around the world.

Now, here’s what’s interesting going forward. We have found some good opportunities in materials. I’ll specifically mention BASF, a very large German chemical company — really the world’s largest completely integrated chemical business. They provide various types of materials for the auto industry, and certainly also for any other industrial. They’re one of the global leaders in high-performance plastics around the world, for example.

As I’m sure you can appreciate, BASF was very hard hit by the downturn in demand, and in fact, that downturn started last year, 2019, when China had a massive slow-down in the auto sector. So, interestingly, their business had already slowed tremendously coming into coronavirus, and then got hit again. Given their leadership position and their low-cost position in many of the places that they play, we think they might indeed pick up some share as we move through this recession globally. They are very well-positioned in the businesses where they play.

I will just emphasize again, the key is to understand: Do you have the staying power through a massive downturn? What does your cashflow look like? What does your balance sheet look like? In this case, BASF’s balance sheet, incredibly robust. It enables them to make it to the other side of this very horrendous event, whereas some of their competitors might not.

So, when you look around the world, one of the things we see is a tremendous opportunity to pick up some leaders in industries like automotive. Another good example — [we] kind of talked already about a German company called BASF — another Germany company is Volkswagen, which really has the staying power, the scale, the balance sheet, and the competitive leadership to make it through this very difficult time. Again, as you’ve probably already seen other weaker auto companies needing to get government support, and this is typical in these very big downturns where, as a public shareholder, you have to be careful to make sure that you don’t end up with a situation where the government comes in, takes a massive stake in the company, and you get pushed to the back of the queue.

Volkswagen, on the other hand, is tremendously well-positioned, its balance sheet, a leader in electric vehicles that are the way of the future in terms of future automotive demand. This is an opportunity to pick up leaders in the space like automotive, and we think Volkswagen is the next example of a very under-priced company with a leadership position.