Having been involved with the Corporate Reporting Users’ Forum for a number of years as a UK co-chair and now a participant, I felt it important to reflect on the prominent role corporate reporting and financial analysis will play in the aftermath of the coronavirus pandemic.
If you are an old school professional such as a fundamental equity analyst, investor relations officer, corporate accountant or auditor, you might be forgiven for feeling a little bit unloved. Long gone are those halcyon days when nearly every investor chose securities based on the quality of the issuer’s business and even constructed portfolios based on the characteristics of those operations. In today’s world of passive and computerised investment approaches, we have largely accepted our lot in life as a lower life form, with bonuses, promotions and recognition increasingly bestowed upon “quants”, “data scientists” and “algo traders” who, until very recently, were seemingly able to generate better performance by pressing a few buttons on their keyboard than we ever could by burning the midnight oil dissecting financial reports. But do not despair – we are poised for a glorious revival! In this blog, I will set out how the next chapter in financial markets will unfold, and why I think it will play out this way.
Do you remember that fateful day just before the lockdown when the markets remained in free-fall despite central banks’ de facto promises to turn on the printing presses to prop them up? Nobody seemed to know what was going on. I found an explanation eventually. Apparently, it was a classical sigma crash that occurred as a result of levered risk parity funds being forced to close out their delta-gamma positions. Or something like that. I’m paraphrasing to the best of my ability here. Truth told, I can’t make head or tail of any of this Greek alphabet soup. In the course of my own simplistic world of analysing products and markets and businesses, I never got beyond alpha and beta. I don’t think you need to understand a word of what I just said to realise that we have a bit of a problem. (I actually suspect that anyone who did understand what was going on is part of the problem!)
The good news is, it’s not really necessary to grasp how all these derivatives of a derivative of a derivative trades intertwine, because the investment world is on the brink of a major paradigm shift. As “non-essential” businesses shut down, with bailout or bankruptcy as the sole alternatives for many of them, humans are poised to retake an element of control from the machines. It is finally dawning on us that businesses are living entities. Capital markets originally came into existence to make capital available to those pursuing economic projects that benefit real-life people. Secondary markets were intended to improve liquidity and thus access to capital before we repurposed them into casinos. The current approach to “investing” cannot continue forever. Post-corona, the divergent operating performances of corporates will drive home the message that whenever you make an investment, you ultimately gain exposure to an entity’s ability to generate cash flow. In good times, there are of course myriad ways to temporarily suspend economic reality that evaporate in bad times. If you (or more accurately, your IT infrastructure) has the ability to trade a million securities in a fraction of a second, you may have had a realistic expectation of flipping the overpriced securities of a low-quality business before reality catches up with you – until the day that everybody scrambled for the exit door. And if you get stuck with your securities as and when markets seize up completely and/or close, you will no longer even be able to rely on financial gimmickry to mask poor operating performance: regulators are increasingly leaning towards the view that buy-backs and bailouts just don’t mix.
In conclusion, there has never been a better time to find out what the companies that issued your shares, bonds and convertibles do. In other words, it is time to rediscover the art of analysis. Make no mistake: we have kicked the debt-fueled everything-bubble can to the very end of the cul-de-sac; the coming economic, financial and monetary reset will be brutal to the point where everybody will develop an intuitive understanding of the difference between capital formation and PR stunts. Businesses will need to re-value everything from their loan portfolio to their contingent consideration. And what will be the main input into all those sophisticated valuation models? Management’s best guess as to what governments will do when, and how much irreversible economic damage this will have caused and continue to cause in the future across the entire supply chain. This is not a trivial task to start your day with. We are deep into chaos theory here. An important corollary is a growing realisation that you often can’t wrap the cash flow streams associated with assets and liabilities into one number. How do you fair value a contractual obligation, when armies of contract novation specialists (some would call them thieves) are hard at work to get their clients out of their payment promises by pointing to unforeseen and unforeseeable circumstances such as a – drumrolls! – virus?!?
And please don’t look at the quarantine measures as a once-in-a-lifetime event. At the risk of ruining your day, I must tell you that from a scientific perspective, Covid-19 leaves me unimpressed. Sure, it causes severe symptoms and risks overwhelming our healthcare systems. But that is probably true for a very large number of pathogens that will cross our paths every now and then, including the common flu virus. What with the recriminations that governments were doing too little, too late to “contain” something that is completely and utterly un-containable to begin with, rest assured that in the future, the world is at risk of being under martial law every time somebody sneezes.
Needless to say, this will have repercussions for the cost of capital and, by extension, the financial and operating structures of “non-essential” businesses (and quite possibly even some “essential” businesses that got caught out by non-paying customers and other unpleasant surprises). Even pre-corona, we had witnessed a meteoric rise in the complexity and interconnectedness of the business world as companies sought to share resources as well as risks. Unbeknownst to many new-age capital market participants who have never opened a company annual report in their lifetime, joint ventures and associates, asset swaps, contingent consideration and contingent valuation rights associated with transactions have in recent years been the norm, rather than the exception.
In the aftermath of the lockdowns, the economic wreckage will serve as a brutal, but long overdue wake-up call that extrapolating growth rates and throwing random multiples at random “consensus” forecasts (all too often, management views reformatted into an Excel sheet by analysts) is not an adequate tool in the analysis and valuation of a business. In future, the only way to get comfortable with the risk-reward profile of an investment will be to understand the business inside out, as well as the ramifications of anything “unforeseen” happening – because the world will never again be “foreseeable”. High quality corporate reports, combined with the knowledge and skill of professionals that have dedicated their careers to understanding every driver of cash flows and profit in the segments where they operate, will once again become the cornerstone of any investment decision. Lifelong learning and regular interaction with brilliant colleagues covering the full spectrum of industry sectors, asset classes and capitalisation ranges all over the world will be more important than ever.
The best venue to achieve this? The CRUF! There is no reason for not joining our open sessions, be they in-person or on virtual platforms.
Marietta Miemietz, CFA is a CRUF UK participant and former CRUF co-chair, as well as a member of the International Accounting Standards Board’s (IASB) Capital Markets Advisory Committee (CMAC) and vice chair of CFA UK’s Professionalism Steering Committee (PSC). She is the founder and director of the research boutique Primavenue. Marietta has more than twenty years’ experience as a sell-side and independent analyst covering the pharmaceutical & healthcare sector.
The views expressed in the blog are those of the author and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the comment letters section of the CRUF website.