How Covid-19 has exposed the dangers of overspending

The pandemic has revealed a shocking level of fragility among global firms. How might businesses thrive in future, and which country has become a shining beacon of safe dividend yield?

Coronavirus is especially dangerous for patients with pre-existing conditions. This is true as much in the corporate world as it is for human beings. The unorthodox nature of the situation should not be allowed to disguise the fact that it has revealed a shocking level of fragility among public and private companies across the globe.

One proxy for fragility is the percentage of companies with net cash balance sheets. As Warren Buffett recently said: “Cash means you don’t have to rely on the kindness of strangers” – he has stashed $130 billion (£103 billion) inside Berkshire Hathaway. Debt magnifies the impact of outcomes, cash on hand dampens them. If you came into this with cash, the probability of your business needing life support is reduced.

Unbeknown to many shareholders, corporate management have been engaged in a previously implicit, but now very explicit, trade-off between optimisation and resilience.

The story of boardrooms for the past couple of decades has been one of globalisation, financial engineering and shareholder value.

Companies have strived for, and investors have encouraged, operating leaner, faster, more efficiently, from complicated global supply chains to the relentless shedding of “non-core” assets or the outsourcing boom.

Management have been highly incentivised to ride this gravy train with incentive plans tied to return on equity and earnings per share. What an easy win – pay out all your cash, borrow cheap, buy back shares. Stock markets loved it. What could possibly go wrong?

Covid-19 revealed all the flaws. To use the major US airlines as an example, they have spent $43 billion on buybacks in the last six years while increasing their total debt. The four CEOs pocketed $430 million between them. The industry just needed a US government bailout of $25 billion and is raising equity.

Corporates, particularly in the US, have become highly evolved to operate in a globalised, hyper-connected, stable economy. But the opposite of efficiency is not inefficiency: it is robustness. Highly evolved for one environment, means less adaptable to another: cockroaches outlived dinosaurs.

Facing extinction

One dinosaur that faces extinction is General Electric. Formerly at the cutting edge of technology, engineering and management techniques, it is now a textbook example of hubris and capital misallocation. Had an investor sold on the revelation of the CEO’s “back up” corporate jet they would have been down roughly 60% from the peak, but the shares have since fallen a further 75%. Over time, executive attention drifted from innovation to financial engineering via growing debt, poorly timed buybacks, earnings manipulation, spin-offs and latterly write-offs.

Going forwards, robustness will be prioritised. It is easy to picture boards of directors demanding balance sheets and business plans that can survive “another Covid-19” – expanding the parameters of stress tests and “what if” scenarios.

That means holding more cash and inventory on hand. It means shorter, local supply chains, diversified suppliers and re-shoring manufacturing, de-globalisation. A CEO weighing up a production facility in Guangzhou, China, versus Alabama may now consider lower costs are outweighed by higher risks and political pressure.  

Companies will care more about other stakeholders, running with less debt and lower shareholder payouts. In a sentence, as entrepreneur, CEO, writer and keynote speaker Margaret Heffernan put it: “just in case over just in time”.

So, what does that mean for investors? All these things are bad for corporate profit margins, but good for ensuring the business can survive another crisis.

Companies with foresight will thrive; sensibly run Tesco is positioned to regain national champion status – vulnerable staff were sent home on full pay, those who worked received a bonus and they hired 45,000 new staff as unemployment spiked. Management can pay a 4% dividend with a clear conscience.

The gold star for prudence goes to The All England Lawn Tennis Club, which has purchased pandemic insurance for Wimbledon for 17 consecutive years at a cost of £1.5 million per annum. This super-conservative policy will net a £115 million payout just when they need it.

Lastly, this is corporate Japan’s “I told you so” moment, having long been criticised for considering a range of stakeholders and for large cash balances, now they look quite clever. Perhaps Keyence, the Japanese automation and sensors company, had the right idea in boasting that they had enough cash on hand to survive for 17 years with no revenue!

At a time when we are seeing unprepared companies make forced dividend cuts across the world, Japan has become a shining beacon of safe income yielding a handsomely covered and growing 2.8%, which is why it remains a key part of our portfolio.

Duncan MacInnes is co-manager of the Ruffer Investment Company.