A Marathon, Not a Sprint

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When will we be able to enjoy the simple things in life such as going out for a sit down dinner at a restaurant, talking to our friends at a house party or run in a race with more than 50 people?  COVID-19, the invisible enemy, has certainly disrupted the global way of living.  

We have had many pandemics.  Some causes of pandemics have been eliminated, smallpox; some controlled, measles; and some still run rampant, yearly influenza.   How will COVID-19 play out?   Only time will tell, however, as medical and financial professionals, we have some expertise to forecast when and how this crisis might resolve.  (We understand that drug and vaccine development outcomes are probabilistic).

In Part 1, we provided a synopsis on COVID-19, its start in China at the end of 2019; the market impact resulting in large corrections in global markets; the development of therapeutic treatments to attack the virus instead of playing defense until now; and the government’s predicament balancing saving lives versus disrupting its’ economies.   We are four-plus months since discovering SARS-CoV-2.    It’s looking more likely that the resolution of this COVID-19 crisis will be a marathon, not a sprint.   

Part II:  Scenario Analysis and Our Thoughts

As investors, we are  interested in figuring out how the COVID-19 crisis will end and impact investment markets.  The longer the disease takes to resolve, the greater the likely impact the disease will have on the global trade, unemployment rates and market returns.  Businesses are starting to fail and many companies have furloughed or laid off their employees.   The global economic machinery has never had a total disruption almost everywhere at the same time.   It is also a reasonable statement to make that the longer the global economy stays disrupted, the more difficult it will be to restart the global ‘engine’.  Not to be alarmist, but it is plausible that a protracted COVID-19 outbreak could lead to multiple industries and government failures and defaults leading to the next Global Depression.   Fortunately, pandemic history over the past 100 years has normally resolved over months, some over years.   

As Bayesian thinkers, it helps to create a scenario analysis as a framework to assign probability outcomes.   The better we predict the COVID-19 outcome, the better we can construct the financial models we use to calculate the intrinsic value of individual companies.  Our objective is to create a logical, systematic approach in navigating through the COVID-19 ‘black swan event’ as it continues to impact the investment markets.  

Note the following discussion about the various scenarios are our conjectures.  Please use at your own risk.   We are not providing specific stock investment advice.   Our goal is to demonstrate that we have developed a strategy to analyze the economic impact from COVID-19 in our investment portfolio.  We provide a brief description of our three-step TOF COVID-19 Corporate Assessment Tool below.  For a more detailed description, including using  Disney as an example, please read the full article here.

Step 1:  Assign Probability to Our COVID-19 Scenarios ​

We created four scenarios.  We choose two key variables to differentiate the four scenarios:  Time and Economic Impacts.   In the first three scenarios, we assume that an effective treatment or vaccine will be developed, or that herd immunity develops from prior exposure.  In the fourth scenario, we assume that COVID-19 will become a new endemic illness, similar to the yearly influenza.   (COVID-19 would be classed differently from other coronavirus infections, a cause of the common cold, due to its much higher proclivity to cause serious and fatal illness). ​

Step 2:  Rating COVID-19’s Corporate Impact  ​

Physicians, especially our colleagues in Psychiatry, use assessment tools to help aid in diagnoses.  Similarly, we developed the COVID-19 Corporate Assessment Tool, to aid our analysis on companies and business units during this crisis.   This is a qualitative assessment tool and is used as an adjunct to the traditional financial model and analysis we use to elicit the intrinsic value of investable companies.   As with many assessment tools simple, short and understandable are highly desirable traits.


Using the above Ratings Template as a key, we complete our COVID-19 Corporate Assessment Tool (below) for select companies we own or are researching that may be materially impacted by the crisis.  The goals are two-fold:  first, to make us think about a company’s abilities to survive and operate through this crisis; and second, to separate the company’s business units and ensure we have reasonable modeling assumptions.

Step 3:   Adjusting Our Financial Models

Now that we have reviewed COVID-19’s possible impact.  Do our assumptions used in valuation need to be changed?  What is the new intrinsic value?  

When significant new information is available that may affect our Scenario (Step 1) or Rating (Step 2) analyses, we would repeat our TOF Covid-19 Corporate Assessment Tool for our investments.   

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Our Thoughts on COVID-19

Our Panel Discussion:  Dr. Lorne Porayko, Intensivist and Analyst, Dr. David Wingnean, Family Doctor and Analyst, and Tim McElvaine, Portfolio Manager.


What probability do you assign each of the Scenarios based on information as of today?  Scenario I (SI) and Scenario II  (SII)

Lorne-  SI- 20%, SIIa-30%, SIIb-20%, SIII-30% and SIV-10%
I think that there is a 20% chance of a pharmacologic breakthrough and a V-shaped recovery.  I speculate that there is a 30% chance of scenario 2A and a 20% chance of 2B, mostly because of logistical hurdles to scaling of a potential therapy, along with the inevitable political headwinds.  Scenario 3 is less likely but possible, I assign 20%.  Scenario 4 is the least likely but unfortunately remains possible:  I gave it a 10% probability.  I sincerely hope I am being overly pessimistic and that it is much less likely than 10%.

David-   SI- 5%, SIIa- 20%, S IIb- 30%, SIII- 30%, SIV-15%.  
I don’t see a silver bullet in current development.  This makes me think Scenario 1 is unlikely.   There are numerous promising vaccine candidates in clinical trials.    However, there are some things in clinical development that you can not speed up, for instance, what are the longer-term side effects of the vaccine or how long will a vaccine work for?   I think Scenario II and III are more likely to occur.  The globe is throwing a lot of resources behind this problem.  We are an advanced society compared to previous pandemics. We just need time to find an effective COVID-19 solution.   Unfortunately, Scenario IV is also possible.  We don’t have vaccines for any coronavirus even though there have been attempts, and some viruses have been insusceptible to vaccine development.  

Tim-  S1- 0%, SIIA-0%, SIIB- 80%, SIII-20%, SIV-0%
It is unrealistic to think everything gets back to normal by the end of summer. The path forward I suggest will be similar to my experience with a manual transmission car; it will consist of lurches, mostly forward but sometimes also backwards. 


What are you most worried about?

Lorne-  I think that the dispersion of potential economic outcomes is large and that there is an element of reflexivity at play here.  By reflexivity, I mean that the longer the economic lockdown remains necessary, the more likely the worst case outcome (scenario 4) is bound to happen, due to a cascade of economic failure.

Put differently, there will come a 'tipping point' beyond which a recovery may be incomplete or very protracted.  I do not believe we are there yet.  If an effective and rapidly scalable pharmacologic therapy (or combination of therapies, like commonly used for HIV) for COVID-19 were to be discovered, I think that business would return to usual within months and certainly within the 8 month window of Scenario 1.  69 molecules are being tested in proper RCTs and 6 are in phase 3 trials.  Although that is hopeful, I believe that if history is any guide, the therapies will only be partially effective and may involve large molecules, which are much more difficult to mass produce.  Nevertheless, if even a partially effective therapeutic regimen is developed that keeps the majority of patients out of hospital and the ICU, that would be enough to allow businesses to go back to work.  The other nuance is if herd immunity is possible or not.  The 4 other coronaviruses that infect humans do not induce much of a durable immunologic response, and if this is the case with COVID-19, an effective and safe vaccine is unlikely and we may be stuck with a seasonal return of COVID-19 that will reduce productivity and strain healthcare systems for many years to come.


David-   The world governments are racing to fight this crisis on many levels:  financial impact, unemployment, treatment and vaccine research.   Resources are being thrown and government decisions are being made that make me worried that unintended consequences may happen.  The question is how severe.   I am worried that we may see an ultra rare ‘double black swan event’.   We are all hoping for the best, but also understand that this war is unprecedented in its speed and global nature of its spread.


Tim-   Aside from the path of the virus, I suggest there are 4 things to keep an eye on:

1. Consumer behaviour
2. Company behaviour – Firms will favour durability over efficiency. There will be a focus on rebuilding balance sheets and operations. As Canadians we will benefit as US firms bring their supply chains closer to home.
3. Governments behaviour – The govt will be a more active participant in commerce. This will go well beyond simply increased taxation as recent events have given govts the “moral authority” to increase their involvement in the economy.
4. Political & Social tension – The economic and social stress will magnify underlying political and social tensions both domestic and foreign. While the virus has brought people together, it has also made people less tolerant of others behaviour.

 
Out of the 4 listed above, I worry most about political and social tensions. The first 3 we have dealt with before while the 4th is an unknown.


How do you think about investing in this environment?
Lorne-   Corporate allocation behaviour will be influenced by this experience (assuming scenarios 1 or 2); however, I think that an austere mindset will fall by the wayside within a year or 2 (much like after the Great Financial Crisis in 2008) when greed overcomes fear.  This is a pattern that seems to emerge again and again in history, with the exception of the Great Depression (akin to scenario 4).
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As an investor, I think that planning for the worst probable outcome, while still cultivating optionality to the upside is the art and science of our craft.  To do so requires flexibility with skepticism and the ability to balance priorities.

David-   First priority is to figure out if the company will survive this crisis.  Second, is to find investment opportunities that have emerged because of COVID-19 concerns that are short-term based.  Since we are longer-term investors, we are discovering more investment opportunities now than prior to the crisis when markets were at all-time highs.   

Tim-  For value investors, it is about pricing and not timing. The future is of course uncertain. We determine what we think a company may be worth under a couple of scenarios, then look to invest at a discount to this appraisal value. This gives us a margin of safety and the bigger the margin of safety, the more attractive the investment. 

Ending Thoughts:  It will be a marathon not a sprint.  ​

As of now, our team at the Osler Funds agree that the most likely scenario to play out for COVID-19 is Scenario II.  Lorne is leaning that governments will be able to effectively ‘dance’ through this crisis; whereas, Tim strongly predicts  we are heading towards SIIb, the Bad Dancer scenario.   David’s forecast is in between.

Most likely, we will have to wait for an effective vaccine before we can all go back to normal, pre-COVID.   Eighteen month is the most often cited timeline for vaccine approval.  It may take another extra twelve months for full scale ramp up in production and delivery.  In the meantime, most governments around the world will use a phase approach to open up their economies.   In Canada, our strong healthcare system and rational government approach will incorporate a large public health component to screen for new cluster outbreaks and encourage social mitigation strategies to limit outbreaks to controllable ‘flare-ups’ instead of uncontrolled ‘fires’ requiring further lockdowns.   Diagnostic testing will be important but has significant limitations due to the reactive nature of testing and the strain in securing adequate testing supplies.   The good news is that global manufacturing of masks and other PPE equipment will ramp up sufficiently (due to positive economics and relative ease of manufacturing).   We might see a new form of fashion, the ‘must have’ decorative masks.  

Governments that chose to not or could not use prevention strategies (we call this the non-interventional approach) and instead allow for natural disease progression could be subjected to significant death rates (accounted for or not by official government numbers).  Those that favour non-interventional approaches claim that we will not know the success of this method till a year later.   They believe that the death rates will level out with herd immunity; whereas the countries that used a Hammer and Dance strategy will have early success, but infections are inevitable to hit the rest of society.  Regardless of  the government strategy deployed to fight this crisis, we believe that consumer confidence will be a vital variable to monitor before global economies can be reestablished successfully. 

Admittedly, forecasting how the investment market will react in the next 12-36 months is more an educated guess than a precise calculation.   We predict that if Scenario II plays out, a U or W shape recovery is likely.  A possible differentiating variable between a U vs. W shape recovery will be how the large world economic players, such as China and US, are able to prevent future large waves of infection, requiring further widespread lockdown(s). 


Fortunately, it is easier to predict the outcome of specific companies and sectors.   Historically, major disruptions in the investment market is often the best time for investors to earn a superior investment return.    We believe that COVID-19 will eventually become manageable, like all previous pandemics.  However, it may take 18-36 months for people to resume normality (pre-COVID).   Some companies will not survive the COVID-19 chasm, while a few will prosper.  For example, select airlines and cruise ship companies with poor balance sheets, may face illiquidity and possible bankruptcies; many companies, like Disney, will survive, eliminate excess expenses and potentially become stronger post crisis; and a few companies, like Amazon, could strengthen during this crisis.   (We own Amazon and Disney in the Osler Funds.)  The new challenge for us is to find the companies that meet our previous stated investment requirements as value-based investors and are also able to survive and thrive through this crisis.  We developed our screening tool to help us navigate through this crisis.  We strive to protect our investments and find great investment opportunities during these unprecedented times.   We are invested alongside our investors.


We wish all our readers, our best wishes to stay safe, healthy and strong through the COVID-19 crisis.  

DW, LP and TM