History Lesson II – Estimating the dilution from a COVID-19 recession for equity investors

Equities have displayed remarkable resilience so far in this crisis. The first quarter fall in equity prices was steep with the S&P 500 down 20%, a record for the first quarter. But, considering the magnitude of the crisis, some have argued that equities should have fallen by more.

Summary

Equities have displayed remarkable resilience so far in this crisis. The first quarter fall in equity prices was steep with the S&P 500 down 20%, a record for the first quarter. But, considering the magnitude of the crisis, some have argued that equities should have fallen by more.

The market’s behaviour was not that irrational, though. Prompt action from various central banks and governments reduced the risk of another financial crisis following on from the economic crisis that we likely face. So, investors only had to account for the loss in earnings, and that has little impact on equity prices in the long term. We demonstrated this in our March report[1]. One assumption we made in that report was that companies in aggregate are conservatively financed, having resources to tide through these difficult times. Of course, there will also be bankruptcies and shareholders will probably be asked for additional funding. However, a significant rebuilding of capital bases, such as banks needed after the great financial crisis, should not be necessary. Then, banks had to raise USD 650bn of additional capital, significantly diluting their existing shareholders thereby reducing their potential returns[2]. Is this likely to occur again? This paper explores this dilution risk for equities and analyses its implication for equity investors.

In particular, we develop two scenarios. The first assumes the current crisis is of a similar magnitude to the great financial crisis, affecting listed companies’ revenue and margins in a way similar to that experienced in 2008/09. The good news is that equities, in aggregate, do not need much additional capital under this scenario. Dividends and capital expenditure (capex) will likely be cut but equities can weather such a storm. Our second scenario assumes that the crisis this time will be much worse than that experienced in 2008, in line with the worst-case estimates for global GDP. Operating margins fall by three standard-deviations under this scenario while revenue falls by about twice as much as that experienced during the 2008 crisis. This scenario is a stress-test for equities, modelling a once-in-a-century type event. Unsurprisingly, equities suffer more under this scenario. Dividends would likely halve from the 2019 level and may take years to recover. Still, the dilution risk is not as significant except in Japan (at both banks and non-financial companies) and for European banks.

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1. If we were to write-off 1) half and 2) all of the next two years’ earnings then prices should only fall by 5% and 9% respectively.

2. An investor may buy a stock at $10 expecting a return of 10%. However, the company may need an additional $1 to deliver the same earnings as before because of the economic crisis. At a practical level, the return is not 10%, but 9.1%, i.e. 1/(10+1).

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