Although the COVID-19 crisis continues to rage on, much of the country has now reopened after a long shutdown. In many ways, this economic reboot will have long-term consequences for businesses and individuals. In this series, we’ll discuss many of the lessons that this crisis has highlighted for managing your investments and personal finances as the country recovers.
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What We Can Learn from 2020
One of the important investment lessons of the first half of 2020 is to focus on long-term and sustainable company financials. This is because the nature of the economic shutdown required that companies be on strong financial footing with no advance notice. Many parts of the country — and across the globe – shut down their commercial and retail activity for weeks and months. Even without full lockdowns, consumers faced financial and economic uncertainty and hardship, causing many to tighten their wallets.
As a result, most companies, from Fortune 500s to small mom-and-pop shops, saw their sales plummet, even as they continued to have rent, wages, and other bills come due. Those companies that were more financially disciplined before the crisis were likely to be in a better situation coming out of it.
Trust Fundamentals Over Hype
This is the case regardless of how exciting a company might be or how trendy its stock is. Thus, this is a reminder that disciplined investors should consider many aspects of an investment in a company’s stock – and not just how well it’s performed lately, what the company sells, how much other investors talk about it, etc.
The chart below shows how much debt companies had compared to the earnings they had to make interest payments (EBITDA). The lines represent small, mid, and large cap companies.
A lower debt/EBITDA ratio is a positive indicator that the company has sufficient funds to meet its financial obligations. A higher debt/EBITDA ratio means that the company might face difficulties in paying off its debts.
Chart 1: Comparing Debt to Earnings (debt to EBITDA ratio) for small, mid, and large cap companies
Many companies had raised significant amounts of debt over the prior decade as low interest rates since the 2008 global financial crisis made it easier for even risky companies to borrow. When the economy is growing steadily, using debt to finance new projects and growth can be worthwhile and financially sound.
However, large amounts of debt become a burden when the economy slows (or halts suddenly). Interest payments on this debt consume a much larger portion of a company’s revenue. As the chart above shows, the amount of debt compared to earnings has risen for many companies over the last several years, but especially for small- and mid-cap ones.
Large Cap Stocks Have Performed Better During COVID
You can see in the chart below that the stocks of larger companies have performed better during the COVID-19 crisis compared to small companies.
Chart 2: Stock Market Size Style Performance
This is one of many reasons that the stocks of large cap companies have performed well compared to their small- and mid-cap counterparts. Larger companies will tend to be in more robust financial condition, on average, and have more abundant access to financing. Large cap companies, represented here by the S&P 500 index, recovered their year-to-date losses in about two months – although there is still uncertainty ahead.
For small businesses, most of which are not public companies, government programs such as the Paycheck Protection Program (PPP) and the Economic Injury Disaster Loan (EIDL), helped to provide a lifeline until they could reopen. But the story is similar – those that were not already saddled with debt and that were able to reduce their expenses, even if it unfortunately meant furloughing their staff – were in a better position to weather the crisis. Fortunately, there are signs that many businesses are bringing workers back when they, alongside local governments, determine that it is safe to do so.
Disciplined Businesses May Be Better Equipped to Survive Crises
Thus, one of the key lessons during the most recent crisis is an obvious one: Businesses that were disciplined with their financial situations were in a better position to weather the past few months. The stock market performance for many of these companies is consistent with this as well, since larger companies tended to have more sustainable levels of debt. This will continue to be important as the public health crisis and economic uncertainty continue.