Broker Check

Why Balance Sheets Matter

| May 07, 2020
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                The eruption of the coronavirus known as COVID-19 caused a rapid market crash reminiscent of 1987. The background causes were different, but the results were similar. The market fell about a third in a short period of time. In 1987, the market bounced and then grinded modestly higher. This time, the market recovered half its losses in a short period of time. The S&P 500 is only down 11.83% year-to-date through May 6th. The Standard & Poor’s Midcap 400 Index and the Russell 2000 Index both of which include many smaller, more leveraged companies than the S&P 500, are down 22.75% and 24.30%, respectively as of May 6th closing prices.

            The market’s bounce has been led by well-known names with strong balance sheets. The reason for this is completely understandable. A complete shut-down of a large part of the economy has never been tried before. Revenues crashed for many companies and industries and cash-flows disappeared. Hotels went from high occupancy to close to zero overnight while restaurants shut their doors indefinitely in some cases and permanently in others. Cash has been king in weathering the storm. If you look at a breakdown of the S&P 500 Index, companies with the highest credit ratings by Standard & Poor’s have outperformed those with lower ones (see chart). It should be noted that not all companies in the index are included in the calculation. Companies not rated by Standard & Poor’s were excluded.

          

Nobody knows when the economy will return to normal and when or if a cure will be ready. NPP thinks that unless a vaccine is found shortly, it will take the economy a few years to get back to its previous peak level. Many small businesses have closed or will be forced to close and new businesses will not replace them overnight. We think cash and balance sheet strength, will remain king. The lower-rated companies will need to or already have diluted current shareholders with debt and/or equity offerings if they can find investors. While they struggle to stabilize, the larger and better capitalized companies can invest for the eventual recovery.

         We’ll likely need a COVID-19 treatment or cure before the economy comes roaring back. Until then, large companies with solid balance sheets should continue to thrive and outperform. This has been a persistent trend since 2009 and is the reason NPP has emphasized large companies with good balance sheets and will continue to do so. One caveat is that once a recovery becomes imminent, it’s likely some of the companies with weaker balance sheets will start to outperform assuming their businesses are not permanently impaired which is consistent with historical patterns. As investors become willing to take on more risk, they look for beaten down lower quality names. We suspect that any snapback in lower-quality companies will be short-lived after the initial bounce. This is still a domestic and global economy short on growth, and after a temporary pause, secular growers with good balance sheets are likely to resume their outperformance.

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