(Following is a copy of Memo shared with subscribers of SA’s Model Portfolio)

Starting this earning season i.e. of Q4FY20 (& beyond), we would hear a lot of exceptional items in the form of loss of revenue and profits due to lockdown, increased operating expenses, changes in the way businesses operate, etc.

For some businesses like Wonderla Holidays, the impact of lockdown is extreme – All its parks are closed and revenue will be zero until they reopen, while a significant cost base is fixed in nature (salaries & maintenance) so the company will report losses for this period. On the other extreme, there are a few businesses in our portfolio from agro-chem/pharma sectors for whom it is literally life as usual. In reality, most of the businesses will lie somewhere in the middle – there will be a significant drop in revenues however it will not be zero like Wonderla, and with some cost control they may avoid sliding into losses.

The other pertinent dimension to consider is the timeline to recovery. Again, for a business like Wonderla the recovery could take long, maybe a couple of years, whereas for some it could just take a few months or quarters. Once the economy is completely opened up, for the vast majority of our portfolio companies the normalcy should resume within a year.

Lockdown Impact on Intrinsic Value of Businesses

Before we get to impact on business values, I’ve got a small exercise for you. Let’s assume you have decided to invest in agricultural land and after considering various options around your city you have got your eyes on a particular land parcel. To arrive at a fair valuation, you have considered prevailing market price in that region but since you are a long-term value investor who wants to actually do farming on that land, you use yield method to determine its fair value. Based on the long-term average, this land produces agricultural commodities worth anywhere between Rs 40,000 to Rs 50,000 per annum per acre. You prefer to buy it at a yield of no less than 4%, and accordingly, you make an offer to its current owner of Rs 10 lacs per acre. He accepts your offer, you pay him in cash from your own pocket (without resorting to any loan), and the farmland is yours.

Unfortunately, the following year experiences a major hailstorm that destroys the crop just before the harvest, giving you zero revenues in that entire year. On top of that, you had incurred expenses on procuring seeds & pesticides and labor charges, etc. which have all turned into irrecoverable losses.

Now an opportunistic stranger walks up to you and offers you Rs 5 lacs per acre for the same piece of land which optically may look like a good offer given the gloomy environment, but is it? Think about it. How would a one-year loss of revenue affect the value of the land which has the potential to offer you farm produce for an indefinite future? The 4-5% yield also has the potential to increase if you re-invest annual surplus in farm mechanization, rotate to different high-yielding crops, deploy new technologies like drip irrigation, etc. Under any circumstances, can the capital value of your land erode by 50% just basis one year’s loss of revenue?

This is exactly what has happened in equity markets; stock prices in many cases have crashed as much as 40-50-60% even though the drop in the intrinsic value of the underlying businesses maybe just a fraction of it, of course assuming they are not leveraged a lot and have a business model that will stay relevant.

We are confident about our portfolio companies to not only survive this storm given their strong balance sheets but also thrive on the other side. However, 2020 will be a year of lost harvest for some of these. We have to be mentally prepared to read horrifying P&L Statements and yet retain the sanity that its impact on intrinsic value may not be that material. We can’t panic and impulsively sell our valuable stake at a distressed price, rather this is the time to sit tight on those attractive assets.

Jatin Khemani, CFA
Founder & CEO,
Stalwart Investment Advisors

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