The emergence of the novel coronavirus (nCoV) has serious short term consequences for growth and demand in China. In this journal we address the financial position of the stocks in the TM Cerno Pacific portfolio and their revenue sensitivity to a protracted downturn in activity within China.
The situation has naturally led to parallels being drawn with the SARS epidemic of 2003-04. While the pathologies are linked the context exhibits marked differences. At this stage of endemic spread, some caution is warranted when extrapolating outcomes for nCoV.
In our recent Investment Letter, Camus and all that, we discussed these points of difference. China was just 5% of global GDP in 2003 vs 17% today. The measures put in place by the Chinese government, most notably the quarantining of entire cities, are more severe and restrictive than applied during SARs.
Beijing’s approach to nCoV is akin to corpus calloscotomy, or split-brain surgery, whereby the link between the two hemispheres of the brain is severed to prevent the spread of seizures from one to another in patients with severe epilepsy. A drastic measure which is effective in its targeted goal but risks long lasting adverse consequences. Aside from the tragedy of human lives lost, it is this abrupt severing of the factors of production from each other and their respective global supply chains which points to a deeper fallout than 2003.
In periods of economic stress, balance sheet resilience is essential. In the Cerno Pacific Fund, we invest over the long term in a concentrated portfolio of innovative businesses. Balance sheet strength is a factor we consider. Strong balance sheets provide a key strategic advantage, allowing businesses flexibility to take advantage of opportunities as they arise and potentially emerge stronger competitively from any crisis.
The Net Debt/Equity position of the fund sits at -15% (i.e. net cash), as exhibited in the table below, which compares favourably to broad Asian and the World Equity indices.
Three-quarters of the portfolio companies are net cash, with generally resilient cash flow patterns to service liabilities during this period of economic disruption as a going concern. Most of our companies have well covered interest (median interest coverage ratio at 201x) and generous free cash flow margins of 11%.
With Chinese companies accounting for over half of the fund and China representing 45% of the underlying revenues generated by invested companies, earnings will inevitably suffer, to varying degrees, from the outbreak.
Consumer and services companies are the most directly affected, reflected in our exposures to Trip.com, the largest Chinese online travel ticketing platform, and Kose, a Japanese cosmetics retailer, both suffering a sharp drop in Chinese tourist demand. Internet based companies should fare better, such as Bilibili and Tencent, as citizens self-quarantined at home turn to online streaming or gaming for entertainment. Healthcare names should also witness limited downside impact.
The more significant second derivative effect will be manifested in industrial suppliers, representing over 40% of the fund, who have customers or manufacturing bases in China, or both. The outcomes for these businesses will be more uncertain, and the magnitude of the economic impact will depend on how soon China’s workforce can normalise after the extended Spring Festival holiday period. Whilst 10th February is the due date for workers to return to their posts (for all provinces except Hubei, which is 13th February), we are doubtful whether these dates will hold, given the continuing rapid spread of the virus.
Hubei province, with its capital city Wuhan, being the epicenter of the outbreak, is home to the China’s optoelectronic, semiconductor and auto industries. Notably, Korea’s biggest automaker Hyundai just announced suspension of all three of its domestic plants as factories shutdowns in China is squeezing its auto part supplies. Several European and US automakers have warned of the same.
Hubei is also a large source for migrant workers for coastal cities (Zhejiang/Jiangsu) and pearl delta (Shenzhen/Guangzhou) factories. If workflow is forced to be interrupted further, China’s position as an integral link in the global supply chain will be tested.
Markets entered the year at elevated valuations and proceeded to extend further. The novel coronavirus may be the excuse needed for a reset. Nevertheless, the companies in the Cerno Pacific portfolio are well placed to withstand this turbulence. Their prospects over a longer time horizon are bright. It is our observation that many of the most innovative companies globally are originating in Asia which is the focus of this portfolio.