What hoarding toilet paper teaches us about stocks

We don't know how fast the coronavirus will spread, or how soon it will hit our communities, but we'd sure feel better if our homes were well-stocked with toilet paper, hand sanitizer and canned food. 

The same logic applies to stock investing. No one really knows the full impact of the virus, what it will do to supply chains or how hard it will hit consumer demand. But we are starting to appreciate companies with healthy balance sheets. Cash is king once again. 

Pinched by the virus and an oil price war, fundraising in the US junk bond market is getting harder, with spreads over Treasuries rising sharply. A renewed focus on credit quality is now spilling into stocks. During Monday's sell-off, companies with lower leverage fared better. In an analysis of US-listed companies, the least indebted — as measured by leverage ratio — outperformed the most indebted by 3.2 percentage points, according to data compiled by Bloomberg.¹

For now, balance sheet health doesn't appear to be priced into equity valuations at all. And why would it? The Federal Reserve's monetary policy has stayed loose since the collapse of Lehman Brothers Holdings Inc.

In the last seven years, investors have favoured growth stocks and those with share-price momentum — electric vehicle maker Tesla Inc., for instance — while value names got the kiss of death. Leverage, on the other hand, hasn't featured much either way. 

As the virus spreads, however, credit quality will start to matter more in the US During previous earnings recessions, investors held onto companies that offered good income in the form of share buyback yield, dividend yield or even free cash flow yield, analysis from Bernstein Research shows. But what's the point of looking at historical free cash flow if the coronavirus disrupts the supply chain? No matter how profitable a business model, a company won't be able to sell anything with entire regions on lockdown. When a black swan arrives, only those well-stocked with cold, hard cash can survive.

To determine how leverage affects stocks, look no further than China, where the virus originated. 

In the past decade, the People's Bank of China hasn't been as generous as the Fed, alternating between opening and closing the money tap, and experimenting with all sorts of lending facilities to target liquidity to pockets of the economy. Starting in late 2017, officials declared war on shadow financing, an important funding channel for private enterprises.

As a result, a company's leverage ratio is what really matters. In the past year, the least indebted companies on the benchmark CSI 300 Index outperformed the most leveraged by a whopping 21 percentage points, according to data compiled by Bloomberg. 

To be sure, the Fed wants to keep liquidity flowing, having already cut 50 basis points this month, and is expected to slash its policy rate further at its next meeting. But as we've already witnessed this week, with credit spreads soaring, a lower benchmark rate doesn't necessarily mean financial conditions will ease. 

In the fall of 2018, when Beijing was in the throes of its shadow-financing crackdown, real estate titans hoped they would merely get by. Investors took notice, treating stocks more as a call option on survival than a bet on earnings growth. While the US is by no means at that level of distress, it's time for investors to factor in leverage as well. As we all know, only the most diligent squirrels hoarding nuts will make it through a long, harsh winter.

¹ For the factor analysis, we looked at the top and bottom quintile of companies by leverage ratio.

Disclaimer: This article first appeared on Bloomberg.com, and is published by special syndication arrangement.