In this series of videos, our research analysts discuss how the global spread of the COVID-19 coronavirus could affect various sectors and what investors should be considering amid rising volatility. Joshua Cummings addresses consumer stocks, David Chung gives his views on industrials and Jon Bathgate offers insights on the outlook for tech companies.

Key Takeaways

• Within consumer stocks, it is difficult to assess the impact of the virus on bottom-line results or short-term valuations, as the market is still waiting to see when the situation will bottom and then start to improve. While the outbreak could affect near-term fundamentals – particularly for companies with direct operations in China – we think it is unlikely to have a material impact on the long-term value of most businesses.
• The coronavirus outbreak has stalled factory production and disrupted the supply chain within industrials, causing the sector to revert to the level of uncertainty that dominated 2019 before trade discussions calmed and consumer sentiment lifted. Against this backdrop, we think investors should focus on finding companies whose earnings and cash-flow potential is higher than what the market has priced in amid the sell-off.
• Technology companies started the year in recovery mode, planning and investing for growth in 2020, but renewed uncertainty related to the global spread of COVID-19 has clouded that outlook. Regardless of the near-term outcome, we believe long-term opportunities in the tech space remain robust, especially as semiconductors are building blocks for secular growth trends such as artificial intelligence, the Internet of Things and 5G.

View Transcript

Joshua Cummings: Consumer stocks have done about as well or as poorly as the rest of the market; they don’t stand out in any meaningful way.

In order of magnitude, clearly the most impacted names are companies that have either stores or a big, direct consumer presence in China and Hong Kong. So, think luxury companies, luxury goods, things like that. Travel has obviously been significantly impacted, not just because of travel restrictions within Asia. It’s more about the outbound travel from Chinese consumers. Chinese consumers are where all the growth is coming in terms of global travel, and so to the extent that they’re not traveling, that has a massive impact on European hotels, U.S. hotels, cruise lines, a variety of travel-related businesses.

Within staples, companies that have direct operations in China are obviously feeling a sales impact. But for the most part, global staples companies have fairly modest exposure to the most impacted parts of the world, at least at this point. Supply chains in staples, not really as much about China. It’s the more discretionary items that tend to be woven and constructed and labor-intensive in their manufacturing, where the exposure to China lies.

For more discretionary types of purchases, things that are seasonal, like apparel, footwear and toys, I think it’s unlikely that the sales will be made up. For consumable items, I think it’s just a deferral of activity. But things you have to make reservations for, like cruises or vacations, if you’re booking a family vacation months in advance around a school vacation or something like that, those are going to be difficult to make up.

As to whether we’re finding more or less value, tell me when the situation is going to bottom. Right, so we’re still operating in a complete information vacuum here. So, all stocks are theoretically cheaper, but we don’t know yet what the impact of this virus is really going to be on bottom-line results, so it’s pretty hard to assess short-term valuation. What the market obviously is wrestling with now is duration. Initially, we saw some of our global luxury companies warn on the impact of the coronavirus, mostly as a result of their direct selling operations in China and in Hong Kong. But when they gave that guidance, obviously, they have no idea when the situation is going to bottom and start to get better. So, every day that that doesn’t happen, earnings risk increases.

What’s interesting about this episode is it represents both a supply-side and a demand-side shock. We’re now living in a world of social media. And so, the transmission of information or misinformation in some cases happens in a much more fluid way than it has in the past. There’s a couple of takeaways: Maybe these situations come and go quicker than they used to. Maybe the reactions in the financial markets and risk markets are more sudden and dramatic. But over the long term, I think the net result is the same, which is these episodes tend to come and go, they impact near-term fundamentals, but they don’t impact the long-term value of the businesses.

At Janus Henderson, we’re intently focused on the long-term fundamentals of our businesses, and we are not inclined to react to short-term news around a virus that is highly likely to prove transitory. Over the long term, events like this don’t tend to materially impact the value of the businesses in our universe.

David Chung: In Q4, all the earnings results were in mid- to late-January, primarily, which is right when the first cases began, and so most companies that guided to Q1 in terms of financial performance talked about the Chinese Lunar New Year extending one or two weeks past the original date, and over the past couple of weeks, clearly the situation has intensified, and so the ramp of factory production has been much slower than people initially thought. What we’re hearing is between 50% to 75% utilization. Most factories are up and running, other than the Hubei province, for the most part, but clearly the supply chain is disrupted, the ramp-up in factory production has been stalled. Where we’re more worried about, in terms of potential damage, is just how does this spread to Europe. Germany, in particular, is a much bigger industrial base than Italy or even South Korea, so we’re watching it very closely.

Unfortunately, things were actually getting a lot better, despite all the back and forth on the trade war, especially with the December Phase 1 trade deal, announced back in December. PMIs [purchasing managers’ indexes] and global confidence and manufacturing sentiment was actually improving quite a bit. So, this is unfortunately a sort of a shock to the system that sets us back to kind of that world of maximum uncertainty of where we were for most of 2019 before the trade discussions calmed.

By far the biggest one is travel and airlines and clearly whether U.S. airlines have a lot of travel, flights to Asia Pacific. So that’s clearly the one that’s been the biggest hit. For a lot of large cap U.S. industrials, they are multinational companies with big footprints, both factories as well as customers in China. As so, airlines is the big one, but it’s really all throughout industrials, as the world, as the industrial production base has broadened globally, it’s really hard to kind of escape China.

I think for airlines, for example, the most important question is as long-term investors, we look at the future cash flows of the company, and what we’re focused on is will this make global travel less appealing to folks? Do people look inwardly and do more domestic travel vacations and business trips, does it go to more virtual calls? And so, to the extent we have a more negative view on that, that would affect our views of, kind of, stock prices.

I think within the traditional industrial complex, waste and trash disposal is one that would be immune; it’s primarily a U.S. business. You would have to go multiple layers to hit U.S. consumer sentiment before people stop eating at restaurants and buying houses and lower volumes, so, that would be one area. We’re focused on if the supply chain disruptions happen, what happens to input prices. I guess from an academic perspective, if the supply were to fall, demand falls as well, so maybe the equilibrium price change is unimpacted, and so, that being said, if there are pressures on input costs, we, similar to our investing philosophy, we’re focused on companies that have pricing power and can pass those on in these kind of situations.

And I think that’s where we’re focused, that’s where the bottom-up stock-picking research really shines, is we’re trying to find companies where that earnings power, the cash-flow power is maybe higher than the market is discounting in this broad market sell-off. So, we’re really focused on those dislocations, even as the valuations have come in and there’s uncertainty about earnings and free cash flow.

Jon Bathgate: The coronavirus impact on tech has been more pronounced on the tech supply chain and semiconductors and hardware and names like Apple. And I think coming into the year, there was a general mindset for investors in the supply chain that we were in a recovery phase following a pretty tough 2019, and the coronavirus has really created some near-term uncertainty around the trajectory of that recovery from here. And so, it’s both a supply and demand issue and companies’ inability to meet demand globally because they manufacture a lot of products in China, I think, are a problem for the tech supply chain. In addition, China is a large demand driver for a lot of products that carry a lot of electronics and so the demand perspective from China, as well, is a little less certain than it certainly was six weeks ago.

One thing that’s been an outcome of the tougher 2019 that the supply chain had is inventory throughout the entire supply chain are at historically low levels. And so, usually what creates the boom-and-bust cycles in the supply chain are elevated inventories. And so, since we’re coming off historically low inventories, I actually think that creates a little bit of a dampening effect. But certainly, a lot of companies are investing for growth and were expecting positive growth in 2020, and so given the demand uncertainty, I think that just really clouds companies’ outlooks and certainly impacts the way they’re going to manage the business from here.

I’d say, from the semiconductor ecosystem, what we’ve heard is a lot of companies are expecting just kind of zero sales of goods into China in the month of February. And so, you’re talking about no one is buying cars, smartphones, no one’s building factories or putting in heavy equipment, and so I think there’s a little bit of a hope that February will be kind of a month of literally zero sales and then we’ll see a pickup into March. But this situation remains fluid, obviously, so we’ll see how things track from here.

From what we can tell right now, I think most of the demand that we’re seeing kind of move out of the March quarter will probably be made up in the June quarter or in the second half of the year, just with the mindset of, if you’re a consumer and you need to buy a new smartphone and you were going to be in the market in February or March, you certainly will still need to replace that device next quarter or later in the year. Similarly, I think most factories are being built with a mindset of demand for the back half of this year and 2021, so I think you should see, kind of, factory automation activity pick up as well. I think the key caveat is as the virus spreads globally, do we see a strong enough economic impact where it really impacts consumer and business spending? I don’t think we’re there yet, but that’s certainly … the potential for that rises as the virus keeps spreading.

Growth software, in general, has been relatively insulated. I mean, I think it’s been impacted by just kind of the risk-off mindset in the market. But these are recurring revenue business models that are largely U.S.- or kind of Western Europe-centric, and so, in terms of an impact to the fundamentals near term, it’s pretty unlikely that you would see that in someone like a Microsoft or an Adobe. They’re relatively insulated. I do think this, the whole virus impact, has brought up more urgency for companies to look at the way they just communicate globally and potentially looking at more unified communications or video conferencing or things like that. And so you’ve seen some pockets of strength within tech around collaboration and, you know, basically, if we’re not traveling, then we’re doing video conferencing instead. That’s benefited a small handful of companies as well.

Certainly, valuations have come in over the last few days. I think for context: Just coming into, I would say, the coronavirus scare and coming off of the Q4 earnings season, valuations for a lot of the tech supply chain was at historical highs. And I think that was really in anticipation of a recovery, following a really difficult 2019. And so, that was already being priced into investor expectations. We’ve certainly seen a pullback in stocks and declines in valuations accompanying that. But I would say we’re still toward the relatively high end of history, and so it will really just depend on how the year plays out.

I think investors should be looking at companies with strong free cash flows and strong balance sheets that really can be successful in any economic environment, because we could be, six weeks from now, back in a strong recovery phase; that the coronavirus impact is relatively manageable. Or we could be in a recession, so I think we just need to be mindful of all those potential outcomes and just own companies that can be strong in any environment. And we’re also mindful that semiconductor companies, especially, are the building blocks for secular growth trends in the economy that are going to impact the economy over the next five to 10 years – like artificial intelligence or the Internet of Things or 5G – and so we’re mindful not to be too scared out of what’s going on in the near term because the long-term opportunity is still so robust.

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