Jonathan Tepper, Chief Investment Officer of Prevatt Capital, warns that today’s unprecedented monetary stimulus programs make the financial system more vulnerable. He advocates a quick re-opening of the economy, and spots attractive investment opportunities in travel-related companies such as Expedia and Zurich Airport.
After weeks in crisis mode, some European countries like Switzerland are getting ready to re-open their economies. According to Jonathan Tepper this is the right thing to do.
The founder of the investment boutique Prevatt Capital argues that shutting down significant parts of the economy hardly stops the virus and does more harm than good. Instead, he advocates a targeted approach with extensive tests, rapid tracing of infections and a strict isolation of people who test positive for COVID-19.
Tepper who is about to launch a new investment fund focused on family offices also criticizes that today’s unprecedented policy interventions make the financial system susceptible to renewed upheaval: «Central banks are promoting moral misconduct,» he thinks.
In this in-depth interview with The Market/NZZ, the highly regarded thought leader draws parallels between the recent market crash and the catastrophic wildfires in Southern California. Additionally, he explains why he avoids stocks of oil and gold companies and why he spots investment opportunities in travel-related companies such as Zurich Airport and Expedia.
Mr. Tepper, it’s now two months since the outbreak of the pandemic started rattling the financial markets. What’s your take on the situation today?
The coronavirus is obviously a huge exogenous shock, as economists call it. We haven’t really seen anything like this going back to the Spanish Flu in 1918. Even previous virus outbreaks, whether it’s the Hong Kong Flu in 1968, SARS or MERS, didn’t cause governments to shut down entire economies. So you see sudden stops in terms of production and traffic or closures of retail stores and restaurants. It’s truly unprecedented.
What’s going to happen next?
The economy is very similar to a patient: During the Spanish Flu for instance, most people died because of the immune response to the virus and not necessarily because of the virus itself. Right now, the economy is a patient who is in danger of dying due to the response from policy makers more than from any damage the virus itself may cause. That’s why I hope that we lift the lockdown quickly. If we don’t, then I think there is an awful lot of businesses that will go bust and we probably will kill the economy in the process.
But in places like Italy, Spain or New York we learned how quickly these outbreaks can get out of control, overwhelm entire healthcare systems and cause many people to die.
I’m not an epidemiologist, but according to the data the COVID 19 disease overwhelmingly affects the very old and people with multiple underlying medical conditions. Almost all of the people who died were 70 and older, and over half were 80 and older. This virus doesn’t really affect anyone under the age of 30. And, only 1% of the people in Italy and Spain who have died or who have been hospitalized are under 45.
Still, shouldn’t we as a society protect the people that are most at risk?
Shutting down the entire economy will not solve the problem. So far, the policy responses in most countries are not targeted. They fail to tackle the source of the crisis and will do little to contain future outbreaks. The cardinal rules for public health specialists fighting epidemics are: Test, Trace, Isolate and Identify high risk groups. Yet most countries have broken every rule. Hospitals and retirement homes are one of the main transmission vectors. Little has been done to make sure that people are isolating, rather than visiting hospitals. Doctors and nurses still lack proper protective equipment, and many hospitals are still mixing Covid-19 patients with those who are not infected. Until we properly diagnose the problem facing us, we will not emerge from this crisis. The virus will continue to spread, and economies will collapse. Millions of citizens are paying for this calamitous misunderstanding with their livelihoods.
Which parts of the economy are most vulnerable right now?
Clearly, the pandemic is a catalyst for many underlying trends: A lot of companies had high degrees of leverage and didn’t save much money in terms of cash on the balance sheet. So any disruption in the debt markets or in their business would immediately lead them to go bust whereas companies that are better capitalized would be able to ride this out. Now, the coronavirus is speeding up some of these trends that were already in place.
Central banks and governments are trying everything to soften the blow to the economy. What are the chances that we can avoid an economic depression like in the 1930s?
It’s very interesting that the Federal Reserve is going to be buying high yield bonds and high yield ETFs which are essentially packaged bonds that trade. The underlying bonds of these ETFs are not very liquid since they generally have been a pretty big ticket. For example, the average person can’t just go and buy some bonds of a high yield oil driller. Yet, hundreds of these bonds get packaged together and then people expect sort of second by second liquidity in financial markets.
With these kinds of interventions, the Fed is trying to loosen tensions in the credit markets. What’s wrong with that?
Why the Fed should step in and buy these bonds is beyond me. It’s probably illegal under the Federal Reserve Act. But also: Why should the Fed be stepping in and bailing anyone out? This is not even money going to companies. It’s just liquidity in the secondary markets. In many ways, this situation is similar to the mortgaged backed bonds and the problems with the underlying mortgages in the previous crisis. It underlines the point that the system is generally being geared toward creating greater efficiency even if it means creating greater fragility. In theory, by being able to trade high yield debt quickly, markets can be more efficient. But in fact, they get certainly more fragile.
What do you mean by that?
When it comes to risk, one of the key insights we get from the physical world are forest fires in Southern California. Southern California looks very much like Baja California in Mexico. Both regions have a similar climate, geography and vegetation. Yet, the US side has almost no frequent small fires and occasional catastrophic large wildfires. In contrast, the Mexican side has many frequent small fires but almost no major catastrophic wildfires. One of the main reasons for these different outcomes is undergrowth: If you let it build up over time, it makes the eventual fire all that much greater.
And where’s the link to monetary policy?
Risk is like undergrowth: Suppressing small risks only makes them emerge eventually as very big ones. Over the last ten years or more, central banks have immediately launched QE programs or cut interest rates at the slightest weakening of growth or the slightest volatility in the financial markets. Essentially, what they have done is to allow a buildup of imbalances like the accumulation of debt at zombie firms that can’t afford to even service their debt. What we’re seeing now is that these underlying trends that have been going on for some time have been accelerated by the virus.
Then again, without accommodative monetary policy we would likely have experienced a recession already earlier on.
Central Banks are in the business of moral hazard. I do think that they have to help people out right now and make sure that short-term liquidity problems don’t become a long-term solvency crisis. But what’s very clear is that even in December 2018 when the market was down and there was no real threat of a recession on the horizon, the Fed immediately backtracked and started cutting rates. So we just know that central banks have been encouraging moral hazard. Certainly, we need a loose monetary policy right now. But my fear is that any volatility in the financial markets will just elicit a further central bank response.
So how should we tackle these virus-related threats to the economy?
Governments have a moral responsibility to help out companies if they’re mandating that they can’t open. That said, many companies would have a much better claim to being bailed out if they had behaved in a prudent way. When you’re paying out 100% of your free cash flow in the good years, it’s quite clear that you made absolutely no preparation for any piece of bad news. Just look at a cyclical business like airlines: Over the last thirty years, they’ve had two Gulf Wars, SARS, MERS and multiple other pandemic fears. Also, various airlines went bankrupt. So it really does smack of paying out absolutely everything they can in the good years and waiting for someone to bail them out in the bad ones. That’s really true for cruise liners which are owned by billionaires, many of whom live in Monaco. They don’t even represent the 1% like a wealthy engineer or doctor. We’re talking here about the 0.001%
What kind of structural changes to the economy are you expecting with respect to the pandemic?
We have to see how this plays out. But I think people always overestimate our ability to change. After 9/11, people said that no one will fly again. Sure enough, people were flying pretty quickly. I suspect that people still want to travel and go on vacation. The virus is not going to change that. I just hope that companies save a little bit more, and that we let all these zombie firms go bust.
What does this mean for investors?
From an investing standpoint, we’re in a very interesting time. Many stocks were very expensive before the outbreak. Now, there have been sell-offs in many different areas; whether it’s travel, retail or cyclical stocks. On the other side, high quality stocks are still very expensive. So there is much more dispersion in terms of valuations.
How do you position your new investment fund against this backdrop?
For many investors, markets provide entertainment, like watching and commenting on sports. For others, markets are like gambling, and even supposedly sound managers treat stocks like lottery tickets. For us, stocks are not lines on a screen that fluctuate and give us a sense of excitement as they move. Basically, all we need for a portfolio is ten to fifteen stocks since most stocks are simply not worth owning. Dozens of academic studies show that a small number of stocks produce almost all the gains in stock indices. In the US, the lifetime return has been negative for 40% of all stocks. Only 40% of stocks have even beat one-month Treasury bills.
Where do you spot opportunities in this challenging environment?
Travel is one, as I’ve just mentioned. I don’t think every travel stock in the world is going to go bust. Not all hotels are going to go bankrupt, although some may. And, you have a wide variety of other beaten down stocks like restaurants and entertainment. Some companies are better than others, certainly in terms of their debt position or how much cash they might have. So if you can find companies with decent balance sheets and a better competitive position, there are some very attractive stocks right now.
Any specific names you like?
Our new fund starts on May 1, so I can’t give you much information in this regard. But just look at the Swiss airport, Flughafen Zurich. I will bet you money that Swiss people will fly in and out of that airport after this crisis. Another good company is Expedia: pretty asset light, with strong network effects.
Network effects and other competitive advantages are usually an important concept for value investors. What’s your approach with regard to such kinds of moats?
Moats are a useful concept. But the problem with any useful concept is that eventually they get used and abused. One problem is that analysts fall in love with their stocks, and so they claim that there are moats there. It’s almost laughable that almost 80% of consumer staple stocks in popular ETFs have a Morningstar «Wide Moat» designation, and over half of consumer discretionary stocks and 64% of industrial stocks have a «Wide Moat Rating». But a brand is not a moat, neither is a first-mover advantage, scale or a high market share. These are not real moats or barriers to entry.
With that in mind, what sectors would you avoid?
In general, oil, gold and shipping are terrible sectors because anyone with a little bit of capital can drill a hole into the ground. Similarly, anyone with capital can order a ship and operate it. These industries tend to move in a boom-bust-cycle and are extremely asset intensive. Particularly in the oil and gold space, if you make any money with a find, you take all that money and put it into the next giant project. As a result, there is very little left over for the shareholders. It’s not that you can’t get very rich in these sectors. But it tends to be the owner/operators that make money, like the Fredriksen family in shipping. But the average investor doesn’t. As an average investor, the only way you can make money with such terrible businesses is to find someone else to sell your shares to. In other words: If you buy a bad business, you need a greater fool to buy your shares from you to make a profit. But at Prevatt Capital, we do not intend to rely on fools to make money.