OTOS Quarter-End Investor Letter Q1 2020
This is the last update of the first quarter 2020 and only 10 companies reported financial statements last week. What a fascinating quarter it was, with index weighted sales growth stabilizing at 7.4% down from 14% last year. Nearly 50% of companies recorded an improvement in sales growth. It was the second quarter of last year when the proportion of index market capital accounted for by rising sales growth companies dropped to an unusually low 23% and that was our clear sign of a growth slowdown.
Coho Capital 2Q20 Commentary: Podcasts, The New Talk Radio
Coho Capital commentary for the second quarter ended June 30, 2020. Q2 2020 hedge fund letters, conferences and more Dear Partners, Coho Capital returned 46.6% during the first half of the year compared to a loss of 3.1% in the S&P 500. Many of our holdings, such as Netflix, Amazon, and Spotify, were perceived beneficiaries Read More
The Index Average Gross Profit Margin
In the third quarter of 2019, the index average gross profit margin was also down on average and more frequently. That lower growth trend continues into the recent 2020 quarter with the average gross profit margin down more steeply. The broad market index price is more than 80% correlated with the average gross profit margin. The end of every market decline in the past 30 years has been anticipated by an improvement in the index average gross profit margin.
Use the recent market strength to reduce portfolio exposure to falling sales growth and falling gross margin companies, (Red trunk of the MoneyTree and Red top rim of the MoneyTree Pot) particularly those trading at premium prices (Red price report).
The quarter ending this week will be the most fascinating ever. The first quarter is ended March for most companies, so the virus impact was only one month. The upcoming quarter ended June will have 3 months of virus impact. That might give us a measure of the bottom. If reopening proceeds, then the third quarter ended September will give a measure of the shape, strength, and breadth of a recovery.
Many companies recorded a steep drop in financial condition, and it is very likely that the recent ripple of bankruptcies will become a wave. Even if the recovery from the virus is steep and even if it has already begun, many high debt companies will be in default before the recovery can lift cash flow. Companies have already begun to conserve cash. Even at the index average company, SG&A (fixed operating) expenses fell enough to produce an increase in the average EBITDA (operating) profit margin even with gross profit margins down. (Total Index MoneyTree top rim is Red [down] while bottom rim is Brown [up]).
Reducing Or Cancelling Dividends
Companies have very limited scope to reduce costs and many have already reduced or cancelled dividends. We must expect a steep drop in sales growth in the coming quarter. It is the profit margin that will drive our decisions. Last quarter companies sustained an improvement in the EBITDA profit margin.
Can companies reduce costs enough in the second quarter to shore up cash flow and improve their financial condition?
Could the decline in the gross profit margin of US companies that began in the third quarter of 2019, before the virus, be a multiyear trend?
The all-time high gross profit margin achieved by US companies last year was the result of years of efficiency gains that US companies generated in global trade. It was also the result of a widespread shift to subscription pricing. Gross profit margins are down in the recent quarter on average and more frequently.
Will the disruption in global trade clobber the margin again?
Will people review their subscriptions and reallocate?
Can companies reduce costs fast enough to protect cash flow and meet their financial obligations?
There will be solid evidence to support an answer to those questions in the upcoming second quarter 2020 financial statements. It will be mid-August before the update is complete enough to venture an answer.
Meantime, look for rising sales growth and rising gross profit margin companies where shares are trading at a discount price. Many of these companies will have weak financial condition (a wobbly pot).
Be careful that cash flow coverage of the dividend is good (greater than 2). Verify that rising cash flow is funding improved financial condition (make sure it’s a Golden pot and a Green globe of the tree).