Coronavirus seems to have no sign of abating with the US becoming the worst hit country with over 20,000 deaths. Life is such an irony that with such technological prowess and economic might, it seems so helpless when the death toll keeps rising everyday. This is a very powerful psychological attack around the world – if the Humpty Dumpty can’t handle this, what’s going to happen to the rest of the less prosperous countries if they get hit? Understandably, market sentiment is terrible everywhere and this could well be an understatement.

Off the top of my head, I can imagine a few industries getting hit really badly – airlines, hospitality, retail and real estate. Over the years I’ve gathered some general understanding of their underlying economics that instinctively tells me whether I should stay away or dive in. There are undeniably some great companies within these industries but it’s not easy to correctly identify them and I prefer to look at something easier. After all, there are thousands of choices in the market.

Airlines

I’ve always thought that an airline is one of the toughest businesses on earth. It’s generally a hospitality business whereby you go through lots of pain to introduce top-notch customer service in a consistent manner. At the same time, it is very capital intensive and super competitive. There is very little brand loyalty as most of the travellers I know will not hesitate to go for cheaper fare regardless of which airlines serving the same route. Therefore we often see airlines invest heavily in marketing and loyalty programs to make sure they generate enough volume to support their massive fixed cost.

Even if you managed to build a super efficient organisation, you will still face several headwinds beyond your control – change in fuel price, regulations (it’s a heavily regulated industry) and currency fluctuation. Hence it’s not unusual to see airlines dabbling in the financial market by executing various derivative contracts to hedge their risks. These financial instruments become another distraction because they often cut both ways. In short, to make an airline successful, you need to do a lot of things right, all at the same time even though some of them are beyond your control. Imagine you pass 10 rounds of job interviews only to get rejected in the end because they don’t really like your face. You will get similar emotional pangs by running an airline.

Property Development

Property development is a very cyclical industry and it’s exceptionally tough in the current market condition. A lot of people think property development is sexy because of the huge profit reported and, to a large extent, the lavish lifestyle of property developers. Most of them look at reported profit, which is usually high, but conveniently neglected other parts of the financial statements. It’s not unusual to see property developer generate high profit, but poor cash flow coupled with high level of debt. Most developers construct new buildings based on the availability of credit before they consider the market demand for their products. There is this subconscious thinking that when you build, then the buyers will turn up and whatever not sold will become valuable assets.

A little example will help us understand why a developer has poor cash flow. Let’s say you build 2 houses that cost RM500,000 each and managed to sell one for RM800,000. It shows a nice profit of RM300,000 on the income statement but you suffer a negative cash flow of RM200,000. In the meantime, you probably have to dig out your saving to pay income tax charged on the RM300,000 profit you just made and cover all the existing overhead. Try asking a banker how much a developer usually wants to borrow and the answer could be the maximum the bank is willing to lend.

I find it hard to analyse the cash generating ability of most public listing property developers. Real estate projects usually take 3-5 years (some even longer) to materialise and developers are expose to all sorts of changes in the market demand, lending practice, government policy, construction cost, interest rates and competition which are very hard to predict. Revenue and profit reported during the project cycle are very much dependent on management’s estimate due to the accounting rules which in this case, could be very different from reality. At the same time, there won’t be enough public information disclosed on each project to allow proper assessment of the overall health of the developers. You won’t be surprised to see a developer with bloated inventory which doesn’t get written down (property value can only go up, isn’t it?) and growing amount of debt collateralised by the same asset. Bankers love to accept the these “hard assets” because their credit committee checklist allows it.

Retail

Retail is also a tough business but it’s one of my favourites during a crisis like this. Most of the counters got sold down so badly that the price is way below intrinsic value. The general thought is that retail earnings will get hammered badly because of the 6-week complete shutdown. Shoppers are expected to be more cautious when it comes to shopping in case the virus is still lurking around and they might even shift to online shopping permanently.

That is true in the near term, possibly in the next 12 months. I don’t know how long exactly this will last but I expect retail to be one of the first to recover after the crisis is over. Malaysians are generally addicted to shopping malls because they can get whatever they need there and the hot weather generally stops them from going to the outdoor park. Try asking a typical family in Klang Valley how they spent the last weekend and you know what I mean. Online shopping is popular but what about family activities while you are busy browsing the websites?

The thing I like about retailers is the relatively understandable and predictable business model. Retailers also enjoy negative working capital which is essentially free money to finance the operation. Due to the asset light model, the return on equity can be rather attractive and there are no cumbersome capital expenditures that eat up free cash flow. At the same time, you generally don’t see too much debt loaded on retailers and that’s probably because they don’t have many hard assets to show the bank in the first place.

There are of course certain downsides face by retailers, such as thin margin, huge competition (especially e-commerce), currency fluctuation, inventory obsolescence etc but I think these are relatively more manageable compared to problems like regulatory risks. I generally don’t like highly regulated businesses because a lot of things are beyond control and they are exposed to political changes as well. Retailers, in my opinion, have less things to master in order to do well, unlike the airlines industries. Why is it important? Imagine you need to solve 10 questions to pass an exam and you have 90% chance of getting each question right. It sounds rather favourable but your probability of passing the exam is only 35%. I would rather go for an exam which only has 2 questions with 70% chance of getting each right – 49% chance of success.

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I don’t think it’s a no-brainer to simply invest in any retailers because each has very different fundamentals. By narrowing down to one industry does not mean I adopt a macro analysis because that’s a totally different angles which has far lower chance of success, at least according to my own ability. I’m just trying to narrow down my focus because this industry seems to be most feared at the moment. It’s not easy to be contrarian but the reward is there if you get it right.