Views From the Floor

High multiples often collide with reality – just ask Scott McNealy; crowding in EM currencies may be cause for concern; and the impact of the coronavirus on catastrophe bonds.

What Are We Thinking? The Scott McNealy Principle

On 1 April, 2002 (after the TMT bubble burst), Scott McNealy, the CEO of Sun Microsystems, was interviewed in Bloomberg Businessweek. The interview provided one of the great CEO quotes of all time, a cautionary tale on the dangers of stocks trading at high price-to-sales (‘P/S’) multiples:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at USD64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

Figure 1 shows the subsequent trajectory of Sun Microsystems’s stock price (and doesn’t capture their ultimate problem: being outcompeted by Microsoft and the personal computer, and giving Java away for free). Nevertheless, today there are 35 stocks in the S&P 500 and Nasdaq Indexes, with P/S multiples of more than 10. Food for thought.

Figure 1. Sun Microsystems Stock Price

Sun Microsystems Stock Price

Source: Bloomberg, time period: 1996-2006. The organisations and/or financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation for their purchase or sale.

Cause for Concern: Crowding in EM Currencies

For some emerging market (‘EM’) currencies, positioning is now so extreme that it is at the 99th percentile long from a historical perspective. This gives us cause for concern for two reasons.

First, EM currencies look cheap on a standalone basis. However, when you look at the fundamentals – in this case, current account balances, which is a measure of whether the country is a net debtor or creditor to the rest of the world – it doesn’t imply that currencies are cheap. If they were that cheap, the current account balances should be positive (a cheap currency means countries import less and export more, which leads to a positive trade balance. Note that trade balance is one of the main components of the current account). Yet today, they are still negative. This tells us that, if anything, the currencies need to cheapen further in order for current account balances to improve from today’s levels.

Secondly, speculative positioning in the Mexican peso (the most liquid EM currency) – as measured by the number of net futures contracts outstanding on the Chicago Mercantile Exchange – is at an all-time high. Internal positioning tools show a consistent story: that EMFX is crowded. Why is this important? Even if currencies are cheap, it is hard for them to appreciate versus the US dollar if everyone is already in the trade, i.e. there is no more marginal buyer left to push the currency stronger. Instead, you’re left with a lot of downside risk if the markets correct, given the crowded positioning (everyone is trying to get out of the trade at the same time).

Coronavirus and Catastrophe Bonds

In 2017, the IBRD (International Bank for Reconstruction and Development, part of the World Bank Group) launched two classes of notes linked to pandemics. The riskier class B bonds1 are linked to filovirus, coronavirus, Rift Valley fever and others.

Unlike typical mortality bonds (which compensate for losses), the purpose of the protection provided by these notes was to “slow the spread or mitigate the impact” of the outbreak. We expect this concept of fighting disease and providing disaster relief to be replicated in the future.

Figure 2. Class B Pandemic Bond Price
The bond has suffered both from the DR Congo Ebola Outbreak and Covid-19.

Class B Pandemic Bond Price. The bond has suffered both from the DR Congo Ebola Outbreak and Covid-19.

Source: Bloomberg, SwissRe; as of 13 January 2020.

The first test of the class B bond began in August 2018 with the Ebola outbreak in the Democratic Republic of Congo. With 2,250 deaths to date, this is the second- most deadly Ebola outbreak on record and is ongoing. Two features of the outbreak make it very different to previous ones:

  • There are two effective vaccines. The first (by Merck) has been used to vaccinate at least 283,000 people. The second (by Johnson & Johnson) has been used to vaccinate more than 9,700 people;
  • Progress has very much been hampered by the security situation within the country.

While the outbreak is now being brought under control, the bond was marked as low as 40 in mid-2019, before returning close to par by December 2019.

The second test of the bonds has been with the Covid-19 coronavirus originating in Wuhan City, first reported to the World Health Organisation on 31 December, 2019. At the time of writing2, there are 45,000 confirmed cases and 1,115 deaths.

Will these bonds trigger? There are a number of conditions to be met, we believe, before this can happen3:

  1. The bond cannot trigger within the first 84 days of the outbreak;
  2. The total number of confirmed deaths must be at least 250;
  3. There need to be 20 or more deaths in each of two or more countries. Note that Hong Kong is a special administrative region of China and therefore deaths collectively count as one country;
  4. There is a test for how the cumulative total case amount is growing.4 A rolling set of five growth numbers are computed, each being the (natural) logarithm of the increase (of cumulative total cases) over 14 days divided by the increase over the previous 14 days. This requires six 14-day periods, i.e. an 84-day window. An average minus a multiple of the sample standard deviation is then calculated. This must be positive.

The last condition is less straightforward than the others, in our view. To illustrate the condition, we consider four hypothetical scenarios in Figure 3. Each looks over an 84-day window, with the rolling case amount starting and ending at the same values. As a result of different paths, some (dashed lines) would not allow the bond to trigger. Others (solid line) would. Loosely, sub-linear or linear growth will not trigger the bond. Instead, growth needs to be convex and sufficiently ‘smooth’.

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Source: Man AHL; as of 14 February 2020.
Note: The test is invariant to within a linear function of the case amount, and therefore no numbers are shown on the y-axis.

Clearly, (1) will be satisfied in due course, and (2) is already satisfied. The market is well aware of (3), but perhaps less focussed on (4) because of the complexity of the test. Adding to the excitement is the fact that the bond is scheduled to mature in July 2020 (although is extendible). If the bond does not trigger, we can expect more negative press coverage of it. To be fair, in our view, the architects probably never anticipated a quarantining as draconian as has been imposed.

With contribution from: Ed Cole (Man GLG, Managing Director – Equities); Phil Yuhn (Man GLG, Portfolio Manager), Andre Rzym (Man AHL, Portfolio Manager) and Tarek Abou Zeid (Man AHL, Principal Analyst).

1. ISIN XS1641101503

2. As of noon GMT on 14 February 2020.

3. The prospectus is publicly available. See For illustrative purposes only. This represents only a partial summary of our understanding of the trigger requirements. It should not be relied upon for any investment decisions.

4. Ibid., PT-32