"If you can't measure it, you can't manage it" takes on a new meaning in the face of the COVID-19 pandemic. The systemic declines affecting assets across all categories are abundantly clear. What's less obvious is where to find the points of friction within a company's operating model, which drive the narrative that explains how declines in economic activity will translate to lower future earnings. Identifying those points of friction, or inflection points, necessitates having a firm grasp around what makes a company tick. At a high level, we can generalize those activities by answering three fundamental questions to help frame a company's operating model:
In what industries does it operate (what)?
In what countries does it do business (where)?
What do its supply chains look like (with whom)?
Select a Universe of Companies
To begin exploring those questions, we'll limit our focus to companies held within the S&P 500 and analyze their exposure to countries with large numbers of confirmed cases of COVID-19. That list is growing as we write this, so for now we've limited our scope to China, Italy, South Korea, and Japan (CIKJ).
With mounting concerns about the decline in production coming from countries with exposure to COVID-19, it's important to understand how the expected output decline will impact companies in our universe. Let's begin by looking to the country of domicile (CoD) by counting the number of entities in each company's corporate hierarchy with a CoD in CIKJ. The companies in the S&P 500, while headquartered in the U.S., are globally-distributed businesses with massive operations worldwide. The chart below helps paint that picture, showing that many companies within the index have anywhere from 50 to 500 entities in their corporate hierarchy.
The sheer number of relationships shown above raises an interesting question: is country of domicile the best measure of "exposure" to a country or set of countries? Unfortunately, country of domicile is limited to a single location and doesn't explore the global network in which most companies operate. One alternative is country of risk (CoR), which is designed to capture influences beyond the country of domicile by accounting for the affect economic and political turmoil in other countries can have on companies.
Let's explore both measures side by side using FactSet’s RBICS Economy definitions as the sector classification. For CoD, we measure the percentage of entities across each corporate hierarchy with a country of domicile in CIKJ. For CoR, we conduct a similar analysis but use FactSet’s GeoRev Country of Risk (GeoCor). GeoCoR combines four country factors to classify an issuer into one country: top country of revenue, country of incorporation, country of headquarters, and primary exchange.
Both measures show minimal exposure to the affected countries and seemingly sidestep the relationships we are after. At the beginning of this article, we mentioned the noticeable influence COVID-19 has had on markets. So why are these measures falling short? One potential reason is the scope of these metrics. Neither CoD nor CoR takes into consideration more complex business models like those of the large, multi-national companies in our universe. Even CoR, which accounts for several factors beyond CoD when assigning a country designation, doesn't explore exposure to multiple countries. These exposures are of paramount importance during a global pandemic.
Geographic Revenue Exposure
So how can we expand upon our current measures of exposure? Let's begin by looking beyond primary sources of revenue and view all geographies contributing to a company's top line. The histogram below illustrates the distribution of S&P 500 companies' percentage of revenue generated from CIKJ by RBICS Economy.
In our hunt to quantify exposure, this information provides us with a few breadcrumbs. Utilities, Telecommunications, and Business Services exhibit minimal exposure to CIKJ, while Technology, Non-Energy Materials, and Healthcare's revenue exposure could translate into higher risk due to COVID-19. Recall that “risk” is defined as the level of uncertainty around an outcome, and in this case, it's unclear that companies with a large amount of revenue from CIKJ will be able to count on that same level of revenue in the future.
Seeing the relatively high percentage of revenue from CIKJ in Technology, we wonder what types of technology firms are at higher/lower risk than others. The chart below illustrates the distribution of total geographic revenue exposure to CIKJ by industry group.
Measuring risk based on revenue exposure leads us to identify Specialized Semiconductors, Analog and Mixed Signal Semiconductors (AMSS), and Semiconductor Manufacturing Capital Equipment (SMCE) as industries that will be heavily impacted by COVID-19. In addition to high revenue exposure (35-65% generated in CIJK), the activities associated with these industries could be susceptible to outside intervention as governments continue to manage the outbreak. For example, manufacturing firms may be hard-pressed to find work-from-home scenarios in the event of extended lockdowns or quarantines, at least without diminishing their current or expected levels of production. This leads us to another important question: how will company to company relationships be impacted?
Supply Chain Exposure
Expanding our definition of exposure to account for global sources of revenue has already borne fruit relative to our earlier, more limited definitions relying on CoD and CoR, but there's more we can do. Exploring company supply chains is an integral step to understanding sources of global revenue and how they may evolve. A simple way to quantify a company's supply chain exposure is to determine the percentage of suppliers and customers with a country of domicile listed as being one of the affected countries (CIKJ). Again, focusing on Technology, it becomes clear that Semiconductor companies have significant supply chain exposure. Nearly one-third of AMSS companies' customers and SMCE companies' suppliers are domiciled within CIKJ.
Company Level Performance
Sticking with the S&P 500 Technology sector, let's see how companies in AMSS and SMCE have fared by examining each measure of exposure and market performance between February 1 and March 13. The last three columns include absolute and benchmark/industry relative returns to distinguish returns attributable to the market from more idiosyncratic returns driven by the company (e.g., remove market/industry beta).
Companies in the SMCE industry have outperformed both the index and their direct peer groups. However, high levels of exposure across the different measures shown above beg the question as to whether the trend will continue or is a more severe drawdown looming. On the other hand, AMSS results are mixed. For example, Texas Instruments has outperformed relative to the sector and market while generating 57% of its revenues in CIJK. Perhaps this seemingly anomalous result is a function of their business model, where near-term revenue growth is tied to contracts that won't be impacted in the subsequent months, or maybe the market has yet to account for this exposure.
With 500 companies in our universe and potentially endless connections when considering each company's supply chain, it's clear that this is just the tip of the iceberg. It's essential to keep in mind that as with most measures of risk, financial or otherwise, there isn't one universal metric that tells the entire story. Gaining a more complete understanding of a company's country or countries of risk requires a variety of checkpoints, just like going to the doctor for an annual check-up. Doctors providing health assessments rarely turn to one number, rather they look to a series of tests to form a consensus (blood pressure, cholesterol level, diet, exercise habits, etc.). In that same vein, the more information you have at your disposal, the better prepared you are to understand the relationships of interest when evaluating companies. In the case of country exposures, these relationships are informed by understanding what your companies do, where they do it, and with whom.