Stress testing the portfolio

< Company names and details of the same have been removed>

To all subscribers,

I have been asked about the impact of the ongoing epidemic (Covid19) on our portfolio companies. I have been doing this analysis and this note is to describe the process. This is a probabilistic exercise which depends on the following factors

• How long will the lock down last?
• Will the lock down be lifted in phases (both in terms of time and geography)
• How will this event impact consumer behavior (short and long term)?

All the above factors are important, but unknowable for now. We have a range of guesses floating around with unknown probabilities. Instead of trying to guess what is going to happen, I have tried to analyze this situation in a different fashion. I have broken down the problem into three-time buckets with a specific set of questions for each bucket

Short term bucket (3months)

• Does the company face bankruptcy risk (due to zero revenue)
• What is the liquidity situation for the company? In other words, does the company have enough cash/ access to credit to tide over this period

Medium term bucket (3-9 months)

• What is the break even revenue for the company at which it can it can sustain its manpower expenses and mandatory overheads (rent, power etc)

Long term bucket (> 9 months)

• Is the long term demand for the company impacted by this event?
• Will the consumer behavior change permanently such that the company’s business model will be impacted?

The above questions are crude approximations and I am not trying to come up with a numerical impact on fair values. I have seen some analyst reports where they have changed the target price by X%. Putting a number, does not change the fact that this is still a guess.

Some of the conference calls by company managements show that they are also grappling with the unknown and do not have visibility on the numbers. To assume that an outside investor can do better is silly.

I have evaluated these questions using the following data points

• Liquidity risk/ Credit report from ratings agencies
• Company annual reports/ financial statements to evaluate how long the company can survive with zero revenue and the level of topline needed for break even
• Management commentary

The stocks in the model portfolio are arranged based on their risk profile. This sequence is again a rough approximation of the risk. What this means is that company 2 is not more risky than Company 1, but Company 2 has lower risk than Company 14 which is at the bottom of the portfolio.

Dynamic situation

The impact on each company will depend on how long the lockdown lasts, whether it is consumer facing and the fragility of its balance sheet. In our case, most of our portfolio companies (other than financials) have low to zero debt. There is only one position which has high debt levels and is exposed to the consumer. As a result, this company is the lowest in the model portfolio and has been on hold much before the current situation (old subscribers including me continue to hold it).

I will be addressing a few more topics in my next post with the above framework in mind.