A Playbook for Navigating Uncertainty: Uncovering Risks and Opportunities in Volatile Markets

Kim Hyland: Good morning, Rob.

Rob Almeida: Good morning.

Kim Hyland: So we are in a period of uncertainty right now, and the markets do not like uncertainty. We have a little bit of a storm caused by changes in tariffs, taxes, deregulation, immigration, and last but not least, the transition that we're seeing in our economy from a public sector economy to a private sector focused economy. And that transition ultimately will probably be good for stocks, but it will probably be a long transition that's not a smooth one. So the journey will be interesting.

What I want to talk about with you today is sort of the rigor and the analysis, the playbook essentially, that our investment team uses when we go through these periods of uncertainty, no different from the Russia-Ukraine war, COVID, global financial crisis. How do our investors look past the noise and the distractions and focus on what could be the new equilibrium and find those opportunities? And so I always think in these periods, because there are a lot of opportunities in volatility to create long-term value, so I always think of Warren Buffett's saying when he says, "Be greedy when others are fearful, and fearful when others are greedy." So how do we stay focused on protecting capital and finding opportunities? But before we begin, can you share with me sort of your take on what the tariffs, all these changes and the implications for the markets and what investors need to focus on?

Rob Almeida: Yeah, well, I think I'll highlight or start with, one of the words that you use, which I think is very apt, which is uncertainty. So if we translate that to financial market vernacular, so what are financial securities? They're just derivatives of what the aggregate investor base believes about future cash flows. Now, there are no facts, right, certainly not in behavioral sciences. So we don't know what the future will be, but investors are always assessing ranges of outcomes.

So when uncertainty is low, or inverse, certainty is high, those assumptions tend to be narrower and volatility is lower. The inverse, which is what you've seen over the last several weeks, which is uncertainty is higher because you've introduced a new risk factor, tariffs, that challenge existing assumptions about future cash flows, compounded by the fact that we really don't know exactly how these tariffs are going to look, what the reciprocation will be by other countries, how companies are going to behave. So therefore, I think what the markets are telling you, not just the downward move in risk assets, but more broadly just the widening range of outcomes, what the market's signaling is its difficulty in underwriting what those impact to future cash flows will be.

But to take a step back, I think there's a lot of ways to think about it. One way that I see a lot of our industry peers that are approaching it, and I don't necessarily think it's the most apt way, but they're looking at it from the standpoint of tariffs are a tax, tariffs aren't new, they've been around for 1,000 years, "tariffs" are Arabic for "taxes," and trying to underwrite, what's its impact going to be to the economy?

But there are so many variables to that, and this gets to your question, how we're going about it, I'm not saying it's the wrong way. It's probably just the most difficult way possible to come up with cash flow assumptions. So the short answer to your question is what we're doing, which is the same thing we always do, but particularly when you're faced with an acute new risk, which is, all right, what is this risk relative to what does a company do? How do they do it? And how is it going to impact the P&L? How is it going to impact profit and loss savings? I think we'll get into that in greater detail, but we'll start there.

Kim Hyland: Okay, great macro summary. Thank you. Now, let's go to the micro. So you're an analyst, you're a portfolio manager on our investment platform. And again, I talked about the playbook. What is that playbook? What's the rigorous analysis that each analyst is doing on their names under coverage? And maybe we can get into some of the questions of the portfolio managers are asking them about each of their names.

Rob Almeida: Yeah, well, I liked earlier when you referenced the Russian-Ukraine war and COVID, so just in the last five years and many others too, changes in interest rate policy, et cetera, but this is a risk factor. And again, I think most investors are approaching it from a top-down level, which it's just really, really hard to underwrite. Where I think instead what we need to think about it as, all right, "Well, what are tariffs?" It's a transfer of economic activity. So all economic activity is energy transformed. So how is energy going to be transformed in the real economy by these tariffs? And I think we can begin with thinking about it as the difference between being a net exporter and a net importer.

And so households, given that we're a consumer-based economy that tends to consume more external goods than internal goods, like we import about 17,000 goods as a country, so right away, this is a tax on the consumer. But to your question about how we approach it from an analyst level, now it's thinking about, "Okay, well, what percentage of the company's revenues are outside the United States? What's that tariff levy going to be? What's the reciprocation going to be? But ultimately, what's the necessity of the good that it is they sell?"

So if the cost of the good is going to go up, I think ultimately what matters to an analyst is, what's the price elasticity? So if it's something that's mission-critical, it's something that their customer cannot substitute, cannot do without for whatever reason, they're going to pay more for it. So this tax, this transfer of energy, is going to transfer from the producer, who's going to be able to raise prices, protect margin, pass that along to the customer, that's where that energy transformed. That P&L of the business is going to be relatively insulated, whereas conversely, there's other industries, other companies where maybe they sell something more of a commodity, they're not going to be able to pass that along. Then at the same time, maybe their cost of labor is going up or the costs of production are going up. So you have to think through all those varying scenarios, and each one's different.

Kim Hyland: And that goes to sort of what's going on with tariffs and how they think about the implications. But then rates are rising, there's concerns of recession. So how about the analysis that we do of the balance sheet and just the overall corporate positioning?

Rob Almeida: Yeah. So what you're referring to there I call second and third derivative effects. So first, we have this impact to tariffs individually. How's this going to affect companies? It's going to affect them all different. So you have to run through all those scenarios. And first and foremost, we don't even know what these tariffs are going to be and we don't know what the reciprocation levels are going to be. So you got to come up with various scenarios just for that. And at the same time, what are the competitors within that industry ... are they going to start cutting prices? Are they going to try to raise prices? So there's just a tremendous amount of scenarios that you have to take into consideration.

Now, enter what you are referring to. So let's draw out a scenario. You're got to stress revenues down 20%, you're going to stress the P&L down 30%. What does that do to the balance sheet? Well, debt is fixed, but most of it. So if your revenues are down 20, operating income's down 30, now your leverage is something much higher. So now that affects the credit markets, it affects capital availability. And if we really want to draw out more dire scenarios, to the extent that this creates a feedback loop where you're now in a more recessionary dynamic, which is another factor the investor has to take into consideration, not only will refinancing costs be higher, but like we saw in 2008, will it even be there? So those are all the scenarios. And I'm making it maybe easier to assess than it sounds. But those are all the different scenarios that investors have to think about.

But ultimately what it comes down to, what's the downside for earnings? And will this company survive it? And then from an opportunistic standpoint, using your Warren Buffett quote, the positive in all this is, look, for the last 15 years we had a 5,000-year low in interest rates. We blunted the market's ability to perform its natural selection process, which is weed out companies that don't belong. So I think what this does is it really accelerates the narrative that we've been telling, which is bad businesses go away, which ultimately increases market share, increases ops…so while there's perhaps a lot of punitive impacts from this, even for the above-average businesses that have a good that people want, longer-term, this is going to create probably some pretty good opportunity.

Kim Hyland: Yeah, so this same rigorous analysis we use on every company helps us when we're thinking about protecting capital, but also creating long-term value and the opportunities in the future.

Rob Almeida: And I think that's not just two sides of the same coin, but it's one side of the same coin. Right.

Kim Hyland: Yes. Yep, exactly. Let's bring it to life and go through an example.

Rob Almeida: Sure.

Kim Hyland: And hope you're okay, I want to use the autos as the example. They're in the eye of the storm.

Rob Almeida: Yeah, I'm just going to leave company names out.

Kim Hyland: Okay, that's perfect. But they're in the eye of the storm. And we need cars, whether we drive them ourselves or we're in an Uber. So talk to me about the autos, and then I also want to get at some of the second derivative plays here that we're thinking about.

Rob Almeida: Yeah, that's a good example, because obviously they're an important part of the economy, because they sell mission-critical goods, just for economic activity and our livelihoods. At the same time, they are large companies that employ a lot of people. And they're a good proxy for population growth, labor health, overall health of the economy. So it's very important. And at the same time, it takes over 30,000 parts to make a car. So their supply chains are probably greater, longer, more complex than any other industry in the world, across 100 countries, 1,500 manufacturers, over 4,000 different manufacturing facilities. So it's vast.

So there you have the complexity of where the part is made, where it's put into another good, where it transfers over borders. And then to your point earlier, are these tariffs going to increase the cost of goods? Because people will need cars. You tend to buy a new car when yours breaks down. But again, it's a balance sheet-sensitive purchase. So if you can't buy one, you're going to repair your car and put it off as long as you can. So this is a really good example of A, the complexity of the supply chains, B, the impact to the economy, because they employ a lot of people. If they're not able to pass those costs, we're going to see layoffs in that sort of element. And finally, C, these are also indebted organizations.

So this is an area where we need to apply rigor from both an equity and a credit standpoint. But I guess where we come at it from is we don't own a lot of auto OEMs, but we do own a lot of auto suppliers, because to your point, they sell a mission-critical good where the differentiation is in the supply chain, are those companies that sell a necessary non-substitutable cog into a car? So the OEM, whether it's companies in North America or in Europe, they're going to buy that cog. And so while that good might not be substitutable, it doesn't mean that the demand from their customers won't go down because of more of the growth pressure.

So those are the sorts of inputs that auto supplier analysts have to take in consideration. And you're seeing the same thing in software companies. Not to jump different sectors on you, but software companies have cut guidance, for I think macroeconomic reasons, also because of AI scaling reasons. But it's the same derivative. So they don't sell something that's necessarily tariff punitive to the same extent that you're seeing in physical good areas like hardware. But you're seeing the same second derivative effect: worries about a recession.

Kim Hyland: Corporates and the government cutting back on your technology budget. If you're nervous, if you're a CFO and you're nervous about the environment going forward, the first thing you're probably going to look at is your CapEx on technology.

Rob Almeida: Yeah. And you've seen, for the first time in a while, on average, a pretty significant drop in budgets for technology. And that's just in this year. We're only 10 weeks into the year.

Kim Hyland: Okay. So can you bring me inside a sector team meeting at MFS right now, maybe one this week, where you're there with a sector team, all the analysts that cover all the different regions and portfolio managers sitting in that room. In these type of environments, what's the playbook for those sector team meetings?

Rob Almeida: Yeah, I mean, you highlighted earlier, it's the same playbook that we're executing constantly. It just becomes more acute when you introduce a new risk factor that you have to change assumptions. So we did it this week in cyclicals on Monday. It's the equity and credit analysts each running through their sectors, whether it's hotels, which isn't necessarily affected by tariffs in the same way that a hardware manufacturer is, but it is from a recessionary standpoint, and walking through all those call them downside scenarios, and then getting input from the credit perspective, getting input from the equity perspective, getting inputs from others, PMs that you mentioned, that either own the asset or perhaps covered it as analysts 10, 15 years ago, say in 2008.

But it's really just talking through all those scenarios. Now I think as an industry, we've, the industry, that is, has put so much focus on counting and Excel spreadsheet modeling, but ultimately it's, what does the company do? Is this business going to be viable, whatever punitive outcomes come down the line from a tariff standpoint or from a fall in demand standpoint, from slowing economic activity? What does the business do? Do we have confidence in the management team to manage through that? And then should we be leaning into these assets even in the face of declining profit margins because it's going to be a good business on the other side?

So I mentioned in the cyclicals meeting this week, what we're also seeing, and this is unrelated to tariffs, but you're seeing a pretty significant drop-off in restaurants, in discount stores, in areas where immigration population is higher, because they're afraid of getting deported. So that's apropos of a recession, apropos of tariffs. But that's something that we have to take into consideration, because I think this immigration policy is obviously here to stay.

Kim Hyland: Okay, so you talk about the equity and fixed income analysts being in these meetings and looking at each company, scrutinizing each company. You and I talk about this a lot: everybody says that equity investors see the glass half full, fixed income investors see the glass half empty. I don't know, the yields on bonds are pretty good. So if I was a fixed income investor, I'd be pretty happy. But thoughts there in how we think about it?

Rob Almeida: I think that's one of those old continuous but incorrect narratives. I mean, it just sounds nice. And I get it. Equities go up 80% of the time. Your downside in fixed is 100%, your upside is capped. So I think it fits, sort of, but I find at least, I've been here 25 years, I don't think that's actually accurate. I think about a company ... and we can approach it from the standpoint of equities are a call option on future cash flows plus property, plant and equipment, all the tangible assets, plus the human IP, which translate into future cash flows, minus the debt. So that's the strike price.

Conversely, what is a bond? A bond is akin to selling a put on the same thing. Now look, I'm being cute with this. The strike's going to be different, the delta's going to be different, the theta's going to be different. But just generally speaking, equity and credit analysts are analyzing the same asset, albeit through different lenses. So to me, the difference isn't, is one always positive, one always negative? They each have blind spots. So an equity investor cares about what's cash flow going to be after liabilities get paid, after you pay people, after you pay bondholders, after you spend money to reinvest back into the business.

That's what an equity investor cares about. An equity investor's not thinking about, "All right, you have a debt maturity coming up in 18 months." It's not thinking about that, whereas the debt investor doesn't really care about the P&L after all these expenses from tariffs. It really cares about, what's revenue coming in the door relative to the leverage on the balance sheet? So I think the interlocking between the two, not always, but in periods of acute stress, periods of new stress, I think the interlocking between the two can provide maybe a more sensible mosaic that can uncover or unblock some of those blind spots that each cohort tend to have.

Kim Hyland: Yeah, the power of the platform. So in conclusion, if you wanted to leave us with three things that we focus on for each company, it's constantly in the back of our mind, our investors' mind, what are those three things?

Rob Almeida: I think always, what's the viability of the business? And I say societal value; I don't mean that necessarily through an ESG lens, it's not what I'm referring to. But what's the economic utility? So every financial asset, really it's just a derivative of its economic value. And we think about that through a P&L standpoint. So what does the company do? I guess that would be one. And maybe, I don't know if this would be one or two, but can somebody else duplicate it, or can somebody substitute out that service being provided? Because if they can, there's probably going to be pressure on prices, which is going to lead to pressure on revenues. And if it's a fixed-cost business, it's going to lead to pressure on P&Ls and it's going to be not a very good financial asset. So I think that would be first and foremost.

The second one is the management team. What is the operating skill, just based upon history and confidence? Because these CEOs are really smart people. They're there for a reason. And some are better than others. And do they have the experience to navigate these environments? Do they have the skill? So it's not just the product set, but do they have the skill to maybe increase the economic mode in the face of new threats, whether it's tariffs or new technology or something else?

And then finally, I don't know if this would be necessarily a separate, but operating leverage, financial leverage. So operating leverage is, what's the sensitivity of the business to varying economic environments? Financial leverage, what's the sensitivity to debt, basically? So are you reliant on the economy to sustain and grow your business? Are you reliant on the balance sheet? Are you reliant on someone else's money, the debt to grow in your business? So generally speaking, you want a little bit of both, but it's really the right amount versus ... So like oil in your car: you don't want too much, you don't want too little; or cholesterol, same thing.

Kim Hyland: Thank you. I think you've definitely underscored the importance of active management-

Rob Almeida: I hope so.

Kim Hyland: ... scrutinizing every holding, and the importance of understanding what you own in order to create long-term value, so thank you.

Rob Almeida: Well, just to add to that, because that hasn't mattered a lot in the last 15 years.

Kim Hyland: No. It just goes straight up.

Rob Almeida: And that's the thing that I think gets lost, right? So with each new ... whether COVID, Russian-Ukraine war, inflation, now this, with each new, let's call it additional risk factor, it's increasing the fragility of profit and loss statements against what's high valuation. So as each time goes by, and maybe this is another head fake and we get past this, but with each new event, this increases the likelihood that there's going to be big dispersion between assets.

Kim Hyland: Yes. A theme that you and I always talk about, what's worked over the last 15, 30 years, will probably not be what works from an investment perspective over the next 10 to 15.

Rob Almeida: Yeah, I think that's right.

Kim Hyland: Well, thank you, Rob. I have enjoyed the conversation with you this morning.

Rob Almeida: Me, too.

 

 

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