Three months into 2020, and it surely is shaping up to be a tumultuous year. The market downturn that gained significant momentum in March is unique. We are not different than anyone else, trying to stay abreast of infection rates at the same time as we are updating and tracking valuations for individual companies. It is rapid treadmill like experience, all taken in from the comfort (or discomfort) of our homes. While it is far too early to say anything too definitive on this pandemic and the looming fallout for markets and the global economy, we wanted to make five points.
First, with a significant global recession and sharp increases in unemployment ahead of us, it would be remiss to start without mentioning the human toll of the crisis. We fear that inequality, already stretched to historically dangerous levels, will be stretched even further (note how Job Losses will be concentrated among low earners below). Our divisions and sense of morality are being challenged on a daily basis. Many are responding with courage and generosity. The potential ultimate consequences for political stability and the integrity of our institutions are alarming and may take many years to comprehend. But as John Templeton once said, “Bull markets are born on pessimism”. Our world has much prosperity, and we must look forward.
Source: Numera Analytics
Second, the crisis will tip unhealthy imbalances over. We have written before about the Corporate Debt excesses of this cycle (November 2018 letter). The Federal Reserve is doing everything it can to get credit markets to function, but over extended credits will struggle to refinance. What for most is a liquidity issue, becomes a solvency crisis for those with too much debt (see chart below). We exited several stocks in March that we feared could face financial distress as a result of Pandemic related disruption.
In March of 2019, we wrote of how we had entered the “Self-Regulating” phase of the cycle. The third point we would like to make is that the bull market has now ended, but Central Bank overstep is very much in vogue. Since March 3rd of 2020, we count that the Federal Reserve has implemented no less than twelve steps to support confidence and liquidity of major credit markets. Given the unprecedented and rapid brake on economic activity, it would require a “tin ear” to describe these steps as “overstep”. We have been critical of the extent to which markets reaching new highs and Central Banks have become self-reliant through the cycle, but we have no doubt that Central Banks have important roles to play during a crisis.
Fourth, we’re interested in the post-mortem for this crisis as far as active managers. Our guess is that many active managers were unprepared. As a fully invested value manager, we have sympathy with those that have been caught flat footed (as we have been, might we add). We have stocks that we own and like in the Healthcare and Consumer Staples sectors, but we could not construct a diverse value portfolio from our screens without a heavy reliance upon Consumer Discretionary, Financials and Industrials – all sectors not built to deal with an economy hamstrung by shelter in place orders. The only active managers that could have outperformed during March were those that leaned on Financial Strength, Momentum, Size and Quality (see below), and deplore value factors. We screen for Financial Strength and Quality, and obviously prefer these factors if we don’t have to overpay for them. We were contacted by an intermediary in mid-March, asking for updates to YTD performance on behalf of asset allocators that wanted to know who had “weathered the storm well”. To us, this is asking the wrong question, and akin to ambulance chasing, except you already have all the information needed to determine exactly who is in the ambulance. The correct question should be, who is well placed to outperform going forward?
The stock market is a discounting mechanism, and will attempt to reflect all the worst news to come in prices as soon as possible. That said, our fifth point is that we would be concerned that the market rebound is not firmly in place as we sit here in early April. We agree with the optimists that the there will eventually be a V shaped recovery. And an inflection point on the virus is a key data point that could be reached within the next few weeks. However, the focus will then shift to two other items : 1) how deep and lengthy will the economic recession be, and 2) will COVID-19 return in the Fall and draw policymakers to demand more “shelter in place” measures? These are the questions that could very well test market participants into Q4 of 2020.
Source: Numera Analytics
We are finding excellent opportunities within our existing portfolio companies in the midst of this crisis. We have chosen to exit several companies where we doubted the upside relative to possible financial strength issues. The portfolios are more concentrated today. We’re finding excellent value in Asia, and also down the market cap scale globally, although careful attention is required with the smaller companies in the U.S. We are experienced with investing in a crisis. We’re confident in the ability to position portfolios for the eventual recovery, and one will come. We also believe that Value will outperform in a powerful fashion coming out of this downturn.
Strategy Performance
International All-Cap Value returned -18.33% (gross basis) in March 2020 versus -16.3% for the benchmark. Year to date performance was -28.9% (gross) versus -24.4% for the benchmark.
Global Small Cap Value returned -26.9% (gross) in March 2020 versus -21.1% for the benchmark.[1] Year to date performance was -36.7% versus -30.1% for the benchmark.
Top Contributors and Detractors
International All-Cap Value’s top contributor in March 2020 was China Shenhua Energy. The Chinese coal producer returned 9.8% in the month of March as China’s factories began to re-open after extended closures due to COVID-19. The top detractor in the strategy was Crest Nicholson. The stock declined -57.6%, as the UK Housebuilder announced that it would eliminate it’s dividend in order to help deal with expected sales weakness due to COVID-19.
Global Small Cap Value’s top contributor in March was Adtran. The U.S. Telecommunications equipment company returned -0.6% in March as investors anticipated increased resilient investment in networking equipment. The top detractor in the strategy was Crest Nicholson. The stock declined -57.6% as the UK Housebuilder announced it would eliminate it’s dividend in order to help deal with expected sales weakness due to COVID-19.
[1] Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)