In our last letter, we spoke of the Ballina investment process that continues on, very much as usual, in the midst of a crisis. The health crisis unfortunately continues to rage in the United States, and in many emerging countries such as Brazil, India, South Africa and Mexico. The financial markets, however, have been calmly put to sleep with a smile on their faces. We find this inconsistency unfathomable. If you would have told us in early April that come the second week of August, the U.S. would still be adding roughly 55k new COVID-19 cases on a daily basis, we would have figured tremendous buying opportunities would still be available. The attractive buying opportunities are actually pretty hard to come by, partially because we do not have an idea when the economy will be able to come back to whatever the “’new normal” will be. Real pain continues to mount for small to medium sized businesses. Many consumers have been shielded from drastic pain by the fiscal programs enacted by Governments around the world. These programs cannot continue forever.
How do we square all of this? Indeed, the cause of the ebullient markets is the usual one from post the Global Financial Crisis. See Below. The Federal Reserve has introduced new tools during this downturn. The primary tool has remained purchasing bonds. Price discovery in the Treasury markets is now a dull and largely one-way affair. We acknowledge that the low rates on longer term highly rates bonds have positive effects on the real economy, including : 1) Governments get to borrow cheaply to make their spending within a downturn less expensive, and 2) Homeowners get to refinance at lower rates. These are the most constructive impacts as far as we are concerned, for this downturn.
Source: U.S. Federal Reserve
There are, of course, other effects. It is well understood that hoovering up nearly $3trn of highly rated bonds (see chart of the Federal Reserve Balance Sheet above) in just a few months will render those securities dearly priced for investors. Real rates on 10 Year Treasuries are now well below zero. Investors are pushed to riskier markets, and this has led to a flood of money back into the same public equity market that were being fled with speed in early March. Improved stock market performance can benefit consumer sentiment, and this benefit is most powerful in the U.S., where stock ownership is higher. However, 10% of the U.S. population is getting the vast majority of this benefit, as they own roughly 85% of the investment. See Below. This third benefit is far from egalitarian.
Source: Deutsche Bank
This yo-yo effect has, in recent months, overwhelmingly benefited growth stocks. In the chart below, note that the S&P 500 Growth Index has returned 23% more than the Value Index (which remains down). The beneficiaries of the equity surge were not discretionary consumer goods, Energy and real estate. Driving to the mall to buy a fancy T shirt and sneakers is not considered to be temporarily on hold, but permanently subdued. The market appears to believe in a recovery, but just for a small subset of companies. Turns out that the Federal Reserve inspired swelling of the equity markets has given disproportionate benefit to the small number of companies that were already doing well during the COVID-19 outbreak.
SOURCE: Factset
We’ve reviewed the performance of stocks within the S&P 500 over the past six months. (The U.S. has the most liquid and well analyzed equity market in the world. We believe similar trends are playing out globally). It turns out that a very small subset of well-placed companies are experiencing multiple expansion upon their growing sales. The Median company in the S&P 500 is expected to have -1% top line contraction in Sales in 2020, and the total return for the shareholders of this median company is -5% over the past six months. With the median company down so modestly, it is not surprising that the current Enterprise Value to Sales multiple has expanded relative to the five year average for that company, by about 8%. Investors will pay a higher multiple for a company at a depressed moment in the cycle.
Underneath the median, however, is a very different picture. We reviewed Twenty relative “Top Growth” companies from the debacle that is 2020. This group includes defending champions like Amazon and Netflix, but also Stay at Home champions like Church & Dwight and Campbell Soup. The Median Total Return for this privileged group is 22%. This is understandable. These companies will come out healthier. Within this, the market is paying more for the elevated sales figures. The multiple has expanded by 16% versus the five year average. This implies that something more is going on. We have seen this before since the Global Financial Crisis. Investment funds forced out of the bond market by a Federal Reserve desperate to ignite growth, pay up for growth that is so very rare and dear.
Contrast this with the “Slight Decliners”(including Walt Disney, JP Morgan Chase and Fiserv) below or the “Struggling a Bit” group (Including Honeywell, Coca-Cola and CSX). The “Slight Decliners” are getting some multiple expansion, but not very much at all (just 6%). The “Struggling a Bit” group is even more shocking. These are the type of companies that should have the most “comeback” potential. These are not structurally broken companies, but companies wounded by COVID-19 for as long as it will have a hold over the economy. This group deserves the biggest re-rating, right? The sales are depressed. Alas, no, the market has moved the multiple down. See below.
Source: Ballina Capital, LLC
The best word that we can find for 2020 is “disparities”. It helps explain the current state of things for someone that came out of a cave they disappeared into on the last day of 2019, even for the equity markets. The Federal Reserve has come in with massive support for the financial system. If you happened to be a company that stood to benefit from the Pandemic, then the wave of money pouring into the equity markets has supported your cause even further. Value investors have had a relatively terrible time, as the possible “Premium” attributable to Growth is, by many, considered to be inestimable. We at Ballina know this misery firsthand, as the month of July was relatively the poorest month of investment performance in the short history of our firm. In such a world where just the Growthiest companies can catch a bid, the wealth of a Bezos or a Zuckerberg are going to keep climbing and climbing (See first table below). There are important questions that should be asked about the sustainability of such policy driven outcomes when the gap between the most wealthy and every other percentile had been widening even prior to the Pandemic. See Second table.
Source: Bloomberg
Source: Federal Reserve
We spoke at length in our last Newsletter about how, at Ballina, our process stays the course in volatile and difficult times. We continue to seek out asset and cash rich undervalued companies. Many of these companies are proving to be surprisingly resilient, given the awful backdrop. Real rates are negative, and investors have reacted, as they have before, by placing a massive “Premium” on Growth relative to Value shares. (See Below) It appears that the market will require a more significant improvement in the economic forecast, the still elusive “V shaped” tide that lifts all boats, appearing in the form of a positive real rate of return, before becoming concerned about the relative prices paid for growthier companies. Our process requires us to remain disciplined to the more egalitarian outcome. Weaker short-term relative performance is a worthy price to pay.
Appendix
List of companies in S&P 500 Analysis
Strategy Performance
International All-Cap Value returned -0.47% (gross basis) in July 2020 versus 4.15% for the benchmark. Year to date performance was -17.66% (gross) versus -7.32% for the benchmark.
Global Small Cap Value returned 0.22% (gross) in July 2020 versus 4.09% for the benchmark.[1] Year to date performance was -20.37% versus -9.42% for the benchmark.
Top Contributors and Detractors
International All-Cap Value’s top contributor in July was Tianneng International Power. The Chinese battery manufacturer returned 40.2% in the month of July as the company had very positive first half results. The leading detractor was Unipres Corp. The Japanese auto body press machinist has warned that results will be very poor in 2020 as car production volumes will be very weak globally.
Global Small Cap Value’s top contributor in July was Tianneng International Power. The Chinese battery manufacturer returned 37.4% in July as the company had very positive results. The top detractor in the strategy was Unipres Corp. The stock declined -14.5% as auto suppliers will have a very difficult 2020 while facing severe order declines from car manufacturers.
[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)