April 2020 Newsletter
The New Grind is Similar to the Old Grind
Last month we wrote about the financial storm inflicting portfolio harm that persisted in the midst of a very real medical struggle. Within the last month, while the human medical struggle continues, possibly going better than feared, the financial storm has largely lifted. Thanks to roughly $5 trillion and counting of combined U.S. Fiscal and Federal Reserve “relief” in the United States, and large programs in the rest of the world, financial markets have accepted their medicine. Within the clearing, of course, more light will continue to shine on the very significant damage in the real economy.
At Ballina Capital, we have been very busy over the last six weeks. What have we been occupied with? For one, we are sticking to the process. Scanning the financial periodicals over the last month, there are many articles referring to a “new normal” or “winners in the Post Pandemic world”. We read these articles. They’re interesting, and somewhat informative. They’re great for media company clicks. Some of these articles list specific sectors or the economy, and in some cases, specific companies, that will be better off in the Post Pandemic world. Some managers could put these companies on their review list, and possibly add them to their portfolios. We at Ballina wouldn’t do such a thing. Our process requires that new securities for the portfolio must come for our quantitative screens. These screens were carefully crafted. Our process is timeless. It doesn’t adjust or change for a new theme, even in response to a Pandemic. Our process is meant to help us avoid where the herd has headed. The reason we are comfortable with this is that our fundamental analysis does the intensive work once candidates have come through the screens. It is within this analysis that we can judge or surmise whether a company is fit to fight in the future economy. We can model for this within our revenue and margin assumptions. This discipline protects us from thinking with the herd.
Second on our to do list has been analyzing new companies from our screens over the last six weeks. Only one of these has made it into a Ballina portfolio. We will keep looking for new ideas within our quantitative screens, but they will have to stand out relative to our existing opportunity set. Third, and frankly what has taken up the most time given the unprecedented halt for the global economy, we have been constantly updating spreadsheets of companies that we already had in our rankings. Stock prices and forecasts have changed rapidly, forecasts almost exclusively to the downside.
Fourth, given the updated rankings, this has allowed us to better prioritize our investment allocation. This is a time that calls for focus on your best assets. In extra innings of Game Seven of the playoffs, a baseball manager is not going to leave his best pitcher on the bench. We follow the same conviction. Who do we feel most confident in? That is where the money is going right now. We did trim and exit many stocks in this period. The stocks we chose to exit were specifically those that we found were risky given the combination of a recession and the balance sheets, together with less than amazing upside. We did not worry about taking losses in this moment. These stocks that we exited ended up being almost exclusively Small Cap stocks. Therefore, the Global Small Cap Value strategy is significantly more concentrated than it was at the beginning of 2020. We’re very comfortable with that concentration. It is possible that we will come back and repurchase some of the exited stocks before 2020 is over. Additional clarity on the fundamentals of these businesses and balance sheet damage may make these stocks compelling again.
Within our fundamental analysis, there are three important viewpoints we prefer on companies: 1) We like Cash, specifically cash flow. For Financials this means we are looking at Dividend capability and willingness. 2) We prefer to look at companies on their normalized earnings. This isn’t to say that depressed revenues in 2020 and 2021 are irrelevant to us. It’s just a very small snippet of the mosaic for us. 3) Balance Sheet strength is usually a positive for us. We usually prefer a company that reminds us of Mont-Saint-Michel in France (See picture below), a commune that remained unconquered during the Hundred Years War.
Mont-Saint-Michel
What are examples of where we have crowded investment at this juncture? Five of these companies are in the table below. We would note the following: 1) They are relatively small with a Median Market Capitalization of roughly $1.7bn. This is consistent with where we were finding value Pre-Pandemic. 2) Four of the five companies are International. Part of the additional discount on International stocks is that they were doing relatively poorly leading into March. 3) They were beaten up in Q1. The Median Q1 return for this group was -30%. 4) They are cheap on Normalized Earnings. We’ll use EV/EBIT for the last FY as a proxy, although none of those companies were “shooting the lights out” last year. The highest multiple we’ve got at current prices is 5.9x EBIT, a pretty miserly multiple. Price/Book confirms much the same, and we think Book Value is pretty clean on this group. 5) Four of the five companies highlighted below have Net Cash on their Balance Sheets. Even if life is very difficult, the balance sheet has the strength to withstand significant damage. Hope is not a strategy for them. This is also reflected in the Dividend Yields, which to be fair, might very well be cut or eliminated from this level for prudence. What’s not reflected in the table below is that all five companies can move to better earnings and returns than they had in 2019, Pre-Pandemic, and the valuation multiples have room for expansion on top of the earnings rebound. Therefore, the upside is significant if management can deliver beyond this very strange period we find ourselves in.
Much has happened in the last month, especially in the outside world, but also within the investment process and portfolios of Ballina Capital. The month of April brought impressive gains for stocks. We still see significant upside for some of our holdings. But the stocks with this description are a smaller subset of our portfolio today than a month ago. We don’t believe we are out of the woods yet. Far from it. We will be speaking to more company managements in coming weeks. We will use what we glean from company reports and management calls to update models and rankings. It is a slightly more frenetic pace, but the process continues. We’ll borrow the refrain from the great David Byrne of the Talking Heads, “Same as it ever was”.
Strategy Performance
International All-Cap Value returned 9.2% (gross basis) in April 2020 versus 7.6% for the benchmark. Year to date performance was -22.35% (gross) versus -18.7% for the benchmark.
Global Small Cap Value returned 17.1% (gross) in April 2020 versus 12.7% for the benchmark.[1] Year to date performance was -25.9% versus -21.2% for the benchmark.
Top Contributors and Detractors
International All-Cap Value’s top contributor in March 2020 was Royal Mail PLC. The UK Mail/Parcels returned 35% in the month of April as investors discounted the group breaking it’s losing ways with it’s 50% share in the home parcel market. The top detractor in the strategy was Chongqing Changan Automobile. The Chinese Auto Producer’s stock declined -8.2%, as there has been little sign of subsidies for the ailing Chinese Auto market.
Global Small Cap Value’s top contributor in April was Adtran. This is the second consecutive month that Adtran was the leading performer in the strategy. The U.S. Telecommunications equipment company returned 33.8% in April as investors anticipated increased resilient investment in networking equipment. The top detractor in the strategy was Invesco Mortgage Capital (“IVR”). The U.S. Mortgage REIT’s shares declined -19.8% as the trading market for Non-Agency Residential Mortgages continues to be very depressed and disconnected from fundamentals. These mortgages are a very small percentage of IVR’s portfolios, but it has had a very damaging impact on their equity given their levered balance sheet.
[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)