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What is Dead May Never Die

Everyone’s activities have been altered at least a little bit during 2020. Everyone is doing something a little bit differently, whether it is Zoom calls, exercising at home, streaming even more TV shows, and possibly even cleaning out the garage. Even the family dog must notice that 2020 is different. For myself, I did work from home for much of the Spring and early Summer. In the late Summer, however, I resumed traveling the short distance to the office. I longed for a strong Wifi signal that I did not have to share with my family members.

It’s a short commute for me down the Pacific Coast Highway from home to office here in Los Angeles. I braced myself for the changes that I would see in the signs that I would see of small businesses that were not going to make it through to the other side. I certainly couldn’t help but notice that erecting For Lease signage had unfortunately become a growth business in 2020. There is one site I pass every day that had been dormant for several years. It had previously been an auto dealership. The previous dealer had moved to a less cost prohibitive location nearby. Clearly this was the kind of location whose fortunes had just become much more difficult with COVID-19.

However, much to my amazement and shock, did I see brand new signage for a new auto occupant at this location just as the children were “supposed” to be back to school. I know what you are thinking, the new tenant must be a new EV company, or even the leader of this sector, Tesla. After all, new technologically led growth verticals have been hastened and emboldened during the Pandemic. But alas, the auto company that was desperate to take on the location that no one else wanted for years was Mitsubishi Motors. Yes, the same Mitsubishi Motors that in the U.S. market has seen sales decline by nearly 2/3 over the last 20 years. This is the same Mitsubishi Motors that just had their share price reach the lowest level of it’s trading history (see chart below). Consumer Reports, in their 2018 review of the Mitsubishi Outlander, said “they’d skip the low-scoring Outlander altogether”. The publication hasn’t recommended a single Mitsubishi model for at least three years. Mitsubishi finds itself barely able to hold a place in the crumbling Renault-Nissan-Mitsubishi Alliance. The company’s own strategy rethink calls for re-focusing on SE Asia and Oceania regions, and away from North America. Since Mitsubishi is not opening this outlet because U.S. business is great, could it be for another reason?

Source: Factset

There was a whirlwind of policymaker activity in March and April of 2020 as the economy was grinding to a halt with the acknowledgement that the Western developed countries did not have COVID-19 under control. In the U.S., the bills passed by Congress were massive and included many tools. Some of these measures leaned on methods used in the past. Many of these approaches are used to “pull forward” demand, taking growth from the future to support the present. The massive CARES Act did have one tool within it that probably sheds the light on why a group like Mitsubishi would make investments like the aforementioned.

Code Section 172 (b) (1) of the CARES Act allows for tax losses beginning in 2018 to be carried back to each of the preceding five tax years. For companies that have had lossmaking U.S. businesses in 2018/19, but paid taxes on profits in 2015/16, this is like found money. It is very possible that Mitsubishi Motors managers in the U.S. wanted to use their “found money”. The benefit to the U.S. economy is that a dormant site now generates labor costs, rent and taxes, and greases the wheels of capitalism. However, we fear this leans into a “zombie” company epidemic that is building in the wake of this crisis.

The descriptor of a “Zombie” company was first generated in regard to the post bubble Japanese economy. The term describes companies that are bloated and failing, yet market disruptions allow them to persist. In Japan, regulators failed to force banks to recognize losses. Today, we have measures like 172 (b) (1) added to interest rates suppressed by central banks. The trouble with measures that support “Zombie” companies is that there is already global over capacity in virtually every industrial sector of the economy. This includes car manufacturing and distribution. Whether it is steel, pulp and paper, energy, shipping, chemicals, heavy machinery, agriculture, or many others, we cannot remember the last time we spoke to a company where they indicated that their industrial or commodity sector was not dealing with a serious capacity overhang. Usually the discussion moves to a “pain threshold” where this capacity may effectively “leave” the market. The trouble with this overhang is that healthy and competitive companies cannot raise prices to a level where they can cover their cost of capital over an economic cycle. Without covering the cost of capital, the company cannot invest in R&D, stronger human resources and competitive projects. This disinflation doesn’t just render a less dynamic global economy, but feeds into the price level of the overall economy. This is the same overall price level that central banks seem particularly fixated on igniting even as the economy recovers to full employment as it did during the last cycle.

Source: Bloomberg

Ballina portfolios have benefited tremendously from measures taken since the Pandemic started. Relative performance for our more “value” oriented shares has been particularly strong in the month just completed (although we do not believe we own any “Zombies”). One could say, “why are you complaining?” We worry that having just completed a cycle that was powerfully dictated by central banks, the Pandemic has unleashed even stronger distortionary forces from policymakers. Having been unwilling to remove these scale tipping measures in the last cycle, we worry that the distorted and unequal speeds of recovery is doomed to be even greater for longer this time around. In the eponymous HBO show Game of Thrones, those of the Iron Islands would say “ What is Dead may never die”. While we at Ballina wish no harm to our friends at the new local Mitsubishi dealership, we think it is healthier that the Dead indeed die.

Strategy Performance

International All-Cap Value returned 22.4% (gross basis) in November 2020 versus 12.62% for the benchmark. Year to date performance was 3.69% (gross) versus 4.55% for the benchmark.

Global Small Cap Value returned 16.79% (gross) in November 2020 versus 15.66% for the benchmark.[1] Year to date performance was -2.8% versus 7.57% for the benchmark.

Top Contributors and Detractors

International All-Cap Value’s top contributor in November was Royal Mail PLC. The UK parcel and mail company returned 39.5% in the month of November as estimates for this fiscal year have improved over the last several months from a loss to a profit. The leading detractor was Inner Mongolia Yitai Coal Company, which declined 11.6%. Investors have begun to worry about the Chinese coal sector after a surprise bankruptcy from a market player.

Global Small Cap Value’s top contributor in November was Galliford Try. The UK contractor returned 57.3% in November as the company reported that operations were going well, and dividends would be reinstated. The top detractor in the strategy was the telecommunication equipment company Shell Midstream Partners LP. The stock declined 6.9% as the stock was only purchased in the last few days of the month when the market was weak.

[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)

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