March 20, 2020
We are staying with our philosophy and process, as we’ve done in past downturns. Given the rapidly unfolding nature of current events, we’ll continue to monitor risks in the strategy while also looking for attractive investment opportunities, always keeping our long-term investment horizon in mind.
We have reduced the portfolio’s energy exposure, and it is our hope that the defensiveness embedded elsewhere in the portfolio will have a more positive impact.
Outside of energy, the portfolio has been positioned fairly defensively (for example, underweights to financials, overweight in healthcare, less cyclical positioning in sectors like industrials and consumer discretionary).
Since the market peak on Feb 19, six of the eleven sectors have contributed to relative returns. Because of the extent of the sell-off, we’re looking for new opportunities across a range of sectors including communication services, financials, healthcare, industrials and information technology, with the idea that it may give us a chance to improve the overall quality, valuation and risk/reward profile of the strategy. It’s our belief that the strategy’s defensive tilt and higher-quality attributes should enable it to hold up better in the later stages of a downturn. This is consistent with what we’ve seen in the past.
— US Large-Cap Value Equity team
US core equities
Our portfolios have held up relatively well during this period of extreme volatility, which we believe is a testament to our risk-controlled portfolio construction process and focus on stock selection.
Our strategy was more benchmark-agnostic than our long-term average heading into this year, a byproduct of heavier investments in the REIT, finance, and utilities sectors. Heading into the year, we had been adding to certain utilities holdings and reducing exposure to energy companies, and those with higher leverage, which we believe helped reduce risk profile.
We have identified a number of new companies to potentially add to the portfolio during this period of volatility. New research has focused on companies with strong balance sheets, durable business models with unique competitive advantages, strong and tenured management teams, in cyclical and defensive industries. Our research has led us to new holdings in multiple sectors of the portfolio, with each of the team’s five portfolio managers identifying additions.
— Francis X. Morris
Small–and mid–cap value
Our small-cap portfolio has lagged the benchmark, the Russell 2000® Value Index, year-to-date. Our style traditionally provides downside protection. In a typical market decline, higher-quality companies decline by less than lower-quality companies. Unfortunately, the recent market volatility has benefited lower-quality companies and punished higher-quality companies, which we find is not common, and has detracted from our performance this year.
The decline in interest rates and the price of oil has created a sell-off in the sectors of the market that have heavier weightings in value portfolios, notably financials and energy. Policy decisions have created those declines with the hopes of supporting the consumer, which is one of the most important contributors to our economy. We are cautiously optimistic, valuations are very attractive, the R2000V is at 12.3x, which is cheaper than its long-term average, at trough levels typically only experienced in time of great financial stress.
We are continually evaluating the fundamentals of each company that we own and researching new companies for our portfolios. We are considering both the near term and long-term implications of potentially lower growth rates in GDP, cash flow, earnings, and capital spending as we speak with and evaluate companies. We have experienced a disconnect between the information presented by companies and the market’s interpretation of that information through price action, which is providing us with opportunities to add to positions.
We are encouraged by recent shareholder-friendly actions taken by companies that we hold in the portfolios. These actions are consistent with our philosophy, and evidence that companies and managements believe the current prices are attractive.
— Chris Beck
Small–and mid–cap growth
The coronavirus is putting pressure on the system to the likes we have never seen. Any industry that involves a crowd is getting decimated - cruises lines, airlines, hotels, theme parks, restaurants, to name a few. Concurrently, the energy markets are going through a price war led by the Saudis that is hurting all kinds of industrials.
All of these are debt-laden industries. As business freezes up, a credit crisis is ensuing. This hits the banks of course, but also creates systematic risk for all equities regardless of the industry they are in, thus the massive pressure we are seeing.
We believe the equity market will most likely stop going down as soon as we get visibility on when the crisis peaks. Any information showing a slowing of deaths or cases in the U.S., or even perhaps in Italy or other parts of Europe, will support the markets. This bottom will happen. China and South Korea have already seen a turn.
The powers that be are rushing with support. The US Federal Reserve cuts of 150 basis points and trillions of dollars of fiscal support from around the globe will be entering the economy in the next few weeks. These efforts are pushing on a string, and we will have a recession. However, it will act as a bridge for many, to get us to when the quarantines end and a new normalcy emerges.
Meanwhile, the market remains at a full panic as people sell at any cost. Fear levels and bearishness are extremely high which indicates that we are getting closer to a low.
We have moved away from consumer cyclicality like housing and retailers. We have embraced areas of strength like virtual healthcare, streaming media, software as a service, and high-quality foods.
We are likely headed into a nasty recession for 2Q, but we believe we will emerge out of this. Undoubtably the vast majority of companies will miss their earnings numbers, but we expect a bounce back economically in the second half.
— Alex Ely
Global / International
The concerns over the coronavirus and its potential repercussions on the economy by possibly breaking down global supply chains, lowering private consumption and travel, only started to hit the markets more seriously since February 20. It is normal that in a broad market sell off, all sectors and stocks are sold down and the baby is thrown out with the bathwater. We find it’s often only in the second leg of a sell-down that investors will begin to differentiate among companies based on their fundamental qualities.
During the financial crisis in 2008, our strategy followed the market down to a large extent for the first 15-20%, and then generally stabilized while the market continued to fall further. Losing less in a downturn generally means that capital stock will be higher, and thus able to benefit when markets recover. We want to help clients sleep better, especially in these times, and keep them in the market.
Our investment strategy is benchmark-agnostic, driven by fundamental bottom-up stock selection. It’s very important in our view to be selective when making investments. We never invest without research.
Our team pays attention to earnings stability of businesses. Earnings resilience should feed into downside protection generally. We only invest in quality businesses that we can buy at a discount. As a result, we do not find attractive investments in all sectors. Currently the portfolio is not invested in IT, energy, utilities, financials, and real estate, although we also never say never for any sector.
Some businesses are value-destroying even in this very low interest rate environment. They earn less than their cost of capital. These businesses may be punished severely in a downturn. Businesses can often be buoyant based upon stories, but if they do not generate a cash flow, we do not invest.
Following a strong start to the year, the first coronavirus concerns came up at the end of January and our strategy showed resilience to the market’s negative reaction. For a long time we have seen that the market had only focused on the good news and not taken note of any negative news. Earlier this quarter, investors tuned out the possible consequences of a developing pandemic. Now we observe a rush to safe havens.
Despite the sad background, we welcome market volatility insomuch as it creates opportunities to select quality stocks which may be overly punished by the sell down. Our portfolio consists of stocks which we trust will show some resilience due to their fundamental strength.
The further development of the pandemic and the consequences for individual companies and the overall economy is likely to continue to weigh on equity markets in the coming weeks. Despite all short-term risks and uncertainties in connection with the spread of the virus, we believe the portfolios we manage are currently well positioned.
— Jens Hansen
We believe there will be significant short-term impacts on both supply chains and consumer demand. We’re encouraged by the signs from Asia that control measures are effective at slowing transmission of the coronavirus. In China, outside of Wuhan, new cases are down dramatically and there have been positive trends in South Korea. While it may take time for things to fully return to normal, governments are taking measures to support stressed areas of local economies.
Timing the exact bottom from a financial markets perspective is always difficult, and price action in developed markets will likely continue to influence emerging markets. We expect short-term price action to continue to be volatile.
The starting point for emerging markets is important to keep in mind. Emerging market stocks were trading at discounts relative to the US, coming into the current selloff. We expect that emerging markets will generally be in a strong position to benefit from the recovery coming out of this situation.
External shocks and volatility are common to the markets that we invest in, and our strategy has been managed before through multiple cycles of severe macroeconomic stress and stock market volatility. We invest in businesses that have sustainable franchises, including resilience to deal with external shocks, and we believe these companies will be better able to withstand the current period of volatility and may emerge with stronger competitive positions. We also believe that key secular trends will remain intact longer-term, and that companies we hold will be well positioned to benefit from these. We will continue to manage the portfolio closely, stress-testing our assumptions and seeking to take advantage of opportunities as they unfold.
— Daniel Ko
Global Ex–US Markets
Global Ex-US markets have collapsed slightly more than the US equity markets since markets turned sharply downward, based on index returns (source: FactSet). This is not unexpected as the US economy is stronger than the rest of the world, the health care system is more robust, and the government has more firepower. In general, the ex-US markets are higher risk and are showing higher beta.
In South Korea and China, the new coronavirus cases have slowed. The Chinese markets tried to rally but failed, and are now heading towards new coronavirus lows. Asia is trading in tandem with global markets. The Philippines has closed their exchange. It is likely more closures will come. In Japan, the government appears to have relative control of the coronavirus situation. Japan has an advanced medical system and, fortunately, is experienced at dealing with natural disaster type events. The yen has been strong but equities remain under pressure.
In Latin America, the beta has been high. Companies with high debt or low margins are suffering the most. Currency weakness has been profound. Coronavirus cases are very low, but like Asia, high population density and less medical resources are creating a recipe for extreme fear.
In Europe, the borders are all closing. There are many reports that the hospital systems in Italy and Spain are being overrun. Restaurants and social gathering spots are closed throughout Europe.
From a financial perspective, one of the most concerning developments has been the increase in bond spreads in Europe. The bond markets are not responding well to the move to zero rates by the US Federal Reserve and the liquidity measures announced by the European Central Bank. The question is whether the financially strong EU countries will have the political ability to support the weak ones during this period. The concept of the euro zone could be challenged again.
During an economic crisis, we can look at historical events to help us with decisions and potential outcomes. The coronavirus and the government response will in many ways determine our future returns from current levels. Many strategists reference The Spanish Flu of 1917 as a corollary. We disagree because it corresponded with the end of WW1 and the news of it was censored around the world (except Spain, hence the name), markets never sold off due to Spanish Flu and were up 50% after it burned out in 1918. It is hard to determine the reason for the rally because it coincided with the end of the war.
The Global Financial Crisis and the Asian Financial Crisis in 1997, are closer comparisons in our view. Both events preceded booming markets and essentially surprised everyone. Both caused shock to the markets and deep pain especially for the middle class. Also, these events created massive government bailouts.
We expect a similar response this time. Massive bailouts, tax cuts, fiscal stimulus and more coordinated central bank action. We expect an eventual burn out of the virus or a strong therapeutic response within a year. We think the market then makes new high and the governments around the world are left with a huge bill that they will kick down the road.
— Joseph Devine
Global Listed Infrastructure
A number of global listed infrastructure sectors are impacted by the rapidly developing changes that are occurring around the world. Most notably, as air travel falls sharply around the world, passenger volume drops and the companies’ aeronautical and commercial revenues fall commensurately. Likewise, as more people work from home, traffic on certain toll roads is impacted. We have seen stock markets around the world react to this business slowdown and have sold off these types of “user demand” companies sharply.
On the other hand, the relatively defensive businesses of the regulated utilities (such as electric, gas and water) should provide relative calm through this period, further bolstered by falling interest rates globally. However, and interestingly, this group have also met with notable selling pressure.
In both cases, the selling through mid-March feels to be approaching a capitulative frenzy, resulting in seemingly attractive valuations for both cyclical and non-cyclical sectors. But during this time, we believe careful fundamental analysis is key to help identify those opportunities where the market has overreacted to the unknown and we are able to acquire a stream of cash flows at well below their fair value, while being mindful of various scenarios that could unfold. To this end, turnover has been higher than normal in our portfolio recently, as we have sought to take advantage of these opportunities.
— Brad Frishberg
The views expressed were current as of March 20, 2020, and are subject to change at any time.
The views expressed represent the investment team’s assessment of the market environment as of March 20, 2020, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.
Diversification may not protect against market risk.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Ex-US investors may not benefit from potential tax advantages associated with investing in US municipal bonds.
Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
Currency risk is the risk that fluctuations in exchange rates between the US dollar and foreign currencies and between various foreign currencies may cause the value of an investment to decline.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
Healthcare companies are subject to extensive government regulation and their profitability can be affected by restrictions on government reimbursement for medical expenses, rising costs of medical products and services, pricing pressure, and malpractice or other litigation.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value and is often used to represent performance of the US stock market.
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