Growing against the grain in COVID-19

17 April 2020

To say that 2020 has been like nothing we’ve ever seen before, is an understatement. Back in February, our chief investment officer (CIO), Ned Bell, wrote the developing COVID-19 pandemic in China was becoming more than a cause for concern, and that the ramifications of this virus would likely be giving investors the requirement to reconsider certain asset allocation within their portfolios. 
Fast forward to April, and we’ve seen markets fall globally under the weight of COVID-19. The nature of this current crisis as a health crisis first and foremost makes it different to previous financial crises such as the Global Financial Crisis (GFC) and the dot-com bubble, as it is affecting more and more industries – the sectors hardest hit include energy, financials and industrials. 
Over the March quarter, the MSCI World index has fallen dramatically by 9.33%. 
In respect of the drawdown in global equities that started on 19 February, 2020, we would make a couple of observations: 
  1. This has been a ‘value’ led drawdown – the crisis has exposed the financial vulnerabilities of companies that exhibit varying combinations of cyclical earnings, poor pricing power, capital intensity and balance sheet weakness;
  2. At a sector level, energy, financials and industrials led markets lower as earnings expectations collapsed. The more defensive sectors such as consumer staples and healthcare held up much better;
  3. Perhaps contrary to many investors’ earlier thinking, large-cap growth stocks actually held up quite well in the drawdown as many of the already crowded recent winners were seen as safe havens; and
  4. Unsurprisingly, global small & mid-cap (SMID) stocks bore the brunt of the sell down and are underperforming the broad market in the drawdown. 
From an economic perspective, the global economy is clearly taking a hit in the short to medium term. What’s less clear is how long the dip will go on and to what extent will the global economy rebound? Governments and central banks are clearly concerned and acting accordingly which is somewhat encouraging. 
When we look to the remainder of 2020 above and beyond 
COVID-19 we believe we’ll see the following:
  • Global earnings in 2020 will fall materially vs 2019 – anticipate 30% to 50% year-on-year, and current sell side earnings estimates have a long way to come down;
  • Balance sheet strength has become a key focus for investors and many companies have been ‘found out’ as a result of COVID-19. There has been a mad scramble by companies to shore up their balance sheets by drawing down existing lines of credit and capital raisings; 
  • There will be a number of companies and sectors that simply won’t fully recover in the foreseeable future. The tourism and energy industries have clearly borne the brunt of COVID-19 and will likely see a number of bankruptcies, bailouts and restructurings that will have ramifications for years to come;
  • The US earnings season in April will provide investors with a reality check as to the magnitude of the earnings hits that companies will take;
  • The earnings recovery in 2021 and beyond – at this point – should be quite sharp as Governments around the world have been very proactive in pumping stimulus into their respective economies. Companies will also pull as many ‘cost levers’ as they can – thereby setting up for strong earnings recoveries once sales growth re-emerges; and 
  • Given that consumer spending accounts for approximately 70% of gross domestic product (GDP) in the US and consumers are in varying degrees of lockdown – the economic impact of COVID-19 is material. 
One of the biggest unknowns is still the length of the lockdown in different parts of the world. While some countries have demonstrated they can successfully curtail the spread of the virus, what is less clear is how quickly the virus could resurface once life returns to normal?
We believe the biggest risk yet to be priced into markets is arguably a scenario whereby the US pre-maturely ‘opens for business’ after a short lockdown period. As economically painful as a short lockdown period will be, a secondary resurgence would prolong the economic stagnation well into 2021. 
As mentioned, the tumble in markets has been largely value-led. During these negative markets, ‘quality’ has outperformed while ‘value’ has underperformed. As much as we cannot understate the human cost associated with COVID-19, from a pure investment perspective the numerous disconnects between quality and value we are seeing are throwing up some excellent opportunities.   
Quality at a Reasonable Price (QARP) describes our overarching investment philosophy and style. Essentially what it means is that we look to address the two most important risks in equity investing – fundamental risk and valuation risk.
In a practical sense this means we build portfolios that simultaneously have much higher average profitability levels and considerably lower leverage, while having comparable valuations to the broader index. 
Once a company has been identified as ‘quality’, the valuation piece of the process is the trigger that determines our decisions. We would argue we are very disciplined about selling names (for valuation reasons) and very patient getting in – i.e. waiting for oversold opportunities like we have seen in March – to initiate positions in names that we have long admired but always considered too expensive. Our recent portfolio activity has been predominantly driven by valuation triggers (the ‘RP’ part of QARP). 
COVID-19 is posing real challenges for global corporates and 2020 will be a year where poor quality companies will be found out and most likely go through material financial distress. 
We think we are still staring down a pretty material earnings cliff in 2020 and the drawdown and recovery curves will be very different by sector and company quality. We are staying well away from companies with weak balance sheets and those that have been seemingly mortally wounded by the COVID-19 crisis – cruise lines, energy.
From a valuation perspective, we would argue global SMID equities are the cheapest they have been in a long time. Since the market started tipping over, we have been presented with some fantastic opportunities to start positions in names that we think will do well over three to five years and beyond. 
We believe our material exposure to some of the highest-quality SMID companies in the world, sets up our portfolios extremely well for what we expect will eventually be a sharp rebound. SMID stocks lagged their large-cap counterparts in the latter part of the bull market and have borne the brunt of the recent sell down – the net result being that global SMID equities are now trading at their cheapest relative valuations in 10 years. 
More specifically we have opportunistically introduced two very high-quality franchise businesses – Idexx Labs and Straumann – after they both had decent drawdowns. Both companies have quite unique health care franchises that generate very strong returns on capital and have much less earnings sensitivity to the current economic weakness. We consider these stocks to be high-quality names and were well off their highs at the time we started buying. 
In the broader global SMID universe there is a massive divergence of quality – we only focus on the highest quality businesses. We expect there will be plenty of smaller companies that won’t survive the COVID-19 crisis and others that ‘stay on the mat’ for the foreseeable future. We have zero interest in these names and would much rather focus on the global SMID powerhouses that will come out the other side even stronger.  
On the other side of the COVID-19 drawdown, this exposure provides investors with a very unique form of upside leverage that large-cap strategies simply don’t have.
We believe investors who adhere to the valuation and fundamental disciplines will be rewarded more so in 2020 than was the case in 2019, when ‘growth at any price’ was the winning strategy.  
Mahesh Fonseka is senior investment specialist at Bell Asset Management.

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