There are some events whose importance far outweighs their financial market ramifications. This is one of those events and our thoughts are with all of our clients, their families and friends in this difficult environment. Given the huge market sell off and unprecedented speed at which it has happened, we wanted to share what we are thinking and what we have been doing. I will go into much more detail below, but in summary;
- Our relative performance has so far been strong
- We continue to follow our stock specific approach
- We have found a select number of opportunities to deploy capital
- We are only part of the way through this crisis, but we are becoming increasingly positive on the market outlook
In a very strongly positive market last year, we outperformed the market by 4.7%, delivering a NAV return of 25.2% against a market return of 20.5%*. So far this year, in a strongly negative market environment, we have outperformed the market by around 3.9%**. In both cases, it is our stock level positioning that has driven outperformance rather than any style or sector bias.
Our performance so far this year has been driven by some of our higher quality companies and those with more defensive business models. For example, we retained a positive stance towards pharmaceutical companies and our positions in Novo Nordisk and Roche have both held up significantly better than the market. Roche are in the process of trialling a product called Actemra for use in COVID-19 patients with very severe symptoms; the early signs are very promising. Cellnex, the Spanish telecoms towers business has one of the more defensive business models, with very long term contractual revenues; this position has also worked well for us. Another part of the market that has held up well has been capital-light, online business models; we own Scout 24, the German classifieds business, Delivery Hero, the German takeaway delivery company and Prosus, the Dutch listed company which owns a large stake in the Chinese internet giant Tencent. We have also had some success in the payments space, with positions in Ingenico and Worldline both having worked well for us; Worldline made an offer to buy Ingenico in early February.
Our worst performing positions have been those with leverage (Credit Agricole, Unicredit, Bawag), oil exposure (Equinor, Total) or those who are clearly and directly impacted by the ongoing spread of COVID-19 (Getlink, the Eurotunnel operator, ADP, the French airport operator). Thankfully, we have tended to be underweight those areas most impacted. We own no transport and leisure businesses, we are underweight in banks, own no miners and have limited exposure to the energy sector.
Having held up reasonably well so far, we will not become complacent. We are confident in our positioning, but will remain vigilant and focused on the 40-45 positions that we own and the small handful of other companies that are on our watch list.
Positioning & Trading activity
To be absolutely clear, we have not made wholesale changes to the portfolio in order to either derisk or to add risk; ‘top-down’ decisions are never our focus. We entered this crisis with a bias towards quality, with around 60% of the portfolio invested in ‘Compounders’. We remain positioned in a similar way and are not trying to take a strong directional view on the market. This is typical of our stock-specific investment approach. NB, we entered the crisis with some leverage (5-7%) and remain at this level.
When we make a change to the portfolio, it is always driven by our Ranking Framework. Simply put, we will consider buying when we find a new investment that scores highly on our Ranking Framework and we will sell a position when there has been a material change to our view on the company which has had a significant impact on the score which we attribute to the company. We believe that our Ranking Framework is a key competitive advantage, especially in times of market stress. It forces us to objectively analyse where we should be investing our capital rather than making subjective, emotion-driven positioning changes.
Our Ranking Framework requires us to attribute a score to a number of different quantitative and qualitative factors and this enables us to rank investment opportunities in several different ways. It has evolved to both aid portfolio management and prioritize candidates for further analysis. By forcing us to analyse and form a view on multiple different areas for each company, our Ranking Framework increases the time we spend on research, and should improve the quality of our analysis. The Ranking Framework is an idea meritocracy and enables us to identify potential investments that we believe have a skewed upside/downside ratio; the extent of this skew together with our level of conviction in our Investment Thesis determines how large a position we decide to have in any one investment.
So far this year, we have initiated new positions in Ingenico/Worldline, Alstom, Telecom Italia and ASML. I will briefly outline our Investment Thesis on each below.
- Ingenico/Worldline; We felt that Ingenico was a good play on the structurally fast growing payments sector and also saw a risk that the company ended up being the target of M&A in a fast consolidating sector. We were proved right on the latter point and much faster than we had expected. Soon after our purchase, Ingenico was bought by the other French payments company Worldline. We like the deal and believe it will be very accretive to Worldline; on the morning of the deal, we bought a position in Worldline and over time we will allow the two positions to consolidate as the deal completes.
- Alstom; is facilitating environmentally-friendly mass transport which appeals to us from a sustainability perspective. Alstom is likely to be relatively immune to the ongoing COVID-19 development.
- Telecom Italia; this business is facing tough competition, but is extremely lowly rated, trading with a negative equity value. We also see a number of ways in which the new CEO, Luigi Gubitosi can improve the business; mainly by selling assets, improving cash generation and deleveraging the balance sheet. We have continued to build this position as the equity has sold off in the recent market rout. Operationally, we do not foresee a large impact on the business from the spread of the virus in Italy, however, the business does have some debt which is causing volatility in the equity value; we believe this provided a decent buying opportunity.
- ASML; is an extremely high quality business and one which we have previously owned and know well. ASML are the sole supplier of lithography tools to the likes of TSMC, Samsung and Apple. As well as having a powerful market position and technological leadership, they are also exposed to very strong structural growth owing to the growing ubiquity of semiconductors. The opportunity to invest back into ASML has come from the recent market turmoil. We have spoken to the company and they do not foresee a significant impact from the virus on either demand of supply; this could of course change in conditions deteriorate further.
We do not spend much analytical effort on thinking about sector positioning, but as we stand today, our largest overweights are Communication Services and Information Technology and our largest underweights are Consumer Staples and Industrials.
Some market level observations
Over the last few weeks, we have witnessed the fastest fall from peak to bear market in history. In the 1930s an Ohio lawyer named Benjamin Roth kept a detailed diary about what he saw during the Great Depression. In summarising what he had learnt from this period, he wrote the following;
“Business will always come back. It will remain neither depressed nor exalted”
“Depression is time of greatest profit. The investor who has the lucidity and the courage to act can lay the basis for great profits.”
It is not realistic to compare the last week or two to the Great Depression. However, it is also hard to think of a time when sentiment has changed so far, so fast, than it has in the last couple of weeks. It would be complacent and dangerous to assume that this abrupt shift won’t become self-perpetuating nor lead to tangible economic problems, but echoing Benjamin Roth’s lessons from 90 years ago we say;
“We’ll get through this”
As I write this, European markets have fallen almost 25-30% and now trade on a forward PE multiple of under 12 x versus around 15 x a few weeks ago. In simple terms, if we are to see 15% market level downgrades from here, then the market would trade on a multiple of 13.8 x, in line with long run average multiples. To state the obvious, a significant amount of earnings downgrades have already been priced in; 20% earnings downgrades would be quite typical for a global recession.
The key question for us is not so much ‘what level of downgrades are likely for 2020?’ But more ‘Is this a transient issue or have earnings beyond 2020 been structurally impaired?’ At the moment, we are of the view that this is largely a 2020 issue and that longer term earnings have not been structurally impaired. If we are right on this, then the current market weakness should prove to be a significant buying opportunity for longer term investors. As such, we are slowly building positions in solid businesses at discounted prices that present us with some very attractive expected rates of returns. We are trying to use this difficult period to our advantage, but portfolio changes are conducted in a slow and measured manner, driven by our Ranking Framework as ever.
It is impossible to ascertain the moment when panic turns to greed and markets could yet see new lows. However, with the global, coordinated effort to slow the coronavirus pandemic, we can both take the threat very seriously and be optimistic about the future. In our view, it will pay to be sceptical in the short term, but optimistic in the long term. Cynicism (i.e., assuming the worst), might pay off in the short term, but in our view, it tends not to pay off over time. For long-term investors, volatility is an opportunity, not a risk.
Our increasingly constructive view on the market has required us to think about the willingness and ability of central banks and governments to react to alleviate financial market panic as well as the state of the banking system versus the last financial crisis. Over the last few weeks, we have seen increasingly coordinated and substantial action from central banks. The Fed has cut rates twice, first by 50 bps and then by another 100 bps. The BoE has also taken action, cutting rates by 65bps. Other central banks have also eased monetary policy. The ECB has not cut rates, but has made it clear that it is willing to do so. In addition to rate cuts, there have been widespread policy announcements from the central banks that will result in bond purchases, liquidity support for the banking system and capital relief. This is all positive and we have also started to see a more coordinated fiscal response from governments. As for the banking system, we see a much healthier environment than in past times with European banks notably better capitalised (stronger balance sheets) than in the global financial crisis. A healthier banking system, alongside central banks who understand the importance of a stable banking system, should reduce the risk of financial contagion.
The world after COVID-19
As the Covid-19 virus has continued to spread across the globe, we have been spending a lot of time thinking about what a post-virus world will look like and what structural changes to consumer and corporate behaviour we can expect. There are many different themes to consider, but I will focus on three for the moment. First, it is clear to us that we are likely to see an increasing virtualisation of business life. Management teams will realise that more flexible working arrangements can bring multiple benefits; we will see more people working from home, smaller office spaces, more meetings being conducted online and less corporate travel. Second, we are likely to see an even faster adoption of e-commerce, with consumers increasingly preferring to transact online rather than in crowded shopping centres. There will be some individuals who have found themselves during this crisis period, ordering a takeaway using a mobile app for the first time or opting for daily essentials to be delivered rather than them collecting them in person; these new habits are likely to become entrenched. Third, factory-heavy businesses will realise that it is becoming ever more important to automate as much of their production as possible to enable them to survive in these kinds of environments.
There are ways in which we can take advantage of these themes. With regards to the virtualisation of business life, we see telecommunication services companies, telecom infrastructure companies and semiconductor companies benefitting in the long term. I hold several companies in this space, all of which should be well placed in this environment. With regards to the faster adoption of e-commerce, payments companies as well as the more obvious internet businesses should prosper. I hold two French payments companies and one German based company. Finally, the portfolio has limited exposure to businesses that could benefit from increased factory automation, but I may consider ways to gain exposure. There are of course many other structural changes that will occur and, as you would expect, I am spending time considering these.
It is too early to be overly confident, but we are gradually building confidence in the outlook for the market. Let’s keep in mind that this is a complex event and as Tetlock states in his book ‘Superforcasting’, predictions in these cases are useless, especially if they contain narrow guesses about the future, even if those guesses seem well informed.
*FTSE World Europe ex-UK TR Index as benchmark
**Based on NAV value as of 03/04/2020. FTSE World Europe ex-UK TR Index as benchmark
All data sourced from Bloomberg as of 06/04/2020
Compounders: companies which, in our view, have been and look set to continue to be reliable and consistent high return companies
Leverage: The use of borrowing to increase exposure to an asset/market.
PE: price-earnings ratio (P/E ratio) relates a company's share price to its earnings per share.
Basis points (BPS): refers to a common unit of measure for interest rates and other percentages in finance
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.