Coronavirus: A different playbook

While the COVID-19 virus has already generated a heavy human toll, new government mandates to combat its spread are producing unprecedented challenges for investors.

Indeed, the impending government-induced recession is quite different from past economic downturns that naturally occur as business cycles mature. The negative impact is indiscriminate – impaired business activity and enforced quarantines are producing negative consequences for both strong and weak companies.

The good news is that central banks and politicians have responded with greater speed and force than we have seen in the past. For instance, the $2 trillion package from US Congress, already about two-and-a half times larger than the 2008 crisis, may grow to $4-5 trillion in total. Moreover, this crisis is time-definitive – the severity of the damage and duration should recede once health risks normalize.

Earnings take a back seat; focus on balance sheet strength

The foundations of expanding global growth are still intact and we remain confident about the medium-to-long term prospects of our current holdings, despite the near-term volatility. That said, a different kind of playbook is required in this unique environment to assess individual stocks and to evaluate portfolio positioning.

As quality growth investors, we traditionally focus on the predictability and stability of a company’s underlying earnings growth. But it is near impossible to accurately predict 2020 profits at this time. Many companies have even suspended earnings guidance. Companies with strong balance sheets, namely those with superior liquidity, will possess the survivability required to prosper and bridge the gap during the next 6- to 9 months.

Thus, as market volatility accelerated in recent weeks, our investment team conducted extreme stress-testing on all of our holdings for heavy pressure on revenues, profits, and cashflow. Our balance sheet analysis extends far beyond the usual metrics associated with EBITDA and leverage. We assess debt rollovers, covenants, lines of liquidity, and the capacity/terms to draw on those lines. We also evaluate changes to fixed and variable costs.

Our clients can rest assured that we aim to manage our portfolios to be in a strong position under normal  economic conditions, heading into economic weakness, and also in the midst of the unique nature of this crisis. We are quite optimistic that our companies could come out even stronger, in a position to take market share from weaker ones that do not survive.

Constantly looking to upgrade the quality of our portfolios

While our holdings are defensive in terms of balance sheet strength, we are looking at volatility more offensively and making portfolio moves on the margin. We are using the crisis to trim back on the margin some names that have held up relatively better and reallocating that capital to our more beaten down names, providing us with a more deeply undervalued portfolio.

We are actively trading day-to-day, constantly looking to upgrade the quality of our portfolios. The extreme volatility – with some stocks down 10-15% intraday and then snapping back a few days later – means we are able to take advantage of companies and industries that have been even more depressed because of the unique nature of this event. For instance, while there is significant near-term pressure on consumer discretionary, we have added to our holdings in the sector whose medium to long-term trajectories is intact. We have also added to information technology names, specifically in emerging markets, and to a few industrials.

Despite the broad based sell-off in consumer staples, good quality staples companies should remain resilient. For instance, while the on-trade (bar or restaurant) business is obviously suffering because of the lockdowns, we are positive on the alcoholic beverages space over the medium to longer term. We believe our holdings have brand power, competitive advantages, and can benefit from a trend toward more premium products, especially in emerging markets. We expect to see higher profits and better cash flow. In our view, the market is vastly underestimating the off-trade business in the near term.

We have not changed our views on areas of the market that what we typically see as lower quality, such as the energy sector, even with the extraordinary downtick. In basic materials, we have added a bit on the margin in developed markets, but in emerging markets those businesses are more commoditized. In the US, there are some high quality franchises in the paint segment, the aggregates space, and cleaning and sanitization space,

While conditions in China have finally begun to improve, the country is still in the early stages of normalization. For example, even as the Chinese population returns to work, Western demand is likely to be depressed for some time. While China’s banks have been relative outperformers, we remain wary about their medium to long-term prospects. Here is a good example of an industry that may outperform in the short-term but is likely to underperform over the long haul. As long-term investors, we sometimes give up short-term returns to maintain conviction in our holdings for the medium to longer term.

Valuations

Valuations have become attractive. Valuations in emerging markets, which lagged developed markets pre-crisis, have come down further. The larger markets that our portfolios are exposed to, such as India and Brazil, will experience lagged trends with COVID-19 – behind China, Korea, Europe and the US. But we feel we are prepared for the higher level of volatility and uncertainty that comes along with that.

In each situation, we assess whether or not there has been any material change to the 5-year valuation of the businesses we own, or are looking to buy – even accounting for what could be significantly lower earnings for 2020. We now need to look to 2021 valuations and the 5-year forecasts to assess the underlying growth in the business. In the majority of cases, we believe that valuations have not been materially impaired and that the strength of the competitive advantages of our companies can endure, supported by strong returns and healthy balance sheets.