INTRODUCTION
First of all, we wish to express our deep appreciation for our clients and sponsors. Our hearts go out to those for whom the corona-related hardship is severe. Thanks to our partners at Baird, we are safe, properly supported and fully functioning.
For the first half of the quarter, global markets progressed sideways to slightly up. Then as the full weight of the spread of the COVID-19 virus spread around the globe, financial assets were battered. We experienced history-making selloffs and rallies netting in substantial (greater than 20%) declines which, by definition, means that we are in a bear market. Late in the quarter, “Big Bazooka” fiscal and monetary stimulus deployed around the world buoyed the market to some extent. This was an extraordinarily tough quarter for all market participants.
It is very difficult for us to come to grips with losing client’s assets. These precious investments are used to secure retirement savings, fund scholarships and carry out important research, so in the face of significant absolute loss it may be cold comfort to know that we were successful in providing some downside protection.
MARKET UPDATE
We are often asked, “under what market conditions does your approach do best and under what market conditions does your approach do worst?” Our surprising answer is the same for both, “in times of great volatility.” As focused and disciplined managers of concentrated portfolios we know a select universe of stocks very well. This enables us to exploit what we believe are mispricings stemming from indiscriminate selling or buying in a volatile environment, like right now. The portfolios generally are richly rewarded for these adjustments. In some cases, however, it can take a while before the markets adjust prices to what we have determined to be the intrinsic value. This makes it the best of times. Alternatively, when investors are piling in and storming out of the market based on headline news, it is hard to distinguish yourself. As active managers, charged with remaining mostly fully invested, we cannot sidestep a market crash. The emotional battle between bargain hunters and breakeven sellers in the face of a novel and deadly virus has made this the worst of times.
Every economic sector and country sold off. Neither growth nor value, large capitalization nor small, developed or developing economy was spared. Quality sold off a little less. Healthcare companies, which were the perceived “bad guys” in the heat of election year rhetoric at the beginning of the quarter, became the “heroes” who might be able to develop better test kits, inhalers and potentially an effective vaccine. Healthcare was the best performing sector. The energy sector plummeted as demand for gasoline contracted in the “shelter at home” environment and as the Saudis and Russia ramped up crude oil production. By country, performance was a quality issue. Denmark, Switzerland, China, Japan, Taiwan then the U.S. did the best. Most of the worst performing countries were in the emerging markets universe. China, where the COVID-19 virus began, applied draconian containment rules then ramped up testing and treatment and was able to stem the spread and as a result at quarter end had reported economic data that demonstrates China has quickly come through the other side. Until the extraordinary monetary and fiscal measures were announced late in the quarter, quality growth out-performed economically sensitive and deep value stocks. The balance sheet strength and consistency of earnings of the quality growth firms were expected to fare better than businesses that must service high levels of debt and are dependent on economic strength to be profitable in this unprecedented crisis.
OUTLOOK
In the most recent quarterly letters, we acknowledged that we were concerned about the fragility of global growth. After 10 years of economic expansion there was no longer a growth gap to fill. Late stage economic stimulus in the form of a tax cut for U.S. corporations did little to auger capital spending. Moreover, reductions to the benchmark borrowing rate did little to trigger borrowing. Government levers to stimulate growth did little to stimulate growth because there was little underlying demand. From the latter half of 2019 the world appeared to be in a mild production recession coupled with a mild consumption expansion. Generally, businesses were not expanding but confident consumers continued to spend. Inflation was absent in consumer prices but on full display in the prices of financial assets. The cost for a dollar of forward earnings was absolutely and relatively high. Stocks were expensive and the global economy was dependent on the fragile confidence of consumers. Accordingly, we remained fully invested with quality growth holdings but took an extra measure of care to ensure the companies we invested with would hold up operationally should the ever-fragile economy topple over. The catalysts for such things are unpredictable. This time the catalyst was a surprise coronavirus, like SARS and MERS before it, but more irksome because the contagious host can spread the disease for up to five days before they know that they are ill. As a result, the disease has spread all over the world and the best option for containment is to lock-down all activity so that the diseased do not overwhelm the hospital’s ability to care for them. The lock-down is massively disruptive and results in stunningly high layoffs and immediate recession. The magnitude of this may prove surprising. In the face of this, we made adjustments such as the liquidation of Trip.com, which is wholly dependent on travel and event attendance. Their business will probably be challenged for a while. We have great respect for the company, and we can always revisit the stock at a later date. TJX represents our only direct exposure to traditional retail. While they have had to shutter their physical stores, we are confident they can survive and within the quarter they were able to augment their balance sheet. We also reduced exposure to Pirelli. Pirelli carries more debt than we are comfortable with currently. Policy makers are under pressure to address the disease and ensure that the economy can recover. In their haste there will be waste. The “big bazookas” guarantee banks ready cash, extend unemployment benefits, subsidize industry and small business but greatly expand public debt. The Treasuries can print bonds and the Central Banks can buy them up so money can be directed where it is needed and the Central Banks as lenders of last resort can prevent liquidity from drying up. All of this is necessary in the moment. But what happens when the lock-down is over? Will citizens who get “helicopter money” checks spend it or save it? When this was done in the U.S. in 2001 and 2008 most went into the bank. Importantly, will investors happily buy 10-year government bonds that yield less than 1%? If not, what happens to interest rates? If rates rise what is a dollar of earnings worth? Could the stupendous amount of new debt result in more, Japan since 1989 “zombie” economies? Or will it ultimately cause inflation to run away as it did in post WW1 Germany? At a minimum we reckon the global economy will emerge with a shallow “U” shaped recovery. But it’s hard to predict as we are truly in unchartered territory.
Up until almost every government announced “Big Bazooka” strategies to address the abrupt slowdown a quality-oriented portfolio outperformed. The stock market regime is likely to shift in the near term as massive government stimulus designed to prevent bankruptcy will do exactly that. Therefore, small businesses and poor-quality companies with dangerously high levels of debt will be bailed out. This means, near term, deep value and small capitalization stocks will likely outperform large capitalization high-quality growth stocks. Should we pivot away from our time-tested successful philosophy and process to catch a short-term trade? That will not happen, and we may under-perform for a quarter or two. Yet, we know our approach will prevail. We were able to provide a bit of downside protection in the recent bear market selloff and this has enabled us to take advantage of attractive prices to initiate the investment in several companies that we have analyzed and have been monitored on our watchlist.
There are heightened risks and opportunities across the globe right now. The team at Chautauqua continues to do what we do well. That is to assess the broad forces, identify trends and then intensively vet those trend benefitting companies that may be able to parlay their advantage to become great wealth generating businesses for our client’s long-term investment.
BUSINESS UPDATE
During the latter part of the quarter, Chautauqua Capital personnel, in order to contain the spread of the COVID-19 virus, worked remotely. During this time each member of the staff had the technology resources to replicate our office environment. As such, we were able to have daily research meetings via video conference and we did so each day without exception. We were able to trade, reconcile and settle trades unimpeded. We were able to respond to client requests and supplied reports and communications without delay. The office NCAA “March Madness” basketball sweepstakes was canceled but the movie tickets supplied to the first, second and third place finishers would not have been readily useable anyway. We are all well and safe.
This is respectfully submitted with our very best wishes to you and the ones you hold dear,
The Partners of Chautauqua Capital Management – a Division of Baird
© Chautauqua Capital Management – a Division of Baird
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