We told investors last month that our view on the situation surrounding COVID-19 is a balanced one. That largely remains the case today and the Fund still has dry powder but, with major indices down around 35% from highs at points during the month, we grew decidedly more opportunistic and the Fund was a net buyer.
On the one hand, the virus blew past early containment efforts and created an economic shock and public health crisis that has not been rivalled in our lifetimes. Sadly, most governments were half-hearted in their initial approach to containing the virus while some are still not taking it seriously enough.
On the other hand, there are plenty of reasons for long-term optimism, the most fundamental of which is that patient investors have historically outperformed speculators who dart in and out of the market. Beyond that, we’ve observed the following:
Social distancing and containment efforts have been embraced in most developed countries and we’ve already seen inflection points on new confirmed cases in China, South Korea, Italy, Spain, and the state of California, which is the world’s fifth largest economy.
Effective, low-cost means of reducing the spread including temperature checks, wearing masks, and washing hands with soap are becoming more widely adopted.
Existing medical supply companies as well as non-traditional contributors such as automakers are rapidly scaling the production of badly needed medical supplies including masks and ventilators. The supply of tests is also quickly rising and new ones on the way will provide results in minutes, not days.
The medical community is learning more about the virus as we go and the World Health Organization is now trailing four different drug treatments for COVID-19.
Money is close to free with interest rates at or near their all-time lows in most markets.
The gross leverage of the world’s 50 largest banks by total assets is 32% lower today than it was when the world was heading into a crisis in 2007, per data we’ve crunched from S&P Capital IQ. This suggests the financial system is far better placed to handle a shock than previously.
Governments and central banks the world over are unleashing wave after wave of fiscal and monetary stimulus that is unprecedented in its speed, scale, and scope, best embodied by the nickname of the Federal Reserve’s newest program: QEinfinity.
We want to be clear: we take this virus seriously and expect every facet of this situation to get worse before it gets better. That’s why we went into March with a meaningful cash position and started working from home across the business weeks before others were nudged to do so. But here’s the rub: the view that things will get worse before they get better has swung from non-consensus six weeks ago to consensus today, as evidenced by most major indices down around a quarter to a third below their February highs despite all of the existing and potential responses we named before.
We will not pretend to know when or where markets will bottom, however, the consensus is already so negative that any hints of an inflection point with COVID-19 or the economy would send share prices higher. What’s more, investors who are waiting for the economy to bottom out before buying again will likely have missed the turn in the market. For example, even if you had known for certain that October 2009 would mark the peak of US unemployment and had waited until that turn in the economy to invest, you would have missed a 64% rally from the March lows. Markets look forwards, not backwards.
Two other points before diving into our holdings. First, as long-term investors, whether we pay $0.60 or $0.70 for a stock intrinsically worth $1 today is not of huge consequence to us if that stock is worth $2 five years from now. Second, we would not underestimate the resolve of governments or central banks to stabilise the economy and pacify financial markets. No, showering financial markets with liquidity does not solve the underlying problem, but it goes a long way towards de-risking markets and supporting the prices of financial assets (e.g. shares).
The Fund was a net buyer of shares during the month but in a very focused manner. We reduced or exited companies that have outsized exposure to demand, supply, operational, or financial risks caused by the outbreak and containment initiatives. Conversely, we actively increased the Fund’s holdings in companies with strong balance sheets, highly loyal customers, digital-first business models, and those with network dynamics where adoption curves might be pulled forward based on changes in how we all live, work, learn, and play. In other words, we are leaning even harder than usual into our preferred style of companies.
We have moved to be a touch more concentrated than usual in its best ideas, as very few businesses are built to weather such an environment. Supporting that view is research by UBS which shows 85% of all Australian companies that have updated the market since this outbreak began have either withdrawn or reduced guidance, with only 13% reaffirming and a lonely 2% upgrading. We’re yet to receive formal updates from most holdings on how business is faring but feel good about our positioning given the backdrop.
Reviewing our Top 5 Holdings
Given the fast changing situation we thought we 'd briefly review the current environment affecting the outlook for our largest holdings:
Facebook will face short-term headwinds via a weak advertising market, however, we expect online advertising spend to hold up better than other forms of marketing spend that have fading relevance and unclear returns on investment (e.g. radio, TV, print, billboard). Usage is also spiking in areas where social distancing is now prevalent, which is currently most of the developed world, and while we expect that to cool off it will have brought more users onto Facebook, Instagram, WhatsApp, and Messenger plus better engaged existing users. Facebook is also scoring points with governments right now for partnering on spreading helpful information about the ongoing crisis. Put all that together with US$55 billion in net cash and the least demanding valuation since listing and it is easy to see why we like Facebook’s range of outcomes.
PayPal has long gobbled up share of online payments, which itself is gobbling up share of total commerce. The economic slowdown will hurt discretionary spending and cross border trade, however, social distancing is pushing current online shoppers to do more shopping at home, which plays into PayPal’s hands, and is also driving consumers who haven’t made the jump to shopping online to give it a whirl. It helps that the business is profitable, cashed up, and should be able to play offense during a tough time, plus the shares trade at a discount to historical norms despite the pulling forward of adoption.
Adyen is in many ways similar to PayPal wherein the company earns the majority of its revenues online, has a huge cash pile, and is extremely profitable. We expect revenue growth to slow down due to some exposure in travel but expect some offset from clients which see an increased demand through online channels. More than 80% of the company’s growth comes from the expansion of transaction volumes from existing clients, so we don’t expect changes to be too drastic. Also, Adyen generates the same revenue on payment volume whether it is made domestically or internationally, so it is shielded from less cross border trade.
Alphabet should experience similar dynamics to Facebook in terms of a weak advertising market but increased usage of some core platforms (e.g. YouTube, Android, and Google Cloud) and increased awareness of others (e.g. Google Classroom and the G Suite cloud productivity suite). Alphabet is also absurdly cashed up with around US$116 billion in net cash, or about 15% of the company’s market capitalisation, which could allow for well-timed acquisitions or share repurchases plus the ability to continue to reinvest in the business against the cycle. Meanwhile, the shares are trading for their lowest multiple of forward consensus earnings in three years.
Amazon has held up strongly as social distancing has driven new users to flock to the platform and for existing users to buy more goods, consume more digital media, and presumably upgrade to Amazon Prime at higher rates. In fact, business is booming to the degree that the company announced it is hiring 100,000 new workers in the US to deal with an unprecedented surge in demand. Meanwhile, in the fast-growing and high-margin Amazon Web Services business, while office closures and social distancing has probably tripped up deals that were close to closing, we expect those same trends to drive usage higher and dramatically underscore the value proposition of cloud offerings, pulling the adoption curve forward in the process. Despite those game-changes in demand and the strong relative performance of the shares, Amazon still sells for a modest discount to its recent history in terms of enterprise value relative to forecast gross profit.
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I can picture the direction on your thinking, but can good stocks go completely out the back door if the COVID-19 carries on for the next 6 months?
Hi Smitty. Thanks for the question. As I said, our views is a balanced one. We will not pretend to know when or where markets will bottom. We're also not fully invested right now and our outsized emphasis right now on businesses with cashed up balance sheets acknowledges the current climate. All that said, could markets go lower from here? Of course, but is that different from any other time? Also note that shares are already down around a quarter to a third in aggregate depending on the market we're talking about. For that matter, while some folks keep talking about the risk of a GFC-level drawdown, they neglect to mention that investors who were long at those lows banked incredible profits thereafter. Again, a balanced view. We appreciate the short-term risks and challenges but also that markets have come off a long way and that exercising patience is the best course more often than not.
Thanks again Joe!