Large Cap Value – 2Q20 Review

What Did You Think?

Transcript:

Good day, this is Brian Barish, President and Manager of Cambiar Investors, large-cap domestic investment strategies. I’m here today to talk about our performance in the second quarter and as well for the first half of 2020, tell you why we’re doing what we’re doing and offer some perspectives on how we see investment opportunities in the investment landscape developing over the balance of 2020.

During the second quarter, we had a very good quarter relative to the overall market. We were up about 20%, we were pleased that we were able to outperform the Russell 1000 Value by as much as we did in the quarter, nearly 600 basis points and 1,175 basis points for the first half of the year, gross of fees.  A lot of that goes to good stock-underwriting, we bought stocks at correct prices and similarly had correct framework for where to step off and I think our overall evaluation of the COVID-19 framework for evaluating how much of a discount one ought to expect given the amount of uncertainty in businesses disruption, has been fairly accurate.

Earlier in March and again, in April, we put out a series of podcasts talking about the markets and how we were handling them. We characterized the situation in 2020 as being an event-driven bear market that happened to be at the end of a long and fairly prosperous economic cycle.

Normally bear markets are brought about by unsustainable economic and monetary conditions, but this one was not, it was brought about by an event, the event being the COVID-19 virus and the very extreme economic dislocations that are necessary to combat its ill effects. It’s more akin to a war than a normal economic recession and the normal conditions that bring about a bear market. And perhaps for that reason alone, it has been not a typical bear market in terms of how stocks have bounced.

They in fact are not down really very much at all year to date. Although if you look at certain distinct pockets, they have suffered very greatly due to the impact of the virus. We try to put together a framework for thinking about stocks and opportunities and discounts, and how to go about allocating capital and came up with a system of five buckets late in the month of March. We had buckets for small, medium, large, extra-large, and needs reassessing levels of business disruption, and potential loss of value.

And we believed it was prudent to allocate capital to the first three buckets where we expected you could have full and complete recoveries and to stay away from the last two buckets where there would be either capital structure damage, or simply certain industries where you needed capacity to be forced out of the system due to economic change and technological change. We were on the right track. We know why we were thinking what we were thinking, but we missed one critical bucket. There really should have been a category zero for big-time virus beneficiaries.

So these include things like work from home, cloud computing, video games, online gambling, home improvement and of course vaccine makers. These kinds of stocks have performed exceptionally well in the COVID-19 lockdown economy. But I think it’s very difficult to extrapolate their performance and their performance potential into the long-term. Due to a bit of luck, to some extent we happen to land on four of those, these were Amazon, Google, Gilead Pharmaceuticals, and Home Depot.

During the quarter, we bought four stocks in total. I would characterize our buys as being fairly vanilla type of names with mild to moderate levels of business disruption, leading to the discounts in valuation that we saw. The first stock we bought was Trane, we bought that in April. Trane is one of the largest manufacturers of heating ventilation and air conditioning or HVAC equipment. We are fairly confident that the outlook for HVAC equipment should be solid out into the right, not much reason to think otherwise.

The second name we bought was Chubb. Chubb is a multiline insurance company. It’s actually a combination of the old ACE and Chubb personal lines insurance companies. In our opinion, Chubb is a very well-run company and very well-capitalized with very good capital management and stewardship. What we see is a rare once in roughly 20 years hard market erupting for property and casualty insurance where between losses due to COVID and an increased sense and form of risk, the ratio of capacity to capital in the system, as well as to demand appears to be out of balance leading to some very strong pricings. We wanted an opportunity to participate there.

Third stock we bought as a company called Motorola Solutions. Motorola Solutions is the last remnant of the old technology conglomerate once known as Motorola. They don’t make cell phones, they don’t make base stations. They make land mobile radios and some of the software and systems that you need to run the call centers that are necessary for first responders. There’s been obviously a lot of news as it relates to first responders that we’re just not going to get into here, but in our opinion, the long-term solution features a great deal more technology, not less tech technology in order to create more transparency in terms of what happens and Motorola Solutions is a key supplier of those technologies. They in fact, have near monopoly market shares.

Last company we bought and we just squeezed it in, in the last couple of days of the quarter was L3Harris. This is the combination of the old Level 3 communications and Harris, which is a defense communications and electronics company. Overall very strong company in defense communications, which is an area of increasingly high importance and we think a very well-run and very profitable business. In order to make room for that, we did need to sell a few things. We liquidated outright only one position, which was a position in Booking.com. We just didn’t think the upside was that great. And so we let that go.

We took some trims in KKR, in Home Depot, in Pfizer, in Union Pacific, and in Stanley Works, which is another company that we had added to in the first quarter and wound up trimming a bit in the second quarter. We added to a couple of our existing positions, but not too many adds. We bought a bit more stock in Corteva, which is a seeds and fertilizers business, very interesting. Citi Group, JP Morgan and Sempra Energy.

So overall we were active, not nearly as active as the first quarter. But particularly in the month of April, and in the first part of May, the market remained way down from where it was for most of 2018 and 2019. And we thought there were some unique opportunities. We get a lot of questions from clients with the general theme of why is the stock market not down more than it is? That the virus and the impact on the economy seems utterly devastating. Shouldn’t we see the stock market down further? So in response, so those questions, we have three answers and we’re going to give them in least to most important order.

First, when you look at the companies that are most profoundly impacted by the virus, things like restaurants, gyms, forms of collective entertainment like movie theaters. These are infinitesimal businesses in relation to the overall value of the stock market. They do employ a lot of people and it is very sad for those business owners to see their businesses damaged or bankrupted by what society is needing to do to combat the virus. But they’re just not that important to the overall stock market.

The second reason is that we were at the end of a long and fairly prosperous business cycle when the virus broke out, and a great number of businesses that are considered cyclical, whether it’s autos, banks and other credit-driven financials, basic materials, other kinds of industrial manufacturing businesses, none of them were really trading at very full evaluations on price-to-earnings or a price-to-cashflow type of multiples. They tended to be trading at discounted valuations as they were anticipating an eventual end to the economic expansion.

They had really been tailing off from a multiples point of view for most of the last three or four years. Now, obviously the COVID-19-driven recession is far worse and far more severe than anybody might have imagined the late cycle or end of the cycle recession would be. But these stocks have declined, but not by as much as you might otherwise think they would. A second and very important point is that even though we’re having a very severe recession, it is also a very fast recession. And by the month of May, we were already back to adding jobs rather than shedding jobs in the overall economy.

So it could be argued and I think reasonably successfully that we’re in a new economic cycle now, which actually favors at the margin, some investment in notionally-pro cyclical type of businesses. And I think those are both pretty good reasons why the market isn’t down as much as you might think it would be, but there is one very powerful reason that trumps them all and that is not Trump. It’s actually the number two most powerful person in the world, the chairman of the Fed, Jay Powell.

The Fed has been unbelievably active and they have unleashed money supply growth the likes of which we have simply never seen in the history of the United States. And this shows the sheer magnitude of this M2 growth is a good proxy for overall money supply growth and it is simply a gusher. At our last reading, M2 growth was up 25% year over year. It should be up to over 30% if the Fed is true to its word by the end of the summer and could be as high as 40% by the end of 2020.

I put this in some perspective during the worst moments of the great financial crisis of 2008, early 2009, money supply growth was about 10 to 11% and during the initial QE phase in 2010, when the Fed needed add reserves to offset the impact of much higher capital requirements on the banking system, M2 growth was also about at 10%. So we’re at somewhere between two and a half and four times the peak of the financial crisis.

And there is a very old economic theory, it’s authored by an economist named Alfred Marshall. Mr. Marshall was in his prime in the very late 19th century, the early 20th century called the Marshallian K and the Marshallian K is a simple theory basically says that when money supply growth exceeds nominal GDP growth, that excess tends to get into financial assets and tends to drive stock market valuations higher, all other things held equal.

Conversely, when money supply growth is below nominal GDP growth, which was in late 2018 as a for instance, then that money needs to come from somewhere. And it tends to get out of financial assets, driving stock market underperformance. I’ve been doing this for a long time and I can tell you that the money supply growth stuff, it works. It’s a fairly potent predictor of stock market performance. So that leads to our comments about what to expect for the balance of the year.

If you did not have money supply growth, that was as prodigious as what we are seeing. And if you do not have that money supply growth offsetting what is it likely to be a noisy political season, I would be at the margin fairly cautious going into the second half of the year. And it’s probably, you’re going to see some rotations into this sector and out of that sector because markets just kind of do this. But with the amount of money supply growth that we have, I don’t think I’d be too cautious here. It’s just simply going to overwhelm other factors.

Now that’s all said, I don’t want you to think we’re drinking the Kool-Aid here. It is an uneasy feeling and it’s uneasy for two reasons. On the one hand, it’s not hard to see ample speculative forces in very newfangled businesses and people extrapolating very short-term business success, way, way, way out into the future. I’ve seen this movie before and it usually doesn’t end very well and it’s a little bit disconcerting. But by the same token, there are a lot of fairly straightforward businesses to analyze that traded undemanding valuations.

Indeed, the spread between growth and value has literally never been higher on simple P.E., and on price-to-book based evaluation measures, the stock market was roughly in the 99 to 100th percentile in historical terms of growth stock valuation versus value stock valuation. So there’s a lot of opportunity to be had that just by leaning a little bit towards the cheap and the unloved, which is not surprising. Most of those companies live in the physical economy that has been damaged as badly as it has by the COVID-19 virus and the impact on the overall economy.

One last point, we are living through an interesting moment in history and it would probably be inappropriate to extrapolate too much out of our current variable unconventional day-to-day lives into the long-term. But there is a feeling that’s hard to completely dismiss that we’re perhaps leaving one era and entering a new one in terms of how we go about certain things.

I don’t think the world of physical retail is going to be the same. I don’t think the world of transportation is going to be completely the same. I certainly don’t think that my business trips are going to be the same because we’ll be able to telecommute in so many cases.

Anyway, I’m not sure what that means, but it does give me both a sense of nervousness about how those changes will feed through to the overall economy and optimism that there is ultimately a brighter future out there.

Thank you for listening and good day.

Cambiar President Brian Barish examines the second-quarter performance for the Large Cap Value portfolio and details what is moving the…