Navigating a global pandemic with realistic optimism and the benefit of hindsight
We hope this newsletter finds you in good health with family members close by or in touch. If you, your family, or friends have already been directly impacted by the COVID-19 virus, we care about you and want to hear from you. These are unique times for families, friends, our country, and our world. We hope and pray for a swift transition out of our current pandemic. Please know that in this work-from-home world to which we are all adjusting, we are only a phone call or e-mail away. We are fully staffed at all hours and working hard on your behalf.
During these unusual times for financial markets, our team at Punch & Associates is committed to helping clients successfully navigate the extreme volatility and uncertainty that characterizes the current investing environment. It would not be inconsistent to say two things:
a. These are unprecedented times, and
b. We’ve been here before.
In the aftermath of 9/11, while the nation was still getting over the shock of two planes flying into the tallest buildings in New York City and witnessing their subsequent collapse, and while we were still mourning the fallen victims, our government was encouraging us to get out of the house. “Go to a restaurant, take in a movie, attend a sporting event, gather with friends” was the general exhortation back then. Today, to do such things would be viewed as tantamount to committing a crime. We must stay in, maintain proper social distancing to slow the spread of the virus, and give our medical community a chance to tend to the ill and come up with an answer. We are voluntarily closing large parts of the economy, which is problematic to say the least. We don’t have a choice. At the same time, we need to be ready to re-open it. Yes, these are unprecedented times.
Like 9/11, the COVID-19 pandemic has caused a re-assessment of the prospects of all businesses in America over a very short period. Financial reporting rules require companies to outline the uncertainties in their businesses. A restaurant or clothing company might typically include risks like changing consumer tastes, rising interest rates, or supply chain disruption. For the first half of the quarter, few companies pondered government-mandated closures or the impact on their business from the new rules on social distancing.
But this is my eighth bear market since coming into the business in 1983. In every past bear market, the pattern was as follows: 1) volatility increased, 2) people got scared, and 3) eventually stocks bottomed before the economy officially did. Given this history, it may never be as important as it is now to control your behavior as an investor. While it’s impossible to predict the exact bottom of the market, we know that acting on panic is generally not useful to guide one’s decision-making in a high stress environment.
Pessimists have a strong following right now. Optimists are the clear underdog. A glass half-full? Are you kidding me? It’s hard to see this situation this way. I suppose that’s why they call what we’re going through a crisis. In a crisis, everything that we thought was true ends up false; that which couldn’t possibly happen, happens. Just a short time ago, current events seemed unimaginable. What we are experiencing now might have been borne out of the overactive imagination of a Netflix producer. Now we are watching it, but this time we all have a role in the movie.
In this movie, there is a positive narrative, one that features heroes. These heroes wear lab coats and scrubs instead of capes. They are the ones working on the frontlines of this crisis, potentially exposing themselves to this virus every day. Heroes stock shelves and check you out at the grocery store. They deliver your packages so you can stay safely at home. These heroes continue to work in factories producing essential goods and, in some cases, life-saving goods. There are heroes all around us and, like our soldiers, we should thank them for their service. Thank you if you or a family member are one of these brave people.
In this crisis, a lot of goods have been in short supply. During the initial stages, there was a run on toilet paper and hand sanitizer. I went shopping for a propane tank and couldn’t find one. Crowds were emptying grocery store shelves of life’s essentials. As people were focused on the immediate term, they may have lost sight of more important things like perspective and optimism.
David Rothkopf, writing for USA Today, recently made these comments about optimism:
Mr. Rothkopf went on to recount a story from his childhood:
The world as we know it will only come to an end once, and I don’t believe this is it. If I did, I probably wouldn’t be writing this article. There are many concrete reasons for my optimism.
The coronavirus is both a medical crisis and an economic one. The cure for one competes with the cure for the other. To treat the virus, we must enact social distancing which means a large part of the economy necessarily must hit the “pause” button. The financial consequences to this shutdown have been sudden and dramatic. It’s clear that strong decisive actions are necessary, and that’s what we’ve seen from the Federal Reserve and other policymakers in recent days:
Markets quickly absorbed the reality that we would need to shut down a large part of the economy to fight the virus. Six short weeks ago, the S&P 500 Index was marking daily new highs. Since those days, we have lost roughly a quarter of the index’s value. Indices measuring small companies have absorbed even greater losses. Here are some reasons we are more optimistic than three months ago about certain stocks:
While there are many positive aspects of our current situation, the real reason for optimism is that after every crisis, we find a way to reinvent ourselves. We can employ the benefit of hindsight as we consider the ways in which other generations have gained strength through adversity. The suffering we, as individuals and as a society, experience today due to this pandemic will lead to character, unified resolve, collaboration, and innovation.
In a few short years after the 2008 financial crisis, we witnessed an expansion in new, creative companies born out of that dark economic time. The editors of the New York Times wrote in March of 2009, “The deck gets reshuffled in a recession as habits are re-examined and patterns of behavior are broken, perhaps to greater degree than when things are humming along at a steady state.” They go on to say, “With business as usual off the table in a recession, people become more open to new and efficient ways of doing things. And they’re forced to show more entrepreneurial discipline—you have to expend imagination before spending money.”
Like the 2008 financial crisis and other economic recessions before it, we may now be entering the breeding ground for entrepreneurship and business opportunity. We find new ways to solve stubborn, deeply ingrained problems. We are forced out of the status quo and into a new perspective. We will emerge with scientific breakthroughs, new technology, more efficient supply chains, and ultimately, we will be better prepared for the years ahead.
We are in a medical crisis that has caused an economic crisis which has become a financial crisis. This has impacted everyone quite quickly. Fact-finding is difficult. Many “experts” with a microphone in front of them are making high-conviction guesses. But they are only guessing. Trying to get to the truth before others is our daily mission. While volatility is likely to remain high in the coming weeks, we believe it will taper down in time as we more accurately separate fact from speculation. Businesses valuations always revert to the present value of future cash flows. In our opinion, our companies are well positioned to get through the current crisis and eventually thrive on the other side.
Historically, times of uncertainty and fear are the greatest moments to be invested in the stock market. In the middle of each past crisis, it was hard to see around the corner. In hindsight, each past crisis has afforded a great buying opportunity for a generation of investors. We see no reason why this time will be different.
Many of you have heard us tell stories of Warren Buffett and his partner, Charlie Munger. We hold them on a pedestal not because of their shrewd investment acumen or their insightful macro-economic analysis. We do so because they behave better than most other investors…especially during time like these.
In the late 1980s, Munger recalled in a interview that a guest at a dinner party asked him, “Tell me, what one quality accounts for your enormous success?”
Mr. Munger’s reply: “I’m rational. That’s the answer. I’m rational.”
Our commitment to you will always be to act rationally in stewarding your resources.
Declines in income asset classes reflect fears of a worse-case scenario
In September of 2008, in the depths of the worst financial crisis since the Great Depression, stock and bond markets temporarily flipped. Assets that are traditionally considered “safe” declined more than assets that are traditionally considered “risky.” As an example during that month, investment grade corporate bonds declined more than their common stock counterparts in some cases.
This topsy-turvy market environment was the result of existential worries on the part of investors. Will financial markets continue to function? Will banks and markets remain open? Are any borrowers still creditworthy? In the face of COVID-19, we are encountering some of these same questions today.
Historically, the Punch Income Strategy has had roughly half the volatility of the stock market. While trying to produce a high and consistent stream of cashflow for clients, we accept some short-term price volatility. In the first quarter of 2020, like in 2008, various income-oriented securities declined in-line with equity indexes or more so. This is highly unusual.
To some extent, these declines simply reflect markets that are moving quickly and indiscriminately. The stock market decline of the past month was one of the fastest in history. Even assets like farmland and government office buildings (both owned in the Punch Income Strategy) saw similar declines as the stock market, despite being more conservative and creditworthy.
The larger concerns, though, surround the ability of consumers and businesses around the globe to continue to pay their debts. As the world goes on lockdown and enters an indefinite economic winter, the uncertainties of credit losses mount. With so much unknown, many investors are assuming the worst and trading accordingly. Once we get to the other side of this pandemic—which we believe will happen with the help of significant government intervention and medical resources—then investors may no longer assume the worst.
Despite this uncertainty and volatility, the Punch Income Strategy continues to produce regular income to investors, and we are on the lookout for ways to increase this income as opportunities arise. The longer the current crisis continues, the more likely it would be that we could see some reductions in dividend distributions to investors; so far we have seen more increases than decreases.
In the first quarter, we added to several existing positions and initiated nine new ones. We believe these investments have strong and sustainable dividend and interest income. In one case, we re-purchased a closed-end fund that we sold just two months prior. We continue to hold higher cash balances than usual, and we are ready to deploy it selectively.
Periodically debt markets catch the flu, and an investment strategy that produces regular income is especially important because of the tangible and immediate return it provides. While this has been the most unusual and unforeseeable set of circumstances that most of us have seen in our lifetimes, we believe that, similar to 2009 and after, ailing credit markets will eventually heal.
Large companies provide haven for “sheltering-in-place” during uncertain times
Early in my career, I was asked to spend a year in London to help establish an investment bank’s European office. I jumped at the chance despite never having been to Europe. One of the first things I noticed were the many useful signs helping people navigate the city. At every busy intersection, a clear message reminded me to “look right” before stepping into a crosswalk. When I boarded the London Underground, signs read “mind the gap” to help me avoid tripping as I entered the train. So long as I paid attention, there were lots of signs to get me where I was going safely.
Like visiting a new city for the first time, each market crisis feels differently. As investor Howard Marks said, “And finally there’s contrarianism, which can convert other investors’ emotional swings from a menace into a tool. Going beyond just fending off emotional fluctuation, it’s highly desirable to become more optimistic when others become more fearful, and vice versa.” While this sentiment is easy to understand, in real life it is hard to implement if we rely too much on our own emotions. Thankfully, well-marked signs can help us navigate and recognize opportunities.
Measurements of fear were at all-time highs during the first quarter. Market fear gauges exceeded levels not seen since the financial crisis in 2008. March delivered two of the six largest days of market decline since 1929. Towards the end of the quarter, we began to see signs of hope, but we still don’t know the full extent of COVID-19’s impact on the economy. We do know, however, when the market is exhibiting signs of panic, it has historically been a good time to get—or stay—invested.
Many companies in the Punch Large Cap Strategy have cash balances well in excess of their near-term needs allowing them to sustain economic downturns and deploy capital opportunistically. A few have strategically built cash balances specifically to take advantage of a correction. In any downturn, the best capitalized end up getting stronger, and our companies are poised to gain market share.
This strategy is also our most geographically diverse, helping to mitigate against any single economic disruption. COVID-19 is a pandemic, but the virus impacts countries at different times. One country’s productivity can help offset the weakness experienced in another.
Finally, many of the companies in the strategy are some of the most prominent in their industries and have customers who will continue to demand their product or service regardless of the economic environment. We have been through market crises before, and we believe we are again well positioned to participate in the recovery.
While in London, it was not uncommon to exit the Underground and be confused about which way I was headed. Thanks to well-marked signs, I was able to get where I needed to go, even if in the moment I felt lost. Despite continuing broad macroeconomic uncertainty, and the natural unease that comes with every market decline, we are paying attention to the signs that historically indicated investors are likely to be rewarded in the future. We feel confident that owning some of the strongest companies in the world will enable us to get to the other side of this crisis without permanent damage, and we believe these companies will thrive at some point in the coming years.
A focus on strong balance sheets and management teams in times of crisis
Our firm has managed the Punch Small Cap Strategy since our founding in 2002. This strategy’s objective is long-term capital appreciation. We do this by investing in some of the smallest, least-followed publicly traded companies where we think opportunities are greatest to find undervalued securities.
Across all the Punch strategies, we are value investors and seek to protect against permanent loss of capital. We like to find solid businesses and buy them at valuations that provide a meaningful margin of safety. If we do this consistently, when something goes wrong, the business can still survive and eventually thrive when the environment normalizes.
We believe that a few factors are causing some of our favorite companies to be punished more than others in this environment:
The COVID-19 pandemic is likely impacting every business across the world in some way. A small fraction of companies may benefit in the near term. The vast majority of companies are like people going through this pandemic, their businesses have no choice but to adapt. Some will have to do so rapidly. Companies with relatively stable demand (or demand that they can recoup) are best positioned to drive shareholder return. Those with deferred demand will need to find ways to defer costs and maintain enough liquidity on their balance sheets to get to the other side of the crisis. Our strategy has always favored businesses with entrenched customer bases (which should leave demand relatively intact or only deferred), strong balance sheets, and strong management teams.
We are not being Pollyannaish with respect to COVID-19 and its near- and long-term implications for businesses. Our investment team is hard at work having lengthy conversations with the management teams of the companies you own. While conversing with management is a regular part of our research process, in recent weeks we have put this this practice into overdrive. That said, we recognize that the world has changed in the last three weeks, which means that a conversation from a month ago may already be quite stale. For that reason, we have dozens of conversations daily with your companies.
Over time, we believe the market will reward the small cap companies you own, even though our strategy lagged the Russell 2000 Index during the quarter. Sector allocation was a main reason for the underperformance. The Punch Small Cap Strategy was underweight in the healthcare sector and overweight in the consumer discretionary sector. As you might expect during a pandemic with social distancing as the only near-term solution, healthcare was a top performing sector, and consumer discretionary was one of the worst. The companies in the Russell 2000 healthcare sector tend to be some of the most speculative with little current earnings power. With our focus on downside protection, we are content to underweight companies with these characteristics.
A majority of the consumer discretionary companies in the Punch Small Cap Strategy have characteristics that make demand largely deferred (housing-related, cars, golf equipment, etc.) but not lost (for example, we do not own any restaurants). We believe, with time, our companies will regain much of their near-term lost revenue, have the balance sheets to sustain themselves, and even gain market share during this pause in economic activity. We maintain our belief that we have positioned the portfolio well to survive the present economic damage.
Comparing our strategy to the Russell 2000 Index, it becomes apparent that:
COVID-19’s economic damage is real, but we recognize the market is forward looking and will eventually see past the current issues. History doesn’t repeat itself, but it rhymes. As with past market downturns, our approach is consistent.
We will be executing these actions over the next few weeks, not months. At the same time, we are careful not to overreact during periods of extreme volatility. As always, we treat each investment as an ownership interest in a business, and in so doing, we maintain a multi-year view for the investment’s potential success.