The COVID-19 outbreak has plunged the globe into chaos. We are in uncharted territory, from both a societal and a financial market perspective. The policy response to the virus has come at a severe economic cost, with a collapse in demand and extensive disruption to supply chains. Whole sectors have ground to a halt, including crucial employers in industries such as hospitality and tourism, non-essential manufacturing and retail. The current uncertainty and fear about potential outcomes feel unprecedented. As stewards of our clients’ capital, we have applied our minds to find the opportunity for our clients in the midst of the COVID-19 storm.
Our response to uncertainty
We set up a task team to monitor the COVID-19 outbreak. The team updates a dashboard showing key metrics across important countries and curates the massive volume of research for circulation within the broader investment team, with a focus on issues that can dramatically impact the COVID-19 outcomes, such as infection rates and death rates, and vaccine and treatment trials.
Forecasts by various experts about the possible outcomes of the COVID-19 outbreak show a huge range of outcomes and have changed dramatically in a matter of weeks. It is clear that very small changes to assumptions have enormous impacts on modelled outcomes, and given the many variables, even highly qualified and experienced epidemiologists do not actually know how COVID-19 will develop in the months ahead.
We don’t aim to predict outcomes, but rather remain focused on managing our clients’ investments
Our goal is staying abreast of COVID-19 developments as they unfold, rather than trying to predict outcomes. We acknowledge that we don’t know what will happen, and believe it is dangerous to make explicit top-down forecasts for the economy or try to predict the impact on financial markets.
What we have done is to focus on stocks, answering two key questions:
- Do our buy list companies have the resilience to weather the COVID-19 storm?
- Has the general collapse in stock market prices surfaced attractive new opportunities for our clients?
Have intrinsic values changed?
We have re-evaluated our existing holdings given the COVID-19 uncertainty, using appropriately conservative assumptions. Our process was to stress-test our holdings for a severe demand disruption, and evaluate available liquidity in the light of this and our earlier work on balance sheet resilience. We have also engaged with management to understand what a prolonged shutdown would look like.
The most vulnerable companies are those in sectors where revenue has shown a dramatic decline or come to a complete halt, while costs are still being incurred. Should those companies have significant gearing, the risk of a wholesale transfer of value from equity holders to debt holders becomes acute. Where our work has highlighted companies that have suffered a permanent impairment of value, we have acknowledged this new reality and changed our portfolios even at the prevailing low prices. Given that our portfolio companies entered the COVID-19 crisis with resilient balance sheets, low earnings and cheap valuations, i.e. large margins of safety, the impact of these portfolio changes was largely insignificant.
Selling, even at depressed prices, offers the prospect of applying cash better elsewhere
Some examples include brick-and-mortar retail exposure such as L Brands and Washington Prime. While it always feels terrible to sell a stock at a depressed price, the upside of the general price decline is the rare opportunity to use the resulting cash to acquire great companies at attractive prices.
A wealth of quality on sale
Every extreme market disruption feels unique at the time. Consider the Global Financial Crisis (GFC) following on the unprecedented US housing and mortgage market collapse, and 9/11 when global terror was unleashed. With the benefit of hindsight, we can say that these periods of extreme uncertainty enabled us to build portfolios of exceptional businesses that set up our clients’ funds for the next cycle. We believe the COVID-19 disruption could provide a similar opportunity.
Seeing the opportunity in the crisis
We have been buyers of companies like AB Inbev, Shoprite, Liberty Global, Prudential, Discovery and Brookfield Asset Management. In many cases these are ‘3M’ stocks we know well and like, but had historically chosen to sell or reduce our positions as prices rose and the margin of safety diminished. Thus, while COVID-19 has produced much hardship and loss, it has also afforded us an opportunity to buy shares in these quality companies at remarkably wide margins of safety.
Low markets provide the starting point for excellent long-term returns
Our ongoing research is focused on adding more ‘quality on sale’ stocks to our portfolios. We are finding these both among our historic holdings that we know well and can convert quickly, and in new opportunities. While we don’t know how long the COVID-19 disruption will last, we do know that buying resilient businesses priced at financial crisis ratings offers a fantastic starting point for excellent long-term returns.
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