As 2020 nears an end, many of us are reflecting on both personal and professional accomplishments, challenges, and opportunities. We make similar reflections as seasoned investors to continually improve our skillset. While the following list is not inclusive, it highlights important points to remember in times of high uncertainty in the markets:
Balance sheets and cash flow matter – As extreme measures forced daily activity in the economy to come to a screeching halt, dire case scenarios for many businesses became a reality. With revenues in some industries declining 90% or more, investors were forced to consider the importance of balance sheets and cash flow. Investors that owned businesses with troubled balance sheets saw their valuations decline well over 50% during the first half of the year.
When comparing returns in the S&P 500 YTD through 11/30/20, companies with levered balance sheets in excess of 4x net debt to EBITDA generated performance of –1.21%, while businesses with net debt to EBITDA less than 4x averaged returns of 18.6%. Businesses with clean balance sheets and adequate levels of free cash flow on maintenance capex faired markedly better.
The Certainty Tax – Early in my career I was fortunate to be surrounded by investors with a rigorously disciplined approach to investing. One well respected colleague, Jim, was instrumental in teaching me everything from how to analyze a business to financial statement analysis to valuations. Perhaps the most important thing Jim taught me was how to understand the psychology of the markets.
One of the points he repeatedly stressed was the cost of waiting for certainty in the market. The Certainty Tax is an added cost to investors who wait for certainty to be realized and translates into consistent long-term underperformance in the market. Those investors that opted to wait for the announcement of a therapeutic vaccine for COVID are clearly paying the price of The Certainty Tax, having missed out on double digit gains in the market.
Special Report: Markets in Turmoil – At the depths of any major crisis, many find themselves glued to their television sets watching hour long special segments on the market well after the closing bell has rung. The media does an excellent job in reporting, but pushes negative news at a rapid clip particularly when markets are at their worst. Historically, these instances tend to be the best opportunities to be invested and a great time to put more money to work in the market.
Stay the course and stick to your plan – Many times investors find themselves overly emotional when faced with abnormally high levels of volatility. Some investors succumb when carnage in the markets is at its worst; others look to take profits too early following a nice rebound.
One example comes to mind with a professional money management firm that opted to reduce their client’s equity allocation by half across the board and leave the proceeds in cash. The decision was made in May following a 32% rebound from the lows we witnessed in March. Since then, the S&P 500 has appreciated an additional 24% from May or 62% from the March lows.
It’s a reminder for investors to focus less on timing the market and more on sticking to a predetermined plan to stay invested and endure the market during times of heightened volatility.
Value vs. growth – Since The Great Financial Crisis, we’ve witnessed growth stocks outperform value stocks by a wide margin. As the markets moved sharply lower over the 5 week period from mid-February to late March, value stocks provided little in the way of defensiveness as the Russell 1000 Value (RLV) fell 38.3%, while the Russell 1000 Growth (RLG) index declined 31.5%. As the V-shaped recovery ensued, market leadership remained squarely focused on growth once again as the RLG rebounded 75.7% and the RLV was up 55.3% (3/23 – 11/30). Many factors, including the stronger underlying fundamentals and the current low rate environment, have provided support for the underlying outperformance.
As the debate among market participants and experts on whether value will outperform growth continues, we remain dedicated to our own strategy. This approach parses through the lines that define the respective investment styles with a focus more on the quality and drivers of business fundamentals in the stocks we own and the fund managers we hire. High quality businesses with a steady stream of recurring revenues, moats around their business, high returns on invested capital, good free cash flow and strong balance sheets, tend to grow into their perceived expensive valuations.
As we look to the New Year and beyond, opportunities appear more prevalent. While the COVID cases rise at an alarming rate, we’ve become more adept and better prepared. Consider the following:
- Novel vaccines from several of the best global pharmaceutical and biotech companies in the world are on the cusp of being distributed worldwide.
- The unemployment rate has dropped in half since the April peak.
- Credit card delinquencies are near historic lows.
- Mortgages in forbearance continue to decline over the last several months.
- Consumer savings as a percent of disposable income is 13.6% – nearly double the historical average.
- Housing trends are exceptionally strong – U.S. existing home sales recently rose the highest level since 2005, and median home sale prices are exceptionally strong.
As disciplined investors, we look at where the puck is going, not where it is today. Oversized, pent-up demand for everything, including travel, dining out, and shopping, will likely outstrip supply and come back in a meaningful way. Coupled with consumer balance sheets heavy in cash, interest rates trending near historic lows, the spending power for consumers positions the economy for a robust multi-year expansion. In the near term, should we see an unexpected turn for the worse, expect to see further stimulus measures taken while the economy remains in a holding pattern.
While the events of 2020 may be unprecedented, we can be rest assured history will repeat itself.