Discretionary Investment Management | Ben Byrom
22 May 20
Investment update - Navigating the exit from lockdown
Have stock valuations already baked in as much as we can expect from an easing of restrictions, or will there be pleasant upside surprises to come as economies get back to work? The immediate future has been about as uncertain as it has ever been, yet the stocks we're most interested in seem to be priced for a perfect outcome - so we thought we’d explain how we intend to navigate it in Blue Chip.
There’s no getting away from the fact that it's getting a bit weird out there.
- Approximately 15% of America’s labour force is now unemployed and Fed chairman, Jerome Powell, admitted in an interview that it will likely peak around 25% - as it did in the 1930 Great Depression
- May-expiration oil futures went negative for the first time ever as demand plunged and storage tanks overflowed – the US regulator is warning it could happen again soon
- Edgy financial blog Zerohedge reported that demand for physical gold temporarily outstripped supply forcing the Bank of England to become the lender of last resort to the largest gold-backed Exchange Traded Fund, the SPDR Gold (GLD) ETF
- Bond investors paid the UK Exchequer to lend it their money during a gilt auction held on Wednesday 20th May. Bank of England Governor, Andrew Bailey, has U-turned on his stance regarding negative interest rates over the last week as the UK’s CPI rate crashes towards 0%.
These are very unusual times indeed - even the veterans are scratching their heads on this one! Who knows what the future may bring as we exit lockdown in amongst a still very clear and present danger. As we noted in our previous article What are our companies up to?, many of them have been forced to withdraw guidance for the rest of the year due to the opaqueness in their own markets. Nonetheless, the people are starting to get restless with indoor living, and containment measures have brought with them huge economic stress despite central bank interventions and state-backed bailout programmes. It seems economic and social factors are starting to drive exit policy decisions, and not necessarily the science.
And it’s this narrative of slowing infection rates, economies opening up, positive news flow on vaccines and therapeutics, backed by extraordinary levels of financial stimulus, including the prospect of negative interest rates, that is driving the current V-shape recovery in stock markets. So, should we be as optimistic as Wharton professor Jeremy Siegel who, in summary, believes that the March lows will not be tested ever again? Should we therefore be buying the highest growth stocks, no matter the price or risk, and ride this bull market like rodeo All Stars? Or should we continue to exercise caution, pay heed to the fundamentals, and stick to our valuation driven process?
Those of you who watched our webinar last month will know that we went into the ‘coronacrash’ in a defensive position with half the portfolio weighted to healthcare and consumer staple stocks, and we remain in a very similar state today. Our preference for quality, our intent to buy at a reasonable price and the defensive positioning has served us well so far - the strategy even poked its head into positive territory on a year-to-date basis – but we are ceding ground to a hot running market that has the ‘FOMO’ (fear of missing out) bit between its teeth. So how can we navigate this?
Coming up for a breather, Global Blue Chip O Accumulation class GBP surged into positive territory on 18th May 2020. Source: Ravenscroft and FactSet, data as at 20th May 2020
With the benefit of hindsight, we now know there were opportunities during the March sell-off that we didn’t seize upon, and on reflection, we feel that our conservative nature got the better of us. As a result, we have tweaked our allocation approach so that instead of waiting for a set margin of safety before adding to a stock, we will now add (or remove) as that margin of safety fluctuates, creating a more flexible framework.
Source: FactSet, Ravenscroft and Google images
For example, Nike is a company that we have admired for quite some time and we hold a 2% position in the strategy as a result. In January, whilst the virus was shutting down stores in China, Nike was trading near all-time highs at around $105. By our calculation this was expensive, with scant Internal Rate of Return (“IRR”) on offer, and so we considered selling the holding. However, as markets collapsed, Nike’s share price slumped to a low of $62.80 with the IRR jumping to almost 8% (solid grey line in the chart) - a level we would consider good value. However, we were holding out for a 10% IRR at $55 (the dotted grey line) as we felt the magnitude of what was unfolding would justify this ‘patient’ approach. Alas, thanks to Jerome Powell, we never got our chance and the ‘swoosh’ in share price from that moment on means we still have a 2% position.
Subsequently, we have decided to adjust the way we allocate by implementing a traffic light system. All holdings will have a base weight of 2% and this can be adjusted higher, depending on the margin of safety on offer or the value we perceive is represented in the current share price relative to the estimated intrinsic value of the company – please read Sam Corbet’s article FAANGtastic or Fanatical? Revisited for an overview on how we approach estimating a company’s intrinsic value.
Anything below what we would consider fair value is ‘red’ on our traffic light system and no further weighting will be applied. In fact, stocks in this zone may actually face the chop if an equal in quality is available at a more compelling valuation. As value increases, so does the ranking to ‘flashing amber’, ‘amber’, and then ‘green’ with the weighting in the portfolio adjusting accordingly. Stocks in the green zone have compelling valuations and plenty of margin of safety allowing us to hold a maximum weight of 5%. Even our ‘smaller’ (still north of $10 billion in market capitalisation), ‘racier’ (faster growing) businesses have the potential to reach this weight but the hurdles are commensurately higher.
Using this methodology on our Nike example, an additional 1% allocation to the stock with its IRR at 8% would have yielded an additional 0.5% in performance – useful when trying to run with bulls. However, remembering Ravenscroft group managing director Mark Bousfield’s metaphor of rock climbers resembling the dangers of over valuation – the higher up the cliff face the harder the fall – Nike, with its stock price back in the $90s and the IRR back in the low single digits, much of the 1% addition would have been withdrawn, reducing the overall risk in the position.
It is important to note that our traffic light system is not a systematic approach but a way of providing a more flexible guideline to stock allocation. Whilst it would be possible, under this methodology, to hold just 24 stocks at 5% each, I would be amazed if we ever got in that position – although it would mean our dear friend at Wharton University was wrong in his prediction.
We would also not want to go beyond 30 stocks in the portfolio as it would mean introducing sub-standard businesses for the sake of fulfilling a systematic approach. Indeed, when we apply the methodology to the current portfolio, we arrived at a 12% cash position. Rather than introducing new companies, we decided to increase the weight to a few existing holdings in the more defensive areas of the portfolio to bring the cash down to a more respectable level.
We can't wind back time and start again, but this adaptation will enable us to increase or decrease positions in a methodical way, as and when stock prices gyrate and opportunities arise. It will rein in emotion, and maintain focus on the fundamentals we work so hard to understand. Furthermore, it emphasises the fact that valuation drives the allocation process rather than what we think will happen in the future.
The desire to diversify away from our defensive positioning is fuelling our research into automation and 5G – areas that we feel will have a real tailwind in a post COVID-19 world. However, the need to diversify is tempered by the uncertainty that persists and we remain comfortable with our defensive positioning for now – after all, we’re not rodeo All Stars and riding volatile bulls is not for the faint-hearted and this is no market to be brave!