The Margin of Safety Quarterly Summer 2020
Second Quarter 2020
- During the quarter financial markets seemed to defy grim economic news, the continued spread of COVID-19, and worldwide protests against racial inequality
- As a reminder, we used the March sell off to add meaningfully to U.S. stocks at attractive prices, funding the purchase from lower risk, “dry powder” assets
- Global equities rose 17-21% during the quarter, with the US market performing the best
- Trillions in direct payments and loans here in the U.S. flowed to impacted citizens and businesses, far surpassing the stimulus from the 2008 financial crisis
- Short-term interest rates are now near zero or negative in most of the developed world and core bonds rose about 3%
- Our flexible fixed income, floating rate and international bond managers all had strong returns for the quarter, rebounding from the poor first quarter
- There are a number of risks looking out to the rest of the year, including health/virus and the election, therefore we expect volatility to continue
For most of the second quarter, financial markets seemed to defy grim economic news, the continued spread of COVID-19, and worldwide protests against racial inequality. Global equities performed strongly for the quarter. From the March 23 low, the U.S. equity market soared 40%, recording its best return over any 50 day period. The S&P 500 Index gained an incredible 21% and smaller cap stocks climbed 25%. The S&P 500, as of June 30, is now down only 3% for the year, despite the huge drawdown in March.
However, there is a distinct style (or factor) bifurcation beneath the surface: The Russell 1000 Growth Index is up 10% on the year, while its Value sibling is down 16%. That is a stunning 26 percentage point difference. Or, from another angle, the S&P 500 technology sector is up 12% on the year, while the financials, industrials, and energy sectors are down 24%, 14%, and 35%, respectively. For those interested in a more detailed discussion of growth vs. value we suggest reading the FMI Large Cap quarterly letter, a copy of which is linked here: https://www.fmimgt.com/fmi/funds/shrpt/qly_shrpt_063020.pdf .
Developed international and emerging market (EM) stocks gained 17% and 19% during the quarter, respectively, and outperformed U.S. stocks in late May and June. For the year, they are down 11% and 10%, respectively. As in the United States, growth indexes are meaningfully outperforming value indexes overseas. The U.S. dollar depreciated slightly during the quarter, providing a modest tailwind to foreign market returns for dollar based (unhedged) investors such as ourselves.
Enormous levels of money printing and government spending certainly helped the investor mood. Central banks around the world provided unprecedented support to markets and economies. On the fiscal side in the United States, trillions in direct payments and loans have been or are going to be delivered to impacted citizens and businesses. The level of stimulus globally already surpasses by far what was issued during the 2008 financial crisis.
Short term interest rates are now near zero or negative in most of the developed world. The 10 year Treasury yield fell slightly this quarter but has revolved around 0.7% for some time. Also, investment grade corporate bond spreads narrowed. Accordingly, core bonds gained another 3%.
Our non core flexible bond and floating rate loan funds, which take on more risk than core bonds but have higher expected returns, rebounded strongly from their poor first quarter performance, meaningfully outpacing core bonds this quarter. Returns ranged from 6-8% for our non core flexible bond positions and over 8% for floating rate loans. Our international bond manager returned over 13% for the quarter as well. Our multi strategy alternatives position also had a good quarter, returning over 7.50%.
While markets have rebounded and with the U.S. market again trading at prices at or above fair market value, we are advising clients that volatility will continue. There is the potential for disappointing developments on the virus/medical front, uncertainties around the November election and the ongoing U.S. China dispute that could disrupt financial markets. This is why we maintain an allocation to core investment grade bonds, despite very low yields. They are one of the few investment classes that should appreciate if the economic recovery stalls or faces a setback.
Second Quarter Portfolio Performance & Key Performance Drivers
The incredible rebound in risk asset markets—stocks, corporate bonds, and other credit markets—in the second quarter provided a strong tailwind for our portfolios.
As a reminder, back in mid March, as the S&P 500 plunged 25%, we added 4% to U.S. stocks in balanced portfolios, funded from lower risk assets. As the market continued to drop, we were prepared to add another increment to U.S. stocks but U.S. stocks rebounded quickly so we did not get a chance to add more to U.S. stocks. We are now at our neutral weighting for stocks for our balanced portfolios.
We are comfortable with our current portfolio positioning, which balances a variety of shorter term risks against attractive medium to longer term return opportunities, across a range of scenarios and potential market outcomes.
As highlighted above, global equities performed strongly for the quarter. While the U.S. market was the best performer, foreign markets gained momentum, outperforming the S&P 500 from late May to quarter end. We repositioned part of our international exposure during the quarter to further take advantage of growth stocks internationally, which we believe are cheaper than growth stocks in the U.S. We did this by removing our direct exposure to European equities and adding Baron International Growth. Michael Kass, the manager of this fund, focuses on global growth themes. Michael does this while also having a price discipline as to what he will pay for a stock. This portfolio change was made in mid May. At this early date Baron International growth is outpacing the fund it replaced by a significant margin.
We continue to expect superior returns from international and emerging market (“EM”) stocks over our five year tactical time horizon. First, overseas stocks are more reasonably priced. For example, EM stocks’ cyclically adjusted P/E ratio is near its lowest point in 35 years of data. Second, foreign economies and their markets are generally more sensitive to global growth, so as the world recovers from the pandemic, foreign stock prices should outperform U.S. stocks. Finally, in a sustainable recovery, we would expect the U.S. dollar to decline, as it is generally a safe haven currency that depreciates in the face of strong global growth. A falling dollar would further enhance foreign stock returns, as well as our international bonds, for U.S. dollar based investors (as foreign earnings are translated into more dollars).
Our portfolios’ fixed income exposure remains well diversified, including core investment grade bond funds (providing recessionary/bear market ballast to the portfolio) and flexible, actively managed credit and income oriented funds, including a tactical position in floating rate loans in some portfolios. All these non core fixed income sectors meaningfully outperformed the core bond index, enhancing our portfolios’ absolute and relative performance for the quarter.
Finally, in aggregate (and with only a few exceptions), our active equity and fixed income managers outperformed their respective benchmarks for the quarter—another reversal compared to their relative performance in the first quarter.
Closing Portfolio Thoughts
So where does this leave us? The successful containment of COVID-19 is not a foregone conclusion. The resurgence of cases in the southern and western United States, not to mention in several EM countries like Brazil and India, is concerning. Local U.S. authorities have so far refrained from large scale rollbacks of their reopening efforts. But if strict, widespread lockdowns return, the global economic recovery will be more drawn out, which would be a negative surprise for markets. There are also other uncertainties around the November election or the ongoing U.S.-China dispute that could disrupt financial markets.
But we also hold a cautiously optimistic view that with the recent uptick in COVID-19 cases, the overall social policy response won’t need to be as draconian. Therefore, the economic impact should be less extreme than during the first wave. If a more benign public health scenario plays out against a backdrop of extremely loose fiscal and monetary policy, there is a good chance we’ll get a sustainable, albeit uneven, global economic recovery. It’s unlikely to be a sharp V-shaped recovery, but something more gradual, with fits and starts along the way and with some sectors and industries doing much better than others. If so, corporate earnings are likely to rebound as well.
Measured against very low interest rates—and with fears of severe recession (or worse) off the table thanks to the government policy response—this would support the view that equities and fixed income credit sectors are relatively attractive compared to core bonds. Our meaningful portfolio exposures to non-core, flexible, and actively managed bond funds should do quite well in this event.
Furthermore, within the equity universe, a global economic recovery, likely accompanied by a declining dollar, would be a tailwind for international and EM stock markets relative to U.S. stock markets, for the reasons discussed earlier.
In our actively managed equity portfolios, we would not be surprised to see value investing and value/cyclical stocks take the leadership reins from growth stocks, potentially marking a new cycle of relative performance in favor of value. Our portfolios would benefit from this change in leadership.
The valuation gap between value and growth is at extremes that have rarely occurred in the past . We thought that it would be interesting to provide some examples of this as the difference is huge and talking about generalities is not as easy to understand as the specifics. Tesla is trading at a value of over $290 billion dollars while revenue is $26 billion dollars, a stunning 11 times. Ford meanwhile produced $155 billion of sales and is trading at $27 billion! A company called CrowdStrike Holdings, that provides internet security is selling at $23 billion dollars with revenue of $563 million. While Diebold, a company that specializes in protection of physical assets is selling at $458 million dollars on over $4 billion of revenue. A company called ZoomInfo Technologies is selling at $16 billion dollars with $340 million dollars in revenue because some have confused it with Zoom Video Communications. A company called Vroom, that sells used cars online, is selling for $5 billion with $1 billion of revenue. Meanwhile CarMax is selling at $15 billion with $19 billion of revenue. The list could go on.
Conditions like this never last and some of those that are trying to ride this wave to the end by continuing to invest in what has worked in the last five years like tech and growth will find that the pullback is likely to be swift and come without notice. This is also representative of what we see when we look at overseas vs. U.S. stock valuations – investors are paying a lot more for companies just because they are based in the U.S.
In sum, we see several ways for our portfolios to outperform over the next five to 10 years.
As always, it is paramount that our investment management be guided by a strategy that meets the risk/return profile of the clients we serve. And we need to keep a long-term perspective with an eye on near-term risks so that we remain disciplined through the inevitable downdrafts when fear in the markets is palpable.
Partnering With You
Investment planning is just one of the services we provide at River Capital Advisors (“RCA”). We are working with clients to review their finances and overall financial situation so that they can easily weather any dark times that may lie ahead. We are working with many clients to help them determine or evaluate an appropriate emergency fund, revisit cash flow and retirement projections to ensure they remain on a sustainable path, or to update an existing financial or charitable plan.
We are working with our clients to take advantage of various provisions of the SECURE and CARES acts. For example, under the CARES Act, required minimum distributions can be waived this year, including those for clients with inherited IRAs. If you’ve already taken a portion or all of your distribution, we may be able to help you use IRA rollover rules to return any unneeded portion to your account. Roth IRA conversions may also be an attractive tax strategy to consider given rule changes for 2020 and recent market volatility. Working with our affiliated CPA firm, Smoak, Davis & Nixon, we can guide clients through a range of financial and tax planning opportunities.
We also think it is time to seek greater inner strength given the stress and fear we are all feeling. Taking breaks from the daily news cycle and focusing on the physical and mental health of you and your loved ones will go a long way. It’s also important to keep a long term perspective when investing and stick to your investment and financial plan. This starts with being invested in the right portfolio that’s aligned with your risk attitudes and financial goals. If you have concerns, we are here to help you re-evaluate your portfolio for the long term.
In the face of an uncertain future, we try to remember that, through history, nothing—not even world wars and pandemics worse than the current one—stopped the inexorable rise of markets, economic growth, and progress toward greater equality and freedom, however slow or challenged it may have felt at any particular moment. As a society, we will make it through the crises we face today and come out stronger and more resilient than ever.
River Capital Advisors News
As most of our clients know, the firm recently announced that Anh Nguyen joined the firm on a full time basis as our Client Service Specialist in May. Anh recently graduated from the University of North Florida with a degree in Finance and Financial Planning, and a minor in Economics; she also has aspirations to pursue her Certified Financial Planner designation. Anh joined River Capital Advisors in 2017 as a Financial Planning Intern. Over the last 3 years, Anh contributed to the firm, its clients and proved to be a valued member of our team. Anh will assist our clients and planners in a number of areas ranging from all aspects of clients service, opening new accounts and money movement requests, to portfolio and financial plan support services. We look forward to you meeting Anh!
For our clients, we are also enclosing form CRS (Client Relationship Summary), which is intended to be a simple, easy to read summary regarding the nature of a clients relationship with River Capital Advisors. Form CRS is a new Part 3 of Form ADV and is in addition to the disclosures already required in the ADV. Please let us know if you have any questions on this new form.
We appreciate the opportunity to work with our clients in all areas of their financial life. We are in unprecedented times and our goal is to help our clients put in place an appropriate financial, investment and tax plan to help them achieve their goals.
Stay cool and safe for the summer!