U.S. core value equity team—market update

As long-term investors, we have been diligently pouring over the four scenarios that comprise our range of values for all of our owned companies as we try to react to the evolving demand environment. These scenarios – the bear and worst-case ones in particular at this moment – help us to understand what the market is discounting as fear and extreme risk aversion drives equities lower. Needless to say, markets are currently discounting a prolonged and severe recession with meaningful and in some cases, permanent demand destruction.

Sometimes, not reacting — or over-reacting as the case may be — is the hardest thing to do and we as a team have remained disciplined. To this point, the U.S. Core Value Equity Team has only re-positioned modestly during this precipitous period since the February 19 peak. In January the team took some profits in financial and consumer discretionary sectors. Most of the proceeds accumulated in a cash position though the team initiated a position in a tower business with exposure to growth mobile data demand as well as 5G and small cell growth in the US. In recent trading sessions we initiated a position in a regional bank that like others already in the portfolio in trading at a substantial discount to book value and at a value that discounts a period of permanent loan demand destruction and structurally lower return on equity than the business has been delivering in recent years and worse than the experience around the global financial crisis.

As everyone is unavoidably distracted by the value destruction reported in the media, we would note that equities broadly are as attractive as they have been since the December of 2018 growth scare, and recent liquidity concerns have seen stocks trade at discounts to intrinsic value akin to those seen in early 2009. In December of 2018, the market was baking in a US recession we did not expect would materialize. This time around, the virus and energy complex-related supply and production disruptions we are experiencing will most likely drive a contraction in U.S. GDP and thus an official recession. The economic and employment disruption is now obvious and so the question becomes one of severity and duration.

Today, we have a global economy that will be unified in seeking recovery (instead of a potentially protracted trade war) and a high likelihood that the Coronavirus disruption will be temporary. History is on our side in assuming this will be a temporary (though of course serious) disruption yet stocks are discounting a period of prolonged weakness and anemic US and global growth.  We do not expect that this COVID-19 outbreak will permanently change the way businesses and individuals produce and consume goods and services. While some travel, leisure and service industries may see demand trends evolve, we believe the American dream is intact and that consumption will steadily resume as the crisis containment efforts take hold. The response to the virus underway is unprecedented and we are confident that health, liquidity and fiscal stimulus measures will speed an end to the crisis at hand.

This market correction has been the fastest ever recorded in US capital market history.  We have a clear period of dislocation ahead of us and our record expansion is giving way to a period of uncertainty and deteriorating employment. We believe the recovery has the potential to be equally swift and welcome the extra-ordinary measures government and private sector entities alike have taken to halt the spread of the virus and ensure business continuity.

While trading has been limited, our research activity has been intensive. The past couple weeks have been particularly busy ones for the team as we collectively met with over 75 companies (over 50 face to face before travel restrictions) in the office, at multiple conferences throughout the U.S., and over the phone. These meetings are a critical source for management updates on the disruption as well as offering perspective on the long-term investment cases for all of our businesses. While our dialogue is now exclusively over the phone, we are having productive interaction with our portfolio of companies.

With recent moves in the market we find ourselves shopping for equities in a target rich environment where there are a high number of very high-quality cash flow compounders trading at 50-60 cent on the dollar levels – massive discounts to intrinsic asset value. Stocks are trading at levels similar to those witnessed during the global financial crisis.  Unlike the 2008/2009 period, we have a banking system that is over-capitalized, a U.S. consumer that has been saving and is under-levered, and a healthy housing market with pent up demand. We have businesses that have experience dealing with supply chain and distribution challenges for over two years that can fund themselves at all time low costs and with the full resources of the banking industry, Treasury and Fed at their disposal if needed. We also have a Millennial cohort that is now larger than the Boomer generation that is flowing through our work force, forming households, and will drive a far faster demand recovery than we saw in the wake of the global financial crisis.