7/5/2020

2020 Mid-Year Update, 7/5/2020:

Dear Clients,

Our first-half 2020 market update letter contains three sections as follows:

I. Long Game Financial (“LGF”) before, during and after peak COVID-19 market fear

II. Interest rates, government stimulus, the demand effects of COVID-19…and the 2020 tech rally

III. Closing

I. LGF before, during and after peak COVID-19 market fear:

As a reminder, when you invest with LGF you own neither the economy nor the stock market. Rather, you own a portfolio of stocks of generally US-domiciled companies that in our judgment fit our CAM Framework. CAM stands for Competitively-advantaged, Attractively-valued, and Managerially-aligned.

If you would like to learn more about CAM, please visit our website here and review an excerpt from our 2018 letter here.

To recap first-half 2020, during 2020Q1 the global economic disaster that is the COVID-19 pandemic caused an unprecedented decline in employment (per the exhibit below, via the St. Louis Federal Reserve) and GDP. Then, to offset COVID-19’s economic consequences, governments worldwide extended unprecedented levels of financial stimulus.

COVID-19, however, has not affected the world’s companies evenly. Rather, it roughly separated them into “haves” and “have-nots.” Returns by sector illustrate this dispersion: per the exhibit below (via seekingalpha.com), energy, financial services, and industrial stocks are down significantly year-to-date (the “have-nots”—predominantly so-called “value” stocks) while technology shares are up year-to-date (the “haves”).

A key lesson here that we have shared before and will share again is the stock market is not a monolith: not all stocks drop when recessions occur, and not all stocks rise when expansions occur. Recession or not, there are always parts of the global economy that are growing and others that are shrinking, and investor expectations are just as varied. In our view, this makes economies and markets far too complex for binary, “It is either a bull market or a bear market!”-style thinking—tempting as such thinking may be.

The good news for LGF clients is that 2020’s “have-not” market sectors have historically graded poorly on our CAM Framework because competitive advantages (the “C” in CAM) tend to be in rarer in energy, financial services, and industrial businesses. LGF therefore entered 2020 with a minimal weighting to the market’s most COVID-19-exposed groups and continues to be positioned as such.

What COVID-19 portfolio exposure LGF did have at the beginning of 2020—most notably, various triple-net lease REIT investments—we sold in early March when we realized how far-reaching COVID-19’s economic effects would likely be. At that time, oil’s 24% price decline on 3/8/2020 and the pandemic’s spread in Italy worried us in particular.

Although LGF targets and measures investment returns in multi-year increments, we are always willing to increase our portfolio turnover abruptly and forcefully if we believe new developments warrant change. This happened with our REITs: although we counted them among our favorite holdings on 1/1/2020, the prospect of indefinitely elevated vacancy due to COVID-19 compelled us decrease our expectations for them by so much that liquidation seemed the only appropriate course of action.

For anyone interested in learning more about how our thought process and positioning changed as COVID-19 unfolded we recommend reading the three COVID-19 update letters that we shared with clients via our website as the pandemic proliferated: update #1, 3/5/2020 (when COVID-19’s market impact was just beginning), update #2, 3/25/2020 (near-peak COVID-19 market fear), and update #3, 5/14/2020 (post-peak COVID-19 market fear).

II. Interest rates, government stimulus, the demand effects of COVID-19…and the 2020 tech rally:

We will take our own advice and avoid offering a short-term forecast for the stock market—but we will leave you with three important positives to consider with respect to the stock market and technology stocks in particular as we move into the second half of the year. These three points may help to counter-balance the doom and gloom that abounds these days (the post-March bounce in the stock market notwithstanding).

(1)    Long-term interest rates are lower than they have ever been

Long-term interest rates and financial asset prices share an inverse relationship: lower long-term interest rates, all else equal, reduce discount rates and increase asset prices. Think of it as a teeter totter: rates down, asset prices up.

Put somewhat differently, lower interest rates reduce the opportunity cost of owning stocks instead of bonds. For example, if the return that investors can earn on bonds declines because interest rates decline, stocks suddenly become more attractive by comparison—and investors may then feel compelled to bid up the price of stocks as a result.

With 10-year treasury yields at the historically low level of 0.7% today (exhibit source: St. Louis Federal Research) it is possible to justify paying a higher earnings multiple for stocks today, all else equal, than at any other time this century or last.

(2)    Indefinite government stimulus

We will reiterate what we wrote in our 5/14/2020 market update:

All governments seem to recognize that COVID-19 is a serious problem and consequently most are extending unprecedented levels of financial assistance to their citizens.

We see no reason why this government financial assistance would subside meaningfully prior to solving COVID-19—and, as we noted previously, our working assumption currently is that COVID-19’s economic effects will last one to two years.

Protracted government stimulus, of course, would be an important ongoing positive for the stock market.

(3)    COVID-10 helps certain businesses – some permanently – and the market rewards counter-cyclicality

A curious but logical business side effect of the COVID-19 pandemic is the fact that it has accelerated the adoption of relatively novel, quarantine-friendly products and services like e-commerce, online video, and software-as-a-service (in addition to increasing the demand for older-school, quarantine-friendly products and services like exercise equipment, pizza delivery, and RVs).

In short, across a vast number of use cases the pandemic has forced consumers and businesses to trial new products and services—and even if COVID-19 were to disappear suddenly it is unlikely that all of this shifted demand would shift back. We have known for years, for example, that once someone trials e-commerce they tend to buy more and more online every year thereafter. It is difficult to imagine this not being the case for 2020’s (unusually large) cohort of new e-commerce users.

We will also mention the simple point that the market rewards acyclicality and especially rewards counter-cyclicality. In other words, the stock market, all else equal, tends to pay a premium for companies that can maintain or improve their competitive positions and financial results during recessions. This is partially why low-growth, defensive stocks like consumer staples and utilities often appear to have abnormally lofty valuations relative to the market.

(4)    We think the 2020 tech rally makes sense

After one considers (1), (2), and (3), we think that it becomes completely logical that certain areas of the stock market have rallied substantially this year—especially technology sector stocks—despite the global pandemic. (This is not to say that there are no situations in the market that we consider frothy, of course.)

Why? Well, if all stock theses boil down to hypotheses about earnings, multiples, or both…observe that (1), (2), and (3) positively affect both earnings and multiples for many technology-sector stocks:

• Earnings effects: COVID-19-related demand shifts and government stimulus have improved current and future financial results for many technology businesses—especially within software.

• Valuation effects: both (a) all-time low long-term interest rates and (b), in many situations, newly-affirmed acyclical and counter-cyclical characteristics (this recession, at least…) mean (c) upward pressure on multiples.

© 2020 Long Game Financial, LLC