Hello clients, friends, and investment professionals.
There is simply no way of overstating the obvious, that we are all living in a strange new world and business paradigm. It was only three months ago that most of us were booking flights, attending conferences, competing for business, going on vacation, enjoying meals at our favorite restaurants, and generally enjoying the fruits of being hard working, successful Americans. Now, we do our best to keep our service levels high while working from home. It is hard not to become fearful of interacting with outsiders or feel down after spending too much time watching the news. Like many, the highlight of the day is a visit to the supermarket or daily exercise outside.
It is all too easy for confidence to be replaced by doubts, and at times fears, about where this is all going. Everyone seems to have an opinion on the path to recovery, but nobody truly knows when and how it will all subside and when/if we will get back to “normal”. While we too have our opinions on all this, we will refrain from speculating on outcomes that are not knowable and stick with what we are doing and thinking everyday with respect to investing.
Overall, we are streamlining and upgrading the portfolio construction of most clients away from a slight overweight to value stocks. This reflects the belief that while we still have faith in traditional “value investing” long term, our sense is that there has been a structural change especially over the past few years in the way investors perceive value and therefore price.
Traditional value investing is defined as buying securities at less than intrinsic value that are “underpriced” by valuation metrics such as “book value”, or “Price to earnings” multiples. This style of investing has been practiced for decades and has many famous followers like Warren Buffet and Benjamin Graham. It is also the bedrock philosophy of major finance school curriculums and is embedded in the mindset of many successful investors- “buy when it looks cheap”. Examples of well-known value investments include Exxon Mobil, GM, Ford, Wells Fargo, and Bank of America. Unfortunately, value investing has been out of favor for many years now and this trend has accelerated recently. Proponents say that value investing will “bounce back”, because its component stocks are so cheap or undervalued compared to growth stocks.
Growth style investing is defined as focusing on companies with “above average potential for capital appreciation”, even if traditional metrics as mentioned above for value investors, are not as favorable (they look overpriced). You all know the most famous of these by the acronym: FAANG (Facebook, Amazon, Apple, Netflix, Google) – to mention just a few.
Although there will surely be snapbacks in the prices of traditional value company stocks, they could be hamstrung due to investor uncertainty on how to price businesses that have questionable growth prospects in this new environment. Airlines stand out as an example; they did quite well in a straight up prolonged growth environment, but now, with many planes parked, and potential business and leisure travel in question and heavily restrained for months and possibly years, their prospects are cloudy. The same can be said for many other sectors – energy, banking, hotels, cruises, hospitality and leisure, retail and the list goes on. It may take years for some areas of the economy to come back and some may be already be irrevocably altered due to factors beyond their control. Government restrictions, operational limitations, fear from consumers, a higher unemployment rate and therefore less dollars/demand from their customers all will combine to alter many industries.
We feel that in the current environment, investors will continue to favor those companies and sectors that can meet the needs and preferences of consumers in this new paradigm and will shun those that cannot demonstrate viability and growth. Investors may also favor the stronger, larger companies who have the staying power to endure a protracted slower growth era. Therefore, we are modifying the structure and tilt of our allocations to better capture these emerging trends and our belief in a new paradigm for commerce. We will keep an exposure to traditional “value” and “small stocks” as they will undoubtedly have their times in the sun, but we will slightly overweight portfolios to larger companies and growth style investing, predominantly in the US.
We are also reshaping our exposure in a similar fashion to international equity positions. We are moving to the lower end of our Investment policy allocation to foreign equities. We believe Europe and developed Asia will recover, but it will take longer than in the U.S. Emerging economies are already poised to bounce back and we have Emerging markets exposure, but these economies and companies are highly dependent on their much larger trading partners to prosper. They will have to wait until the developed world truly starts to recover.
Finally, we have redeployed our fixed income investments into a broad array of active managers, all of whom adhere more closely to the benchmarks in conservative Investment policies. The primary objective of fixed income, especially in a low interest rate era, is to provide real protection if another sudden shock hits the stock market. We learned once again in the latest panic, that no matter how big and how diversified the fund, when everyone “hits the exits” at the same time, the fund better have a lot of exposure to US backed securities and the highest quality investment-grade bonds. We will employ active bond managers that favor US government backed securities and higher-grade corporate bonds which provide the much-needed Federal government backstop should another panic ensue.
Impacts on portfolios: For “moderate” risk portfolios (traditionally a 60% stock/40% bond), we will move over time to a 45% US Equity, 15% foreign and 40% exposure to fixed income. Conservative and aggressive portfolios will be rebalanced similarly but will reflect their appropriate risk exposure by their mixture of stocks and bonds.
I know you are busy and have many important issues now, but we would appreciate your review, consideration, and feedback of these letters. It has been a wild ride, but one that we at Deschutes are well prepared to help you navigate while keeping with your goals and dreams still alive. As it has been said at many critical junctures in history; we will endure, persevere, and one day prosper again.
Thank you and best regards,
MacGregor “Mac” Hall