A contrarian’s approach to market disruption

By Rob Johnson

As global markets fell dramatically in the first quarter of 2020, it provided an opportunity for portfolio managers that had been conservatively positioned to take advantage of the dry powder they had hoarded. 

The contrarian value team at First Pacific Advisors were one of those managers, having reduced their risk exposure in January and February and were sitting with more than 40% in cash or equivalent instruments. 

The US equity market extended its long advance well into the beginning of the year and then the correction hit, entirely erasing (at least temporarily) those historic gains. From peak to trough during the quarter, both the MSCI ACWI Index (Global equity) and the S&P 500 Index (US equity) declined about 34 percent.  For the S&P 500, this was the steepest decline of 30 percent or more in history, occurring more quickly than what previously were historic declines in 1929, 1931, and 1934. Stocks traded down with more fear than they’ve ever witnessed. 

Most companies were ill-prepared for what was a near simultaneous and instantaneous shut-down of the global economy that swiftly destroyed supply and demand. At the time, there was a great deal we didn’t know, but we were fairly confident that business values hadn’t declined by 20-30% up and down day-to-day, let alone intraday. In March, the cheapest quintile of stocks compared to the average stock (valuation spreads), for global and US equities reached their widest levels since 2009.

A lot of this volatility is due to simultaneously dealing with two issues. The loss or reduction of our income and/or net worth and the existential fear that comes with facing our own mortality. The two together created emotion-squared and with it an unprecedented negative feedback loop. However, if one thinks more calmly about what the longer-term impact might be, it’s hard to not want to be more fully invested in resilient businesses because one day people will again be flying in planes, staying in hotels, eating in restaurants and just getting their lives back to ‘normal’.

All this uncertainty translated into opportunities in equity markets around the world and enabled the FPA portfolio management team to increase risk exposure. Their investment approach has always been to think and act longer-term, which sometimes means having to act calmly and contrarily in the midst of turmoil and volatility.

The sectors most affected during the downturn were energy, travel & leisure and financials.

Travel will recover

As the airline, hotel and tourism industries took a pounding during the lockdown, with people prevented from making use of any transport or accommodation, some interesting companies became very attractively priced. One such business is Booking Holdings Inc., the world leader in online travel agency (OTA) and the owner of Booking.com.

The FPA investment team were already familiar with Booking prior to 2020 due to previously conducted extensive research on the industry. At the time of the original research, they invested in Expedia, which was subsequently sold as the share price advanced. Expedia is mainly focused on the US and North America is mostly made up of branded hotels, such as Marriott and Hilton, which have pushed guests to book directly on their sites.

All of the unbranded hotels have to pay the OTAs for marketing or shelf space. Booking is the largest player in the US, Europe and Australia and a defensible moat is in the long tail of travel properties in Europe. Hence, Booking was favoured from a qualitative perspective, but it was trading on a premium multiple. The lockdown provided an entry point as the portfolio made purchases at what appears to be low double-digit multiples of enterprise value to earnings. However, this position was not initiated simply due to a low multiple of estimated trailing or normalised earnings, as these were opaquer. Instead, the team were attracted to Booking because the company is sitting in a net cash position and is well placed to recover as the economy reopens.

I am sure I am not the only one ready to break free and experience some new scenery. When I do, I will most likely book my accommodation through Booking.com due to the breadth of choice and ‘Genius’ loyalty programme.

Another interesting area of investment that the Nedgroup Investments Global Flexible Fund has entered is that of cruise ship companies. The portfolio managers have pounced on negative sentiment to purchase the secured bonds of Carnival and Royal Caribbean at a yield of 11-12%. Both have experienced a screeching halt in revenue and plunging stock prices. The cruise ships are used as collateral on the debt and assuming people go on cruises in the future, the bonds will be accretive.

Irrespective of whether you are a cruising fan or how long it takes for the revenue stream to recover, the coupon on these senior secured bonds is giving an inflation plus 8% yield.

High barriers to entry in energy services

As the oil price fell precipitously in March on the back of a price war, investors scrambled to exit anything related to the industry, including the equity and bonds issued by businesses providing specialist services. This opened up some opportunities in the fixed income sector, as asset-backed securities offered an asymmetric expected return profile. This was not necessarily the case for equities within the energy sector as the persistence of a low oil price was, and still is, uncertain.

The FPA investment team purchased multiple bonds issued by McDermott International, a provider of oil field services. The oil and gas infrastructure business enjoys relatively high barriers to entry as it is one of three options if an oil producer wants a refinery constructed, as they own the necessary ships and equipment. However, demand to build is going to be much worse over the next year or two and the company has been in business rescue since last year. McDermott has a chemical business called Lummus Technology and part of the restructuring is to sell Lummus. Confidence in the deal closing was high as there is no material anti-trust risk. The portfolio holds Debtor-in-Possession (DIP) loans, which would be paid in full at the close of the deal. If it doesn't close, the DIPs are converted common stock which would be a debt free business. The process of restructuring has evolved and the company is expected to emerge from bankruptcy on June 30. The DIP and super senior loans are expected to be paid out in cash and the other instruments are expected to convert into equity. This is all in accordance to the pre-negotiated plan that FPA entered into in mid-February.

The investment in McDermott bonds is a great example of the depth of research and understanding necessary to take advantage of a complicated situation, which many professional money managers will avoid.

Financials continue to offer value

One reason we are excited about the portfolio right now is the compelling valuation of the banks held in the fund, nearly 7% of the portfolio, even after accounting for a potentially prolonged recession. Banks in the S&P 500 Index trade at some of the lowest valuations since either the financial crisis from 2008 into 2009 or the savings-and-loan crisis in the early 1990s. In general, banks not only have better loan portfolios today than they did in those crises, they also have capital ratios, or tangible equity-to-assets, two to three times greater than before the last recession.

Wells Fargo is a prime example of this embedded value. At the end of 2019 Wells Fargo was trading at a share price above $50. It fell to a low of $22.50 and is still only changing hands at around $27. Investors have figured out that Wells is more exposed than any of the other US banks to a weaker economy, with a greater book of mid-America mid-market lending. However, Wells has the lowest net charge-offs, because the company is a traditionally very conservative underwriter. Banks rely on net charge-offs, which allow the lender to write off bad debt as a loss, instead of waiting several months for the borrower to return the money. Additionally, their loans have previously had very low loss content if people were to file for bankruptcy. The bank is also not very exposed to credit card or trading desk operations, where the markets expect charge-offs.

An in-depth assessment of the credit at risk in the Wells Fargo business provides confidence that revenues are unlikely to fall by 50%, as suggested by the share price collapse. Currently trading on a price to book of 0.7x, vs 1.3x at year end, and offering a dividend yield over 7%, suggest upside potential with limited downside risk from such an entry point. There is a caution on some value indicators however, as many companies are responding to the uncertainty of the environment by holding onto cash and taking a pause on outgoing payments, including the dividend. We have seen that in many industries. For some banks, it is reasonable to continue to pay a dividend, while others such as Wells Fargo, should perhaps not pay a dividend at this time.

Elsewhere in financials, another purchase made in the first quarter of 2020 was Swire Pacific Limited, a holding company based in Hong Kong. Swire has a large position in Swire Properties which owns A+ grade office and residential properties in China, Hong Kong and Miami. The Chinese government introduced a bill that essentially subjects the people of Hong Kong to greater oversight and possible extradition to China. This makes investment in HK real estate far less attractive. However, in addition to properties, Swire owns the biggest Coca Cola bottling plant which services most of the pacific including all of China, along with a position in Cathay Pacific, the airline carrier in HK. The holding company trades at a large discount to the underlying businesses. HK is a gateway city to Asia and China and will still be a relevant city in the future even if the Chinese bill makes it a bit less favourable. The holding also has a 5% dividend yield, a look-through yield of 3-4% and is trading on a 10x cashflow multiple.

Once again this illustrates the need for an investor to understand complex business structures and be able to identify the hidden value of underlying businesses with high barriers to entry.

Positioned for a return of economic growth

Eventually we will have a COVID-19 vaccine and central banks are unlikely to raise interest rates for years to come. With those two things in mind, it is difficult not to gravitate toward more investment over time, largely in equities with some high-yield and distressed debt. Cash just won’t produce the return to which we collectively aspire. For better or for worse, central banks have set the stage for inflation in risky assets, and since I can’t tell you when the show starts, it is best to be in our seats in advance.

Sometimes you don’t appear as smart as you are, and other times you look much smarter than you actually are. As we continue to focus on delivering good, risk-adjusted returns, we suspect our clock will be right more than just twice a day.

If the FPA team successfully find a sufficient number of investments with attractive risk-to-reward ratios, this may mean greater portfolio volatility, but there is little alternative if you look out five to 10 years. We believe the strategy’s portfolio of securities at the end of this tumultuous quarter is attractive and interesting. So much so, that the portfolio managers have recently increased their own investment in FPA’s contrarian value strategy. They continue to have the largest portion of their invested net worth in high alignment with holders of Nedgroup Investments Global Flexible Fund.