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An update from our investment manager, Fran Radano - 28 July 2020
The uncertainty and challenges related to the worldwide spread of Covid-19 have resulted in one of the more unusual periods of equity performance in memory. Initially the more typical bear market themes played out as expected (e.g. quality outperformance, leverage underperformance), which were then followed by unusual day-to-day movements such as utilities being treated like momentum stocks and the ten-year treasury yield rising while the market was plummeting. Subsequently both the Federal Reserve and the US government unleashed a series of policies and programs to prevent the capital markets from seizing up and to help both employees and employers get though the initial economic impacts of the virus. Most recently, the economy has begun a phased-in re-opening and the market has responded in a very positive manner.
With the outlook still uncertain, we have generally refrained from making large wholesale changes to positioning thus far. That being said, the unusual market movements and volatility have given us the opportunity to selectively realign the portfolio by adding to positions that have seen unjustified value dislocations as well as adding a couple of names from our watch list where they had met the quality threshold, but where valuation was previously deemed a bit too steep. Following the most recent move back toward 2019 highs, we have become a bit more defensive as we have trimmed positions where a full recovery in fundamentals is unlikely over the next 12 months.
Our use of the options market was quite limited at first, but we have subsequently been able to use this tool more often in a disciplined manner, focusing on short-dated options at prices further out. This works as a means to add to positions at lower prices where we are natural buyers, or to top-slice at higher levels where we would be natural sellers. Lately, we have sold more call options on a few of the stocks given the upward move in the markets.
The significant economic policy response being deployed by central banks and governments has injected liquidity into the marketplace with interest rate cuts, further quantitative easing and fiscal stimulus. Meanwhile, many geographies are commencing phased-in reopenings which should help in normalizing the economy, but the risk remains that reducing "social distancing" policies may result in increased case-loads if done too aggressively. The healthcare industry continues to focus on finding anti-viral measures to combat new infections while ultimately needing an effective vaccine for economies to truly normalize. Despite the fact that this pending recession was not caused by traditional economic excesses or policy errors, we would expect a more muted recovery as employment will likely return at a much more modest pace and continued degrees of social distancing will likely restrain growth over the next year.
In these conditions we are remaining focused on closely monitoring the financial strength of our holdings with an emphasis on operational and financial leverage as well as cash generation. We have adopted a cautious stance for some time and see little reason to shift from this conservative focus on higher quality businesses.
