An update from our investment manager, Fran Radano - 14 December 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, positive developments regarding potential vaccines sparked a historic rally with the market currently trading near all-time highs. Cyclical stocks most negatively impacted during the onset of the pandemic have been some of the best performers recently as investors have better visibility into an economic recovery.
While the positive vaccine news lessens longer-term concerns, the near-term outlook is still relatively uncertain given the recent spike in Covid-19 cases and minimal progress from Congress on additional stimulus. Due to this uncertainty, 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 to 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 although the overall use of the options market has largely normalised over the past several weeks.
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. While these actions have helped support the economy and markets through the summer and fall, the resurgence in Covid-19 cases has forced certain geographies to scale back re-openings and in some cases revert to lock-downs. The healthcare industry continues to utilise anti-viral measures to combat new infections but it will take several months before vaccines are rolled out in a more widespread manner which should result in a difficult winter. 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.