May 2020 Commentary
Wealhouse Panorama Fund was up +3.86% in May. CIO Scott Morrison provides his views on why the market keeps going up despite historic unemployment.
As front-line workers all over the world battled to help patients with the COVID-19 virus, the capital markets continued to appreciate. We continue to field inquiries from clients who are puzzled as to why the markets are going up. Equity and corporate debt investors should be grateful to the world’s central banks. They reacted very quickly to enact quantitative easing (QE) programs in the trillions of dollars. When one studies the brief history of QE programs, you can see an appreciation in asset prices as evidenced by the chart below.
Another reason why markets are appreciating is because many parts of the world are re-opening. In parts of Europe, even professional soccer leagues have restarted. In North America, we will be watching NHL play-offs in July. Even in battered New York, which was the state with the largest and deadliest outbreak, we are witnessing easing restrictions. We acknowledge that the trajectories of different recoveries by geography, sector, industry and company is uncertain. The short-term disruption of the pandemic is in the rear-view mirror. However, the go-forward changes caused by COVID are still to be determined over many months, quarters and years to come. No one truly knows the answers.
From a bottom-up analysis perspective, we would point out that the markets comprise many different types of securities exposed to many different types of business fundamentals and geographic exposures. So many businesses and their employees are tragically suffering because of the COVID impact — airlines, car rentals, cruises, oil, hotels, restaurants, retailers, theatre chains, etc. Unlike in most other recessions, however, some businesses are booming. Amongst the winners in Panorama’s investments this year are: bond rating firms, restructuring advisory firms, semiconductor and software companies that power the tools and internet infrastructure which enables the world to work from home, medical supply companies whose products are being used to battle the virus; and movie streaming and video game software companies that keep the masses entertained in a socially-distanced environment.
We have been taking profits from some of these “booming” industries and re-allocating capital into industries whose fundamentals have in part been negatively impacted by the COVID disaster. One area of the economy that we believe will be more resilient than in the global financial crisis of 2008/09 will be businesses that support the housing industry. Unlike the recession of 2008, this recession is not being driven by excesses in the housing industry, which crashed and burned with high-profile failures from over-levered financial institutions that recklessly provided now infamous “subprime mortgages”. You may recall that housing prices began their descent in early 2006, which led to major banking institutions such as Bear Stearns, Countrywide Financial, Lehman Brothers and Washington Mutual being financially crushed by the devaluation of housing-related securities, due to mortgage delinquencies and home foreclosures. Below you can see a chart illustrating the number of 100+ U.S. banks that failed in 2009 and 2010. Time will tell how many banks, if any, will fail over the course of this recession.
Jump ahead to present day and it is sad to see the number of families at risk of losing their homes and livelihoods if one or both family members are employed in the above-mentioned at-risk industries. For those families who have been able to work from home and keep their jobs, however, we have seen a massive spike in home-related spending. In 2009, we invested in Home Depot because I always noted, when travelling, the number of Home Depot outlets located closer to downtown districts of major cities. Lowe’s suffered last recession because many of their stores were located in the outer suburbs and more rural locations, with rural making up only a quarter of their base sales. In today’s environment, however, these are now successful locations since many people have been leaving their cities where possible, in order to escape the higher COVID rates of the crowded inner-city cores.
So, even though we entered a recession, Lowe’s posted same-store sales up over 11.2% and U.S. comps are up 12.3%. On their management call they stated that: “Our rural stores outperformed the company comp in Q1 by over 250 basis points. Conversely, on average, our urban stores experienced more demand disruption from the COVID-19 crisis, approximately 10% of our U.S. store base is classified as urban and this subset of stores underperformed the company comp by more than 400 basis points.” As Canadians we took special note when they said: “In Canada, we posted negative comp sales as performance was adversely impacted by store closures and other regulatory-related operating restrictions. We have initiatives in place to improve performance and remain confident in the long-term potential of our Canadian business.” As we have said in recent comments, we strongly believe that Canada will economically underperform the U.S. economy moving forward.
We also admired that during a quarter where Lowe’s delivered blow-away results, the company was able to highlight on their call that they, “invested $340 million to support our associates, healthcare workers, first responders, and community. In addition, we committed $50 million of charitable contribution to our communities for our part in this time of need.”
Since many families will be forced to “nest,” we anticipate that home improvement companies such as Lowe’s will benefit immensely from a re-allocation of discretionary income towards improving home environments. Financially, we are attracted to Lowe’s because it generates a 5% free-cash flow yield and has grown its dividend at 19% over the last five years, while taking its share count from 990 million down to 778 million through buybacks.
There are many tailwinds for those individuals and families who presently still have a job. The first chart below illustrates that 30-year mortgage rates in the U.S. are extremely low at 3.39%. Mortgage rates are benefiting from the U.S. Fed buying government bonds to suppress yields in order to stimulate the economy, and a lack of fear from investors surrounding inflation. The second chart shows that gasoline prices are also at very low levels. Obviously, oil prices have seen demand fall off a cliff from industries such as airlines as travel rates have plummeted and more and more people work from home, negating the need to drive their cars to work. So, for those families that have managed to escape with their jobs intact, they are seeing some extra discretionary income that can benefit some of the booming businesses, like Lowe’s, that benefit from consumer spending.
Although there are some tailwinds in place at present, we must recognize those risks on the horizon that could continue to drive volatility in the economy and markets very high, as we rapidly head towards the second half of the year. This uncertainty is why we started the Voyager Fund which is taking far more risk and saw a positive 8% return as a result during the month of May. This is a fund where we are simply focused on where we see the best value and growth trade-off globally in the small-mid cap arena and will not try and time the markets and its underlying risks. The chart below shows how this crisis has continued to exacerbate the valuation gap between the largest and smallest 10% of companies within the S&P 500. Continued consolidation within asset management firms is forcing larger asset managers to crowd into fewer and fewer companies in search of adequate liquidity. With Voyager, we can take advantage of these attractive valuations and believe the extreme discount of smaller companies could drive increased M&A going forwards.
In our November commentary, we highlighted our investment in Aon PLC, a leading global commercial insurance broker. We like the company’s impressive long-term growth track record, innovative new products, and stable revenue, as commercial insurance is largely non-discretionary. During the recent correction, we were pleased to see long-time Chairman of the Board, Lester Knight purchase $13.7 million of shares, his largest purchase ever. Mr. Knight has been an opportunistic buyer of Aon in the past, purchasing over $40 million of equity since 2010. We always look for companies where management and insiders own meaningful equity stakes in the business, aligning their interests with shareholders. In total, Aon insiders now own ~$450 million of equity.
Aon’s management has also been active the last few months, announcing the acquisition of Willis Towers Watson PLC for $31B, which will make them the largest commercial insurance broker in the world. We believe this acquisition helps them in a few ways. It gives them unrivaled scale globally to invest in innovation as data analytics becomes increasingly important, provides them a complementary set of capabilities to serve unmet needs of global customers, and allows them to optimize Willis Towers Watson’s cost base, which was under scale for its global operations. Combined, these provide a tailwind to Aon’s free cash flow growth, as management expects the acquisition to be over 10% accretive to Aon’s free cash flow per share over the next few years. Despite the disruption from COVID-19 in 2020, Aon’s interactions with clients have increased, as they guide clients through the uncertainty and help them reduce volatility in their businesses. We expect Aon to continue to grow earnings and free cash flow in 2020 and view the valuation as attractive, trading at a 5.3% 2021 FCF yield.
Everyone is aware that Donald Trump will compete against Joe Biden for the presidency of the United States this coming fall. As you can see in the below chart, tax rates in the U.S. for businesses continued their secular move lower. We cannot imagine a scenario where tax rates will not increase moving forward. According to an article in Bloomberg: “The U.S. federal budget almost doubled in May from a year earlier… In the first eight months of fiscal year 2020, the U.S. budget deficit was $1.88 trillion, compared with $738.6 billion at the same point last year. The Congressional Budget Office estimated in May that pandemic relief efforts will swell the deficit by $2 trillion this fiscal year…”
Last month we highlighted that Loblaws took advantage of the wide-open capital markets to opportunistically raise hundreds of millions of dollars in the bond market and how this may eventually cause some backlash against its wealthy family-majority owners. We read with interest in the Financial Post that Loblaws would, “return employee wages to pre-pandemic levels starting June 13.” We believe that there will continue to be an uptick in social backlash against those who take advantage of what the central banks have done to support capital markets.
We have long since argued that we do not believe central banks have understood that their QE strategies following the 2008 financial crisis were actually deflationary, even though they were intended to cause inflation. We believe that the central banks have failed to understand that QE has indirectly led to a financing boom for technology-led disruptive businesses to search out legacy industries that traditionally operated with a mindset of generating free-cash flow and earnings profits. One example of the impact of QE in supporting unprofitable business plans is Tesla. We fortunately were able to cover our negative position in Tesla during the sell-off earlier in the year, and have concluded that they will be a huge market share winner versus other legacy internal combustion-engine companies moving forward, thanks to easy access to capital. If our calculations are correct, we believe that Elon Musk, who has Canadian citizenship thanks to his Canadian mother, is now the richest of Canadian citizens with a net worth close to $50 billion.
Another example of disruption risk for Loblaws and other grocery retailers in Canada is robotic technology as they will soon have to compete with a U.K. company called Ocado. Ocado’s intention is to build supersized warehouses and have their proprietary robotic technology pick the online orders they receive; this versus firms like Loblaws that continue to stock shelves via manual labour in smaller-footprint retail centres. On April 29th, Ocado announced that it had completed construction of its first North American customer fulfillment centre in Vaughan, in partnership with Sobey’s, with plans to start serving the GTA in the next few months. I have visited Ocado’s logistics facility firsthand on a research trip to the U.K. Building big warehouses and filling them with expensive robots and paying 1000+ software engineers to write the code to sort the groceries for customers before placing them on trucks is a very expensive undertaking. According to Bloomberg Consensus, Ocado is forecast to have NEGATIVE £407 million of free cash flow this year, with a £13.7 billion market cap, sales of £2 billion and has seen a stock appreciation of 53% this year. Loblaws stock is down 1% and will generate $1.9 billion in free cash flow, has a $24 billion market cap and sales of $52 billion. However, the implementation of QE policies will have enabled companies like Ocado to raise capital in order to finance their money-losing operations and push harder and harder to disrupt established players like Loblaws. Last Thursday, Ocado raised another £650 million of equity, adding to the £935 million it has raised since 2010. In light of massive QE measures in place due to the pandemic, we anticipate that the pace of disruption will only accelerate coming out of this recession. Unfortunately, this will cause more and more workers to have to pivot their skill sets into new professions.
I want to express my thanks to my colleagues at Wealhouse who are working tirelessly to successfully navigate these extraordinary circumstances on behalf of our clients. They have all helped me and each other to take care of operations, marketing and research. We have been in contact by phone and Zoom, with minimal interpersonal contact for risk-management purposes. As a team, we are donating funds to food banks in our local communities and have our fingers crossed for a vaccine to be discovered, so that many can begin to see high-risk family members and friends.
The volatility in the markets has been nothing short of extraordinary. We have worked hard to embrace this volatility and fully anticipate the need to be prepared for much more volatility in the months and quarters ahead, as we navigate through a U.S. election and risks of a fall/winter second wave of COVID. We truly hope the 100+ medical organizations working on a vaccine will be successful, but as always, we will hope for the best and plan for the worst in order to grow and protect your capital. We will remain balanced, since we are one more crisis away from interest rates going to zero in North America, as we have seen in Europe and Japan.
Scott Morrison, CFA is the CIO of Wealhouse Capital Management and the Portfolio Manager of Panorama Fund. Scott is an asset management veteran of over 25 years, who has previously manage notable funds for industry titans such as Mackenzie Financial, CI, and Investors Group. As a keen supporter of non-profit work, Scott sits on the Finance Committee of the Centre for International Governance Innovation (CIGI).
