Second Quarter 2020 Updategciadmin
Globescan Capital was founded on the principle that investing in high-quality companies at attractive prices is the most consistent way to achieve long-run, risk-adjusted returns. As such, as many of you already know, we do not overly concern ourselves with short term market swings driven by ever-changing sentiment shifts or short-term news flow.
Instead, we conduct extensive due diligence on individual companies and their long-term economics – typically making very few trades, as there is a high hurdle for a company to enter or exit our portfolio. However, during the first half of this year, we took the unusual action of making two substantial portfolio shifts and would like to explain our rationale.
During March, we experienced a decline in share prices at speeds and magnitudes that we have not seen since the Great Recession. Such a setup is rare, and when presented with such extreme moves and valuation opportunities, we are not afraid to step in swiftly and aggressively to take advantage of the situation. Indeed, it is our extensive due diligence on individual companies that gives us the confidence to do so – by focusing on real intrinsic value, we are ideally placed to assess the opportunities being presented to us objectively and dispassionately, rather than panicking in the face of falling prices.
Our first shift this year occurred in the middle of March when we sold down around 8% of our portfolio from names that had held up very well (UPS, AMT, EQIX) and reallocated this capital to names that had clearly overshot to the downside based on our revised estimates of value post Covid-19 (WH, KMX, BKNG).
We ran extensive stress testing on each of these names to establish how affected they would be by a prolonged Covid-19 related shutdown. We worked out how much revenue would persist, how much they could cut costs, how much cash runway they had left, whether they had access to other capital, if there were debt covenants to worry about, etc.
While we could not know how long the lockdowns would last, we could come to a reasonable estimate of the likelihood in which these companies would be able to weather the storm. Based on that evaluation, the share prices had fallen significantly below intrinsic business value, so we increased our positions. This willingness to view a business through a different longer-term lens than the majority of the market is a genuine and sustainable edge that has only gained in magnitude over time as the market has increasingly become more focused on the short term.
Our second shift this year occurred in early May when we effectively reversed the first shift. We saw such extreme price appreciations during April that a lot of the huge price overreaction to the downside that we had taken advantage of had simply evaporated. For example, we were buying WH at $15-$18 in March (with a large double-digit expected IRR), and selling it more than 200% higher just six weeks later. Given that significant price increase, the risk/reward had changed so we effectively returned the portfolio to how it began the year, booking short term profits in the process.
Clients should not expect this period of substantial opportunity and increased trading to be the norm. It should be viewed as an example of the fact that while in normal circumstances we trade very little, our trading activity will ultimately be driven by the opportunities presented to us by the market. If opportunities present themselves and then shortly evaporate in such a way that requires us to shift the portfolio aggressively, then we will do so.
Q2 2020: A Tale of Two Markets
Anyone who solely looks at index performance is probably under the impression that markets have gone mad. The real economy has ground to a halt in much of the world and the risk of further economic damage remains ever-present. Yet, the SP 500 keeps going up – now up over 40% from the March lows and trading at decade high forward valuations.
This is when it helps to pay attention to individual companies, rather than indices. What becomes apparent in doing so is that there is a growing divergence in the market between technology companies (Nasdaq trading at all-time highs) and everything else (Financials, Energy, Cyclicals still down 20-30%+). Consider that Amazon is up 64% YTD while Exxon Mobil is down 35% YTD and you will have a better understanding of what is going on in the markets: “It was the best of times, it was the worst of times.”
You may have also noticed that we went into this year holding a significant portion of client portfolios in Amazon, which at the time we felt was trading at an unduly cheap valuation, while owning no Exxon Mobil (nor any other oil and gas producer for that matter). In hindsight, this has worked out well for clients – but how much of this was skill versus luck?
We are often asked the question: “What is your edge with a mega-cap company like Amazon? Surely, enough people are looking at it that it is priced efficiently, if not overvalued?”. This same question could have been posed 5 years ago when Amazon was trading for 6-fold less than it is today. In fact, Amazon’s returns have been greatest from periods when their stock seemed most optically overpriced.
So, why does the market do such a poor job of valuing high-quality companies like Amazon? We think this is because the market is too focused on screens and quantitative accounting metrics based on GAAP accounting, rather than on doing the difficult work of trying to understand the real underlying economics of these businesses.
For example, Amazon is growing at a very high rate and they are expensing, rather than capitalizing, significant investments made in coders, developers, etc. to build out platforms from which they will be able to extract value for years to come. The accounting story here is a business that is very low margin, but the economic reality is that in the future, when they do not need to invest in the platform as much and switch to just maintaining it, normalized margins will likely be much, much higher. This type of analysis is what led to us increase our position late last year when Amazon appeared cheap, and subsequently reduce our Amazon position in recent months as the valuation gap has more than closed.
Where We’ll Continue to Invest Going Forward
We look to three main areas as the most lucrative for sourcing investment ideas:
1. Inexorable Trends
Businesses that benefit from long-term secular trends (e.g. increasing data consumption, e-commerce, aging populations, etc) which are difficult or ideally impossible to disrupt. What matters to us is which businesses are positioned to capture the most value as the trend plays out. As such, we work through the value chain of each trend to establish who is best positioned to benefit – Where are the bottlenecks? Where is the pricing power highest? Where is the competition structurally limited?
If we get this analysis right, it gives us a substantial margin of safety in our valuation assumptions – i.e. we can be wrong in the size and scale of a trend, but so long as we get the direction right, we are likely to generate good returns. Businesses that fit in this category tend to be our longest timeframe investments with our widest expected return ranges in which we remain holders.
2. Earnings Compounders
Businesses that have proven they can continuously compound their cash earnings by reinvesting capital at attractive rates. These businesses tend to benefit from some combination of long growth runways, wide moats and a management culture focused on customer satisfaction, cost discipline and generating attractive returns on invested capital. Since these businesses do not (necessarily) benefit from secular industry tailwinds, our margin for error is smaller – i.e. poor management or new competition can quickly erode the economics here. As such, we tend to hold businesses in this category for shorter durations and demand a tighter expected return range to remain holders.
3. Inefficient Markets
Businesses that the market is simply mispricing. These businesses might belong to a currently out of favor sector, their underlying economics might be misunderstood by the market, or for structural reasons such as liquidity or benchmark considerations, they have been orphaned by investors. In any case, these opportunities tend to only appear at times of extreme market dislocation, so when we do make investments in this category, they tend to be our shortest duration, with our tightest expected return range to remain holders.
As always, please feel free to reach out to us with any questions you may have and we hope everyone is staying safe and healthy during these times.
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