In our most recent Quarterly Letter, we called your attention to the potential threat of the Coronavirus and its associated respiratory disease, COVID-19. In light of the current volatility we are experiencing in the global markets as a result of this concern, we felt it important to provide you with this update.
What We Know
The spread of COVID-19 and its impact on economic activity are increasingly troubling investors. Markets have been exceptionally volatile over the last few days. The only previous time the US market went down 10% from an all-time high over 6 days was in 1928, so this is a rare move. Information continues to arrive daily; however, the peak magnitude of the epidemic and the full extent of the economic implications are still unknowable.
When we highlighted COVID-19 in our last Quarterly letter, the outbreak was centered in China with isolated cases around the world. Currently, the virus is being found in many countries and is confirmed to be spreading on a community level, (the source of some cases is unknown), among the populations of South Korea, Italy, Germany, and Iran. "We expect we will see community spread in this country," said Dr. Nancy Messonnier, director of the CDC's National Center for Immunization and Respiratory Diseases. "It's not so much a question of if this will happen anymore, but rather more a question of exactly when this will happen and how many people in this country will have a severe illness."
We are fortunate to live in modern America with exceptional healthcare, but we can still gain insight from what’s going on in other countries. The China CDC Weekly published results of 44,672 confirmed cases as of February 11th, 2020. Case severity was observed as 81% of patients having mild symptoms, 14% developing severe symptoms like pneumonia, 5% becoming critical. The observed fatality rate was 2.3%. A thankful aside, to date, detected infections in children can happen but are rare.
Vaccines are being developed, but according to the FDA, "We're hoping in the next quarter or two, there will be a vaccine that will be ready to move into human trials." Most estimates suggest vaccine availability is a year or more away. There are anti-viral drugs on the market which have shown some promise, but conclusive studies are ongoing and have not yet been completed.
Investment Implications
Markets and the US have survived previous epidemics and world wars, so we don’t want to lose sight of the future due to short-term challenges. We expect the dust to settle one day and things to be completely back to normal. This does not mean we don't expect disruption in the interim. Whenever evaluating the impact of an event on the valuation of companies, the crucial factor is how the event will impact future earnings.
From previous letters, you know we have been concerned over the risk level of the markets. Historically, market declines have been greater when risk levels are elevated. Two measures we follow to help evaluate risk are valuation and investor psychology. When valuations are high, the decline if something goes wrong is often larger than normal. The same holds true for investor psychology. When the majority of investors, professional or otherwise, are not worried about risk, and therefore, fully invested, there tends to be a deficit of new buyers to step in during declines to support prices if something goes wrong. The rapid spread of COVID-19 is a stark reminder that unexpected events can occur at any time, and that portfolio diversification remains important.
Many of the following positions and shifts seem like easy decisions as of this letter, but in the moment of the decision, they are all made with incomplete knowledge of the future. We do our best to make prudent and well-considered adjustments, but hindsight is the only way to see 20/20.
Several things are mitigating the impact on your portfolio:
- Portfolios have been and continue to be diversified beyond just stocks and bonds. The following holdings have the potential to reduce declines in this situation.
- Cash
- Managed Futures
- US Treasury Bonds
- Gold and Silver
- Newmont (Opportunity Focus)
- Newmont is the world's largest gold producer.
- Tencent (Opportunity Focus)
- Tencent is a global internet giant, their PC and mobile games segment is especially benefiting from the quarantines in China.
- Gilead (Quality, Income, and Opportunity Focus)
- Gilead is a pharmaceutical company that specializes in anti-viral drugs.
- We have been conservative due to market valuations and have held extra cash in portfolios as a way to reduce risk, and to provide an opportunity to invest at lower prices if markets decline.
- We were in the process of rebalancing portfolios when the virus problem began in January. Due to this, we proceeded with selling that needed to be done but paused on most new buying.
- Cases of COVID-19 began to spike, putting the world on notice around January 21st. We have made the following adjustments to portfolios since then. Decisions to sell some companies are more related to the short term expectations than our long term outlook, so we hope to buy these companies again in the future.
- 1/31/20 Sold Walmart (Quality Focus)
- Walmart is America’s largest retailer by sales. Our goal was to reduce risk, and Walmart was on the lower end of our valuation and growth screens when compared to our other holdings.
- 1/31/20 Trimmed Microsoft (Quality Focus)
- Microsoft develops and licenses consumer and enterprise software. Our goal was to reduce risk, and Microsoft had grown to our largest holding and remained our largest holding after trimming it back.
- 2/11/20 Bought Gilead (Quality, Income, and Opportunity Focus)
- Gilead is a pharmaceutical company that specializes in anti-viral drugs. We initially bought Gilead for Income Focus on 1/9/20, due to our valuation and growth screens along with having a 4% dividend. Because of its potential to hedge the risk of COVID-19, we added it to our other Focus Strategies. Their drug Remdesivir is currently in two late-stage studies for the treatment of COVID-19.
- 2/13/20 Sold Las Vegas Sands (Income Focus)
- Las Vegas Sands is the world's largest operator of fully integrated resorts, featuring casino, hotel, entertainment, food and beverage, retail, and convention center operations. At the point we sold, the stock had not declined even though their revenue is dependent on travel and entertainment.
- 2/13/20 Sold Carnival Cruise Lines (Income Focus)
- Carnival is the largest global cruise company, with more than 100 ships on the seas. At the point we sold, quarantines of cruise ships were in the news, but a global decline in bookings did not seem reflected in their price, and so far, this analysis has been correct.
- 2/24/20 Sold Nvidia (Opportunity Focus)
- Nvidia is a leading designer of graphics processing units that enhance the experience of computing platforms. Companies like Nvidia, who are valued based on future growth, can be especially susceptible to declines during an economic slowdown. Since their products are components in everything from computers, gaming systems, and autonomous cars, supply chain issues are very impactful to them.
- 2/24/20 Sold Service Properties Trust (Income Focus)
- Service Properties Trust is a real estate investment trust that owns hotel properties. A decline in travel seems likely; also, there is a risk of people avoiding hotels due to the possibility of being put under quarantine.
- 2/25/20 Sold Disney (Quality Focus)
- Walt Disney owns the rights to some of the most globally recognized characters in the world. Business segments include theme parks, movies, TV, and cruise lines. Most aspects of their business are impacted by people being required to avoid crowds. We especially agonized over this position since we love the business and have owned it since 2011. The possibility of future closures of parks and negative headlines won the day. We sold on the first day COVID-19 was determined to be spreading on a community basis in countries outside of China.
Looking Forward
A reasonable question is what is next, and when do we get more aggressive by buying stocks. It would be wonderful to have a simple answer, but regrettably, this is a much-nuanced question. Our goal is to make prudent and logical investments; the following are a number of considerations concerning the timing of stock purchases. There is no proven way to predict the end of a market decline, so investments will not be made all in one day, and it is likely we will be early on some shifts and late on others.
- Overall View:
- Our working thesis is that the market will be unable to find ultimate support until we know the full extent of the problem. Then, even if the news is bad, the markets will fully discount it.
- Investor Psychology:
- There are many measures, but the ARMS Index has been one of the most dependable at indicating good entry points during declines. This index is a measure based on the number of stocks declining and the number of shares being traded, and we watch it closely.
- Depth of Decline:
- As of today’s close, the US market, as represented by the S&P 500 Index, is down 12% from its high. Obviously, buying lower than the high is helpful to future returns. But keep in mind, if the decline continues to a total of 50%, and if an investor buys when the market is down 20%, they will lose 37% of their investment before the bottom.
- Valuation:
- From today’s US market prices, declines would have to be significant to make valuation a compelling reason to buy. But some international markets have already gone from attractive to very attractive. Valuation doesn’t do a good job helping us time purchases, but it does help us know when risk is lower or higher than normal.
- Opportunities in Specific Companies:
- Some companies are already offering compelling values. Energy is an example. Consider that Exxon is now paying a 7% dividend. Compare this to a 10 year US Treasury bond at 1.3%, and you get the idea.
- Finding Points of Maximum Uncertainty:
- The market hates uncertainty, so when it abounds, the potential for finding a low point increases. In this situation, the potential for future negative news flow is impactful. Potential examples are, when or if COVID-19 is spreading uninhibited in other countries, when or if countries close their borders, when or if COVID-19 is spreading uninhibited in the US, when or if schools and business close in the US. If the worst fears come about, then the point of maximum uncertainty may take a while.
- Considering Possible Long-term Implications
- There may be two tracks this takes long-term. If it gets under control, human behavior will go back to normal. If it doesn’t, it may alter or accelerate some types of behavior. For example, there may be less vs. more travel, an increase in stay at home entertainment and activities such as movies and gaming, e-commerce versus retail and malls, a break of the trend of migrating toward dense metropolitan areas in favor of suburban single-family homes. We know that’s a big picture thought. Finding emerging and high-quality companies that are under pressure but will still perform well in either environment is ideal. But the valuation of companies who may be challenged under that scenario may make those companies compelling as well.
Summary
Challenges lie ahead. On a personal level, we want you to stay safe. On an investment level, we want to make prudent adjustments and look for an opportunity to improve your long-term portfolio. Our focus in both the up years and the down years is to weigh the risks ("The things we know, the things we don't know, and even the things we don't know we don't know.") and put you in the most advantageous position we can to reach your goals.
If you have thoughts or questions about any of the information we've shared, or on any other subject, please don't hesitate to call us. We are grateful you allow us to serve you and your family, and we will continue to make every effort to justify the trust you've bestowed on us.
Sincerely,
Your CCA Investment Team
Advisory services offered through Cravens & Company Advisors, LLC, an SEC Registered Investment Advisory Company. Securities offered through and advisory services may also be offered through, FSC Securities Corporation, an Independent Registered Broker/Dealer. Member FINRA/SIPC. Not affiliated with Cravens & Company Advisors, LLC.
Investing involves risk including the potential loss of principal. Investing involves risk including the potential loss of principal. International investing involves additional risks including risks associated with foreign currency, limited liquidity, government regulation, and the possibility of substantial volatility due to adverse political, economic and other developments. The two main risks associated with fixed income investing are interest rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risks refer to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in commodities may entail significant risks and can be significantly affected by events such as variations in the commodities markets, weather, disease, embargoes, international, political, and economic developments, the success of exploration projects, tax, and other government regulations, as well as other factors. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of FSC Securities Corporation. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis do not represent the actual or expected future performance of any investment product.