Chairman’s Letter Q1 2020

Financial summary at the outset of the pandemic.




April 1, 2020

Investing reality today is formed by two fundamental views: the scientific community and the social science community (popularly known as business). The first group considers facts and the second considers forecasts. Davis Rea is actively listening to both groups. Discouragingly, the investment implications and strategies best enacted as suggested by each group have few common directives. The best strategies to employ given differing time frames for a safe and economic resumption of global activity are elusively inconsistent. Seemingly, we await the next announcement from politicians who reluctantly, but correctly, follow the advice of scientists and tack on an additional 2 weeks for every week that passes. The scientists are saying months while the politicians are seemingly leaking the air out of the balloon slowly to avoid us all losing hope. Hope, we feel is a dangerous forecasting tool.

Presently, we have two crises: health and financial. Most argue that the financial crisis is a result of the health crisis. Others are more nuanced; they point out that the health crisis has exposed and accelerated the death of an already weakened economic body. I side with the more nuanced case, because it encourages the consideration of risks and impending declines that were always present but, perhaps under-appreciated. Risk measurement and management is at the core of what good money management is. Presently, the risks faced by investors globally are ones I have never faced in my 35 years as a professional investor. The future is always a bit different, but this event is sure to accelerate some trends with important investment implications for generations, not to mention portfolio construction today.

Shorter Term Facts and Forecasts (Less Than 1 Year)

Global economic activity has for the most part, stopped. The virus is still spreading and has resulted in over 1.9 million confirmed cases to date (and certainly more by the time you read this), or less than 1% of the global population. The goal currently is to slow down the infection of the remaining 7+ billion souls on the planet. The nature of a pandemic is that we are all in this together. Last year about 28% of us got the flu. For the most part it was an annoyance, so we didn’t take a lot of precautions to avoid the bug. Today, we are mostly sitting at home because this virus is very bad. The scientists think that absent a vaccine, 30-70% of us will get this virus over the next 2 years. The cat is out of the bag - the bug is not going away. Scientists tell us that there will be no vaccine, under any circumstance, for 18+ months. Treatments to lessen the symptoms may be available in 3-4 months. Scientists say that social distancing is here for a long time, for even up to 18 months. Technological tools to track and warn you of potential exposure after the fact are a month away. Whatever may come, it would seem prudent to count on a long and costly struggle. The facts remain, that for the foreseeable future, this is not about money or molecular biology, but rather, arithmetic. 

The business community is of two minds about this mess: bullish and bearish. The financial community (as a subset of the business community) is traditionally an optimistic bunch, prone to oversimplification and promotion, driven mostly by greed and prone to bouts of panic.  The business community (excluding the financial community) is more pragmatic, and by necessity more aware of the monthly realities of a functioning business. I think it is safe to say that the business types side with the scientists, feeling the business climate is bad/challenged for the next year at least. The finance types are more balanced, and rather optimistic after a recent bout of unmitigated panic. 

Our View

While Government is quickly stepping into the financial void with unfathomable amounts of money, ventilating consumers and business, money does not solve the health crisis. No one can predict the final cost, but it is safe to assume it’s very large and corporate profits will decline - by a lot - for a while. In 2008-09, profits fell by 40% for the S&P500.  That seems like as good a guess as any for this year. Stocks are down 18% while profits are down 40%. Clearly, investors are optimistic that profits will bounce back quickly. We err on the more cautious side given the history of investor behaviors when faced with crises far less acute than this. We are positioned for more bad news. Attrition wears down an investor’s optimism like the flu saps one’s energy. 

Longer Term Facts and Forecasts (More Than 1 Year) 

Innovation will ultimately overcome this pandemic, with 2 years being the most pessimistic forecast. Economic activity will still occur, but it will be very slow and then accelerate as time passes. Taking 2008-09 as a guide, a recovery in earnings would indicate a recovery of 30-40%. That would still leave earnings in 2021 lower than 2019. This is not yet the consensus forecast.

We have constantly talked about investing in strong, well-financed companies with great products or services run by smart people because they tend to have strong balance sheets. We have cautioned about investing in companies that are replacing equity with debt. We have relentlessly spoken of investing in companies that are tech-savvy innovators with a vision toward the future. A future where their product or service will not be buggy whipped away. Now, the tide has gone out exposing those who have lived reckless financial lives.  

Below are some questions we ask ourselves when thinking of the future:

How will the consumer respond when the crisis passes? The consumer is 70% of the economy. How will consumer behavior change because of necessity and by preference? Certain industries are winners and others, losers. Will you ever consider going on a cruise again? How long until you fly again? Hundreds of billions of dollars are at stake. Where will the consumer spend?

For businesses, how is corporate liquidity being affected? Past bad behaviors (like having too much debt) may cripple certain companies for years. What are the debt dynamics and how will it affect competitive players? Will indebted players be able to invest in the future? Will working from home flourish? Will we, can we, employ as many?

Equity investors will start talking about balance sheets, not just sales forecasts. Questions about capital spending and the ability to invest will be asked. Dividends, their sustainability, share buy-back philosophies and payroll size will be questioned. 

All of the companies you own are survivors and long-term growers. You have cash. You are positioned to buy great companies at very attractive prices, the likes of which have not been seen for years. Today is scary and trying. That’s when good portfolio management comes into play. Portfolio management driven by risk mitigation and management strategies (executed prior to the crash), and risk measurement going forward in gauging the time to recovery and price paid for the companies we wish to own, will drive attractive results.

Pessimism drives incredible values, but cash rules when the bell tolls. You have cash to invest and the investment returns are going to be very attractive going forward. Lower prices mean better future returns to those well-positioned, and you are all well-positioned.