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Strategy Letter – Valuation 50

It is only early April, but 2020 feels like a year that should have passed. It has been three surreal months, and six long and painful weeks for all of us. We have all agonized over the fast accelerating number of people being infected by Covid-19 around the world, the stunningly high hospitalization and mortality rates as the crisis unfolds, and the long recovery time most patients have to endure. Then we watched a big part of the country and the largest economies in the world shut down in front of us, one after another. With “non-essential” businesses closed in nearly 80% of the US states, U.S. daily output has fallen roughly 30% in the last weeks of March, according to Moody’s. A record 6.6 million Americans applied for unemployment benefits during the week of March 22-28, and 20 million more jobs will likely be lost in the coming weeks. Unprecedented, indeed. While we are among the lucky ones who have a lower chance of infection due to less physical contact with a lot of people, and we can largely work from home while maintaining our productivity, we do have the tremendous responsibility of conducting the essential business of managing clients’ wealth. This responsibility has come with great stress in the past weeks, as we saw part of our clients’ wealth evaporate.

In the first quarter of 2020, the SP500 index lost nearly 20% of its value, mostly since February 24 or in the last 5 weeks of the quarter. In January, the SP500 was largely flat. Investors were optimistic the trade agreement recently signed between the US and China would provide extra growth fuel in 2020 and result in a pickup in business investment. Concurrently, the US just killed an Iranian top military commander, prompting oil to spike to more than $60 a barrel in early January. By late January, China suddenly announced a lockdown of Wuhan, an important industrial city in the middle of the country, due to concerns of a novel coronavirus. Travel related stocks suffered, and the US quickly banned travel with China. Worries about potential supply chain interruptions grew, but were isolated to limited industries. Back then, the United States predominantly focused on the fate of President Trump’s impeachment, whether he would be exonerated, or would the impeachment go into a lengthy and costly trial as democrats wished. On February 5, the Senate acquitted Trump on both impeachment articles, and the market rallied. Equity investors were convinced Mr Trump will likely win reelection in November, and the US economy would continue to chug along. The rest is history: On Feb 18, Apple joined a growing number of companies in forecasting a hit to their bottom line from the coronavirus outbreak in China, and a sell-off commenced. The sell-off accelerated, as investors realized Covid-19 was not contained in China or Asia, and would hit the global economy. From February 19 to March 12, in just 15 trading days, and in the fastest plunge ever, a bear market ensued, with the S&P 500 suffering a 30% drop.

2020Q1 Top Detractors

Q1 2020 will be defined by its sharp reflexive move to safety in the three weeks when the market lost 30% of its value. In Q1, the market capitalization weighted SP500 returned -19.4%(SPY) vs. -26.7% for its equal weighted version (RSP). Such a flight to safety is not unusual, but the magnitude of return differences between the two indices is quite extraordinary. For a point of reference, since its inception in 2003, the RSP has outperformed the SPY by approximately 100 bps annually. The appetite for safety in this past quarter was immense and underweighting the largest stocks was painful.

The Valuation 50 will always be underweighting the largest market capitalization names by design.  Our philosophy of buying quality, undervalued companies results in a very different portfolio than the market portfolio, known as “active share”. While the Valuation 50 has handily beat the market weighted SP500 by approximately 110 basis points annually since its inception in 2004, the strategy could not overcome the negative performance of smaller cap names in the SP500.  In 20Q1, the Valuation 50 returned -24.44%,  outperforming the equal weighted SP500 by 230 bps, while underperforming the capitalization weighted SP500 by 501 bps. We will discuss specific names and sectors causing our underperformance below, but the largest factor by far is the strategy’s average market capitalization of approximately $180 billion versus $310 billion for the SPY, when entering 2020. While the quality of the names in our portfolio allowed to best the RSP, the significant size difference was too much to overcome the SPY. Here are the biggest detracting sectors to our performance this quarter: Consumer Discretionary, Consumer Staples, and REITs.

Consumer Discretionary: Underperformance in Consumer Discretionary was mainly driven by Darden (DRI) – 50%, Aptiv (APTV) – 48%, and LKQ (LKQ) – 43%, compared to – 21.8% for the XLY.

It is worth noting, however, though the XLY returned a negative 21.8%, the performance was largely distorted by Amazon, which returned a positive 6% and accounted for nearly 40% of the weight of the Discretionary sector. Excluding Amazon, the rest of the XLY constituents would have returned an average of – 40% in Q1.

With most restaurants closing doors, auto makers ramping down operations, and non-essential retail outlets in lockdown, the underperformance of Darden, Aptiv, and LKQ is not surprising. Darden, the largest casual dining restaurant chain in the US, Aptiv, a leading auto parts provider to worldwide automotive and commercial vehicle OEMs focusing on modern technologies, and LKQ, a leading distributor of replacement parts and systems for the repair and maintenance of vehicles in the US and Europe, saw their operation came to a sudden halt and their stocks free fall. Before the abrupt and severe dislocation of the worldwide economic activities, all the three companies were operating with healthy momentum,  strong balance sheets, and ample liquidity. While it is impossible to predict the exact timing of business normalization, we do believe a relaxation of the lockdown will have to happen in the next 1-2 months while a full reopening of the economy will happen in the early summer. Each of these companies will benefit from such transitions.

Consumer Staple: Tyson (TSN) – 36%, Constellation (STZ) – 24%, Walgreens (WBA) – 22%, led the under-performance.

For Tyson, the loss of nearly 1/3 of its market value in a single quarter is quite intriguing. The company in early February, lowered its full year chicken margin projection citing soft pricing. Its Prepared Foods margin expansion will also be under pressure due to material cost increases and an ERP implementation. Compounding these issues, most schools and restaurants closed in mid March. Tyson’s foodservice revenue (~30% of total sales) will be negatively impacted in calendar Q1/Q2. However, we suspect the majority of the food service channel revenue loss will be made up by higher revenue gains in its Consumer Products channel. In addition, since meats are perishable, and consumers’ capacity to load up on meats is limited due to limited fridge and freezer space at home, we suspect the demand for Tyson’s products will likely experience less volatility in demand after the initial wave of  “stocking-up” wears off. Lastly but importantly, China has reopened its economy, and importing activity should resume soon. China, in the trade deal signed on January 15, promised to buy at least an additional $12.5 billion worth of U.S. farm products in 2020 and at least $19.5 billion in 2021 over the 2017 level of $24 billion. In Tyson’s FY20Q1 which ended on December 28, 2019, the company already benefited from strong demand for its pork in the export market, by filling additional orders to China and strong increase in indirect shipments via backfills in other markets.

Constellation’s underperformance also seems to be an overreaction. The company’s off-premise channel represents 85% to 90% of depletion volume for both its Beer and Wine & Spirits businesses. Likely, lost volumes from on-premise will be made up by off-premise. In fact, recent IRI data shows dollar sales growth in off-premise for Constellation’s Beer business increased to 24% in the four-week period ending 3/22 vs. 12-week and 52-week trends of 17% and 12%, respectively. For its Wine & Spirits Power Brands, IRI dollar sales growth accelerated to 23% in the latest four-week period vs. 12- and 52-week trends of 7% and 4%. According to management, the margins are comparable for the company’s on-premise and off-premise businesses. Constellation’s Mexico breweries are currently operating, and the company has built an ample product supply across its warehouse and distributor network in the U.S., with close to 70 days of inventory in the system. Separately, on March 23, residents in the border city of Mexicali in Mexico voted against the completion of the $1.4 billion brewery owned by Constellation on grounds of a water shortage. Constellation has spent $700 million on the Mexicali brewery construction. While this is an unfortunate development which speaks volume of the increased uncertainty of operating in a foreign country led by a leftist president, management seems very confident in reaching a satisfactory long term solution with the Mexican government, including compensation and an alternative location. Importantly, the capacity Constellation has built in Nava, and Obregon when completed at the end of this year, will provide more than 400 million cases of beer a year, which will be sufficient to handle beer growth for several years, considering the company’s ~ 300 million cases of beer sales in FY20 and mid- high single digit volume growth trajectory. In short, we believe Constellation’s operation will remain largely intact in the near and mid-term.

For Walgreens, investors were debating if the company’s recession proof retail pharmacy business could indeed deliver the annual volume growth outlook of 4%, after a weak Q1, and if COVID-19 will derail the turnaround of its retail front store business in the US and UK. The company reported its Q2 results (ending Feb 29) on April 2, which saw both revenues and earnings slightly ahead of expectations. Same store prescription growth was up 4.9% Y/Y, vs. 2.8% growth in 20Q1. Comparable retail front store sales increased 0.6% Y/Y, thanks to a strong flu season, vs. down 0.5% in 20Q1. Retail Pharmacy International continued to be held back by a challenging UK market, though Boots UK held shares in its categories. Separately, Walgreens made substantial progress on its long-term strategic priorities and is on target to deliver in excess of $1.8 billion in annual cost savings by fiscal 2022. In short, the company was on track to deliver its annual financial targets before Covid 19. In the first 3 weeks of March, Walgreen’s comps grew 26% Y/Y but experienced a mid – teens decline in the last week. Due to uncertainty regarding the length and severity of the current lockdown, Walgreens withdrew its guidance for FY20. Overall, we believe Covid-19 will likely be a largely neutral event to Walgreens in 2020, and the company’s long term success continues to rely on its successful execution of long term priorities such as fast digital revolution, the transformation and restructuring of its retail offering, and creating a neighborhood healthcare destination around a modern pharmacy. We are also encouraged by management’s confidence in maintaining its dividend payout and continuing its share repurchase plan of $1.75 billion for FY2020 (~5% of its current mkt cap.).

REITs: Host Hotel & Resorts (HST), the only REIT holding in the Valuation 50, suffered big losses in the quarter, as the largest lodging REIT in the country has sizable exposure to business and leisure travel. It is a swift reversal of its fortune from 19Q4, when the stock outperformed the REIT industry benefiting from improved sentiments towards the global and US economic outlook. In addition, Host entered 2020 with leverage at only 1.7 times net debt to adjusted EBITDA, and its investment-grade balance sheet was in its best shape ever. On March 20, citing “out of an abundance of caution”, Host drew $1.5 billion under the revolver portion of its credit facility to have a total of approximately $2.8 billion of cash on its balance sheet. In the meantime, Host has coordinated with its hotel operators to eliminate unnecessary costs at each of its hotels, and is expected to significantly reduce operating costs through this period of uncertainty. We believe Host has strong liquidity to weather the current downturn, and its high quality assets and best in class management team will ensure its long term success remains on track once the outbreak is over.

Looking Backward and Forward

Since the market dislocation erupted nearly 6 weeks ago, the US Fed has shown it would do practically anything to prevent the economy from collapsing. The measures the Fed has taken include: Cutting its benchmark rate to nearly 0%; offering almost unlimited support in the overnight lending markets, including broadened repo agreements with foreign central banks; restarting quantitative easing with open ended commitment to purchase government debt; and extending direct loans to businesses of all sizes.

In late March, President Trump signed a $2 trillion stimulus bill, which would send $1,200 checks to adults making $75,000 and below, expand unemployment insurance payments by adding $600 per week for up to four months, and create a $500 billion pool to extend loans to businesses, among others. Approximately 140 million households will receive the direct rebate, or 93% of all taxpayers. $350 billion will be given in loans for small businesses to cover salary, wages and benefits, worth 250% of an employer’s monthly payroll.

The monetary and fiscal responses have won applause by being swift and big, and it appears the market is satisfied with the government action so far. On March 14 when it became clear the $2 trillion stimulus package would pass the US congress, the equity markets rallied strongly, with the SP500 returning 9.4%, in its best day since October 2008. In fact, the SP500 continued to rebound for two more days to post an impressive 3-day return of 17.5%.

While the US equity market seems to be taking a breather, the worst is yet to come for the real economy. Some estimate the US GDP output could be reduced by 40-50% in the 2nd quarter, which is equivalent to a $2 – 2.5 trillion loss. Nearly 40 million jobs could be lost, at least temporarily, from businesses offering final-demand consumer goods and services, such as restaurants, retailers, movie theatres, hotels, etc. The fiscal stimulus, however, is close in scale to the likely GDP output loss, which therefore should help keep households and companies financially whole. The US government is now rolling out benefits as quickly as possible, so households and firms won’t be left strapped for cash needed to pay for essentials and to meet debt obligations.

It is important to remember that markets attempt to see through temporarily good or bad times to estimate future cash flows and set current valuations. The global health and economic crisis resulting from COVID19 has created one of the greatest periods of uncertainty for market participants to see through, therefore, the fastest plunge of the US stock market ever recorded took place last month. Entering the 2nd week of April, we believe the market participants have likely concluded this is indeed a “temporary” situation, and have now started shifting focus to the recovery of the US economy and other developed regions, which will likely happen in the 2nd half of 2020 and 2021. After all, China and South Korea are in solid recovery phase. Italy and Spain saw the rate of infection slow down in the past days, with the number of confirmed cases increasing less than 5% from the previous days in both countries. Both countries are in the late accumulation stage of the virus curve, which also includes France and Germany. In the next two weeks, the US could start to stabilize, and some of the hardest-hit American cities, including New York, Detroit and New Orleans, could see their infection rate peak in the coming days. Science is working its way through this after all.

To bridge slowing cases of infection with a normalization of business activities, we believe three things need to happen: a therapeutic cure, easy mass testing, and a vaccine. Gilead still has the most promising and furthest along antiviral drug Remdesivir, which could present data from the first of its multiple phase 3 trials as early as this week. Should Remdesivir produce a material reduction in the mortality from Covid-19, or improve clinical progression such as reducing ventilator days, the country and the world will breathe a huge sigh of relief. Gilead has 1.5 million doses of Remdesivir, which could handle 140,000 treatment courses. The company has set a goal of making 500,000 treatment courses by October and more than a million by the end of the year.

For testing, Abbott on April 3 won the FDA granted emergency use authorization (EUA) for its rapid point of care (POC) coronavirus testing system, which can detect positive results in five minutes and negative results in 13 minutes. There are at least 15,000 systems in the United States, placed throughout physician offices, urgent care offices, and other healthcare facilities, that can perform the test. Abbott should have 1 million of these POC tests available per month by early April. Abbott’s other lab-based m2000 system, could perform 4 million tests per month by early April. In addition, there is a wide variety of other testing options available from other entities.

Johnson & Johnson seems to be ahead in the race to develop a Covid19 vaccine. The company expects to initiate human clinical studies of its lead vaccine candidate no later than September 2020 and anticipates the first batches of the vaccine to become available for emergency use authorization in early 2021. The company is also starting to manufacture the vaccine as it sees a high degree of probability of success. Its goal is to provide a global supply of more than one billion doses of a vaccine.

In short, it seems by early Summer, we should be able to conduct mass testing to help with aggressive surveillance and screening, which can help warn of new infection clusters and prevent another unchecked outbreak. Potentially effective therapeutic drugs such as Remdesivir, could significantly reduce the percentage of hospitalized patients from becoming severely ill, reducing mortality rates and speeding up recoveries. Lastly, a vaccine, hopefully less than one year from now, could emerge which would help restore total normality of our productive life.

The stock market is a leading indicator of the good and bad times ahead. It is often wrong in the short term, but is always right in the long run, as the history has shown. The stock market is not just driven by fundamentals, but also by algorisms, emotions, and many other factors. In the past quarter, we saw the Valuation 50 strategy suffer, partly due to its size and weighting bias which is typically disadvantaged in a sell off, and partly due to exposures we have in certain industries which fell victim to social distancing and physical business closures. We believe, however, when the pandemic is over, people will be ready to spend on dining out and buying goods, be ready to travel, fly, cruise, and drive. Those industries will come back and come back strongly. It may take a little longer than we would like to see, but that “a longer while” is still a temporary situation considering the longevity of those companies’ corporate life. People will be eager to reduce the social distance. After all, it is people working together, from the public to private sectors, from healthcare to manufacturing industries, from a landlord waiving monthly rents of his tenants to a foodie ordering a fast food take-out he/she doesn’t really need, from tens of thousands of volunteers working in the hospitals to millions of people diligently confining themselves to their homes, that will defeat the crisis.

We expect many of the underperformers in the Valuation 50 to become outperformance contributors in the quarters ahead, when the market rebounds. We are confident with the leading positions our companies enjoy in their respective industries, and we are comfortable in their strong leverage and liquidity position which will help them successfully navigate the current quagmire.

Mud was thrown at us, but we are all still excited about the new decade!


  • Applied Finance, a thought leader in valuation and portfolio construction, is a true “value” investment management company.  Unlike the majority of firms today that focus on low multiples to define “value”, we define value as identifying companies trading below their intrinsic value.  Our Valuation Driven™ approach forms the foundation of our investment decisions...more


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