October 2020 Investment Commentary

October 26, 2020

Samuel E. Bain, Jr. , Justin DuMouchelle, CFA, CFP®

Investment Commentary

“If the beginning of October is any indication, the 4th quarter will be an eventful one.”

The 4th quarter is shaping up to be a dramatic finale to a year of surprises and challenges. The US election is less than a month away with questions not only as to who the next President will be, but also which party will control Congress, and whether the results will be contested. After a contentious first Presidential debate tensions were high and escalated further as President Trump was admitted to Walter Reed Medical Center having contracted the COVID-19 virus. The President appears to be doing well following an aggressive treatment plan which included an experimental antibody treatment, but his illness represents a significant turn that will shape the final weeks of the campaign. If the beginning of October is any indication, the 4th quarter will be an eventful one.

The news of the President’s diagnosis is a poignant reminder that the COVID-19 virus is still present, and the risks remain high. As the northern population heads back inside and children return to school after a summer highlighted by easing restrictions and fewer new cases, we see early indications of a second wave with unclear consequences. Many schools quickly returned to virtual learning after identifying outbreaks and some of the eased restrictions have been reversed. As a result, we are starting to see a slowing in the jobs recovery which we hope does not turn negative.

We continue to believe that the critical recovery guideposts are progress towards addressing the virus, Central Banks ensuring liquidity in the markets, Federal Government’s support of those impacted most by the restrictions and changing consumer habits, and economic data. The rapid release of President Trump from the hospital, despite showing concerning signs early on and being in a high-risk cohort, provides hope that the understanding of how to treat COVID-19 is indeed improving. Perhaps if manufacturing capacity and distribution of the various antibody treatment can ramp quickly, the mortality risk associated with the virus can be reduced. Improved treatment options in combination with early distribution of vaccines could allow for further easing of restrictions in 2021. There are many bridges to cross before that happens, but the recent news is encouraging. The Federal Reserve and other global Central Banks have committed to supporting markets, but the willingness and coordination of fiscal stimulus coming from the US Federal Government is concerning. How all the pieces come together will significantly impact the path and speed of the recovery.

Alphabet soup, V, U, W, or K shaped recovery?

After initial hope of a rapid “V” shaped recovery it is looking like not all boats will rise with the tide and some industries will take a bit longer to recover. The letter “K” appears to be a more appropriate way to describe a rapid bounce for some parts of the economy and a further downtrend for others. As consumers remained home and shifted purchases to online, companies able to adapt have benefited and those who have not continue to struggle or have failed entirely. As a result, the group of technology providers helping businesses evolve to meet their customer’s needs, as well as allow their employees to operate remotely, have seen their revenues skyrocket to record levels. Representing the lower fork in the “K” are many small retail businesses, restaurants without outdoor seating or takeout options, and the travel industry have seen their business decline with little hope of improvement soon. This is a large and important area of the economy which will weigh on the recovery without further support and unless consumers return to their previous routines, two things that are far from certain.

How can the stock market be doing so well when large parts of the economy are struggling?

It is important to remember that the stock market is related to only a small part of the economy. The market is tracked using indices such as the S&P 500 and the Dow Jones Industrial Average which are designed to represent the composition of the stocks being traded on the major exchanges, not the breakdown of GDP or the US workforce. For instance, the Consumer Discretionary and Staples sectors represent a total of 18% of the S&P 500 compared to 38% of the US workforce1 working in either a retail, hospitality, or food service job. Clearly it is not apples to apples.

“We continuously assess the opportunity ahead for each investment and its valuation, adjusting our position as we see the upside potential increase or decline.”

We invest in individual stocks instead of indices to select the companies which are gaining market share, improving profitability, and creating new markets while driving differentiated returns relative to the economy. We continuously assess the opportunity ahead for each investment and its valuation, adjusting our position as we see the upside potential increase or decline. That is a key differentiator in our strategy versus owning an index and one we believe adds value over time and decreases risk. Like a surfer picking a wave, we can be patient and opportunistic, even moving to a different beach if needed.

It’s 2020, not 1999 or 2000

Human nature drives us to seek out familiarity in the unfamiliar. Investors look to past market experiences for clues about what might happen next and whether the current environment is one of risk or opportunity. With the market showing recent favoritism for the technology sector one naturally recalls the events of 1999-2000, two years of extreme highs and devastating lows. Today there are some similarities, most notably amazing surges in stock prices and spectacular IPOs; but we argue there are also key differences. Valuation, fundamentals, and economic backdrop are all critical components in the future path of stocks and as one peels the onion, they find a different picture than that of 2000.

Today the market is acting more rationally, rewarding companies not just for ideas but for real results in the form of revenues and profitability. We agree that some valuations are stretched and for us that limits the future upside. It also keeps us on the sidelines or leads us to reduce our positions as we have done in Apple and Microsoft, but nothing like we saw in 2000. Today the largest ten stocks in the S&P 500 by market cap have an average forward PE ratio of 31 times earnings, a far cry from March of 2000 when the corresponding group averaged 63 times earnings with the largest holding, Cisco, trading at an incredible 196 times forward earnings.

“Valuation, fundamentals, and economic backdrop are all critical components in the future path of stocks and as one peels the onion, they find a different picture than that of 2000.”

Due to the amazing returns and then crash of the Nasdaq tech stocks it is often overlooked how broadly strong the economy was entering the year 2000. As a result, the Federal Reserve sought to rein in inflation by raising interest rates. During the year leading up to the market high on March 24, 2000 the Federal Reserve had increased short term interest rates aggressively from 4.75% to 6.5%. Investors were given a compelling option to diversify into bonds or money market instruments and make high single digit or even low double digit returns. Today bonds offer significantly less current income than the S&P 500 dividend yield and face the risk of lower prices if interest rates rise. In 2000 the S&P 500 was trading at 27 times forward earnings and paying a 1.4% dividend yield while today the market is trading at 21 times forward earnings and paying a dividend yield of 1.8%. Given the alternative of investing in bonds with no significant return we do not see the current equity valuations as presenting the level of risk of 1999.

A focus on investment versus speculation

With a level of uneasiness due to the continued strength of technology and other growth areas of the market, many investors are considering rotating from Growth to Value oriented stocks. On the surface this makes sense, but we suggest that one must be careful. Benjamin Graham, the father of Value investing, defined an investment as “… one which, upon thorough analysis, promises safety of principal and an adequate return”2. In his writing Graham often focused on separating investing from speculating, not trying to draw a clear distinction between growth and value. At Bainco, we do not focus on trying to classify stocks based on value or growth characteristics, but we do attempt to separate investments from speculative trades.. We believe that any good investment will have clear intrinsic value and the way one should calculate that value will differ between industries. As we create portfolios our investible universe is not defined by any valuation metrics, it is defined by a company’s profitability, size, and volatility. We are drawn to companies that regardless of the phase of the business cycle, can generate a profit, allowing them to take advantage of opportunities and most importantly, survive when others fail. As we have discussed in past letters, the strength of a company’s market position and its ability to withstand competitive threats are attributes we look for to determine staying power.

“Valuation, fundamentals, and economic backdrop are all critical components in the future path of stocks and as one peels the onion, they find a different picture than that of 2000.”

We suggest that the market oversimplifies the idea of Growth versus Value to efficiently create a classification mechanism for strategies, investments, and managers. Value to us is defined as paying a price that is reasonable or cheap relative to an assessment of a business. That is a difficult exercise and it cannot be accomplished by simply ranking stocks based on a financial multiple or metric as most indices do. As we have seen time and again, cheap stocks are usually cheap for a reason; they are associated with struggling or failing businesses. Instead of having a blend of businesses which are either cheap or rapidly growing, we tactically balance between companies with businesses that are more stable throughout an economic cycle and those that are more levered to economic growth. As we get concerned about the economic cycle, we shift our focus to businesses with consistent revenue and profitability throughout all parts of the business cycle. We find that it is those businesses that perform well when times are tough and often, they are not the cheapest stocks in the market.

More concerns to navigate

While we are constructive on the portfolio, we acknowledge the risks that remain present. The path forward in controlling the COVID-19 pandemic remains unclear and there will be setbacks. Market expectations for earnings to rebound significantly in the 4th quarter and 2021 could prove overly optimistic as some areas of the economy remain closed. Some pain will persist in the worst hit areas of the economy. The rebound in job growth is starting to stall, and industrial activity is moderating. With Congress looking unlikely to reach a new stimulus deal prior to an uncertain election, many may see things get worse before they get better. Lastly, sustained levels of Federal Reserve intervention in financial markets is untested. Their goal of stimulating inflation is a little like opening Pandora’s box, the results are uncertain. In this environment, and always, our goal is to remain nimble and react to the data by managing portfolios with a balance of safety and growth. We continue to believe that the companies in our portfolio are well positioned for the current economic environment and are well exposed to the growth areas of the market for the future.

As we near the finish of 2020 we are happy to see financial markets having recovered more quickly than expected which has left client portfolios in excellent shape. Most importantly, we are thankful that we have been able to continue to deliver the client service and performance we intended while keeping our staff and their families safe. We look forward to what we hope will be a positive 2021 filled with much hope and stability and less sadness and difficulty. We look forward to our future conversations and wish you a happy and healthy conclusion to the year.

1 Bureau of Labor Statistics
2 Benjamin Graham- The Intelligent Investor

Content Disclaimers

This commentary/ article has been published or selected for distribution by Bainco based on current events and/or topics of interest. It contains the current opinions of the authors as of the date of publication. All opinions are subject to change at any time. This material has been distributed for informational purposes only and is not meant to convey a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell securities or investment services.

Material in this publication, including market forecasts and forward-looking statements, is original and/or derived from proprietary and non proprietary sources Bainco deems to be reliable; Bainco does not, however, warrant the completeness, accuracy or timelessness of the information obtained from these sources. The opinions and statements set forth do not consider the investment objectives or financial situation of any particular individual or group of individuals. Readers will need to consider their own circumstances before making an investment decision and are cautioned to consult their own tax and investment professionals with regard to their specific situations.

Past performance is not a guarantee of future results.