Glass half full – 1st quarter, 2020
Apr 03, 2020
By Frank Mullen, portfolio manager
Volatility has been a constant in capital markets throughout history. Most years, investors foresee a risk to the economy and its underlying businesses, and they react to short-term views by selling investments and driving the price lower. Many view these movements as investment risk. We, however, choose to view them as opportunity, and we have written extensively about the topic.
A quick change in the price of an investment merely reflects the hurried opinion of the masses. It’s our job as fundamental analysts to apply our own logic and analysis to the situation, then develop our own view. We often agree with the market, but there are times when we think the market is missing something and is valuing a business with far too much pessimism. We fail to see how this is a risk. Identifying a business that’s being offered at a low price because of others’ misguided fears is an opportunity. What would you do if a brand new Honda Civic had its price slashed from $25,000 to $10,000? Would that be a risk or an opportunity? If you were car shopping, you’d know the value of a Civic is greater than $10,000 and would buy it as quickly as you could.
As investors, our job is to value businesses. We need to understand the long-term drivers of a business’s profitability and use the forecasted future profits to come up with a value. When the market offers us an opportunity to buy businesses significantly below our valuation, it’s an opportunity. It’s an opportunity to make a potentially great investment and compound wealth.
This past month has been extremely volatile – and with good reason. The world is facing a threat from a widespread pandemic that is having a significant impact on many businesses. I have never been in a situation where a company I was looking at could see its revenue decline 50% to 100% in a given month or quarter, but that’s something we’re currently grappling with. This has affected market prices materially, with both equity and credit indices registering one of their fastest declines in history. Many of these investments deserve to fall in price. The economics of their business have changed and the actions they take to deal with current conditions could limit their earnings power far into the future.
There are also cases where this isn’t true. This includes businesses that will certainly experience a short-term decline in earnings, but whose future prospects are just as bright as they were at the beginning of the year. If the price of equity or debt tied to these businesses falls, it’s not a risk. It’s an opportunity. Specifically, it’s an opportunity for the investor who can analyze the fundamentals, review the balance sheet and determine that the business can not only survive, but also thrive well into the future.
Your EdgePoint Global Growth & Income Portfolio and EdgePoint Canadian Growth & Income Portfolio have investments in both equity and debt securities. These investments have been affected by the recent decline in the markets, but the Portfolios are well positioned to capitalize on the opportunities that we’re seeing in this environment. Our Portfolios are stacked with companies that we think are priced very attractively and can thrive in the long term. We know there’s a great deal of uncertainty in the world, but we can say again with a high degree of certainty that many businesses will not only survive this uncertainty, but will thrive.
We entered this downturn with close to 25% of the Portfolios in cash and investment-grade bonds, as well as a watch list full of businesses that we have followed over the years but never owned because of their high valuation. The recent market correction has allowed us to buy the debt and equity of these businesses at valuations that are far more attractive than they were mere months ago. Reallocating cash and short-term investment-grade bonds into more attractive opportunities is a key benefit of the balanced portfolios. They should not be viewed as separate fixed income and equity portfolios. Your investment team views them holistically, contrasting the risk and reward of the entire opportunity set. The cash and short-term investment-grade bonds provide us with capital that can be reallocated into ideas with higher return potential, including equities and high-yield bonds. Over the last month we were able to invest in great companies that we believe can generate very attractive returns in the coming years.
Your Portfolios have a growing allocation to high-yield bonds. It’s an asset class that we think is highly attractive on a standalone basis and can meaningfully benefit a balanced portfolio. One of its greatest attributes is how it’s behaved during periods of volatility. Throughout history, high-yield bonds have rebounded from downturns faster than equities and provided a pleasing return throughout the market cycle.i
The chart below shows how the high-yield index and the S&P 500 Index reacted during the financial crisis in 2008. If you invested prior to the decline, your long-term return was still attractive and your recovery time was quicker than that of the S&P 500. High-yield bonds pay you a “juicy” coupon and during periods of volatility that coupon can be reinvested at much better prices. If you have done your credit work, using coupons to invest at much lower and more attractive prices is a powerful tool for generating long-term returns.
S&P 500 Index vs. ICE BofAML US High Yield Index during 2008/2009 financial crisisii
Growth of $100
Dec. 31, 2007 to Dec. 31, 2010
2007 to 2010
|ICE BofAML US High Yield Index
|S&P 500 Index
Source: Bloomberg LP. Both index returns are total returns and in US$.
Although we endeavour to create a Portfolio that looks very different from the index, we do find our ideas by sifting through the overall market. For that reason, we believe looking at index stats provides insight about the overall market. The yield difference between high-yield bonds and government bonds is called a credit spread. In general, the wider the spread, the more opportunity can be found for investment in high-yield bonds. As shown below, credit spreads have widened materially in the last year and are at levels that have represented compelling times to invest throughout history.
ICE BofAML US High Yield Index II Option adjusted spread (OAS)iii
Dec. 31, 1996 to Mar. 25, 2020
Source: FactSet Research Systems Inc.
Below is a quote taken from a JPMorgan report that frames the investment opportunity we see today with credit spreads sitting at just over 1000 basis points (bps), or said differently 10%:
“For historical perspective, high yield spreads above 800bp have led to attractive return opportunities, and the case is even more profound above 900bp. The median annualized return over the next 12, 24, and 36 months for HY as spreads cross 900bp is 36.9% 25.5%, and 20.8%. In fact, with a horizon of a year or more, an investor has never lost money, historically, in 25 examples buying HY bonds as spreads cross 900bp.”iv
To drive home the point, below we’ve listed each period of double-digit declines experienced by the high-yield bond index over the past 30 years. There’s no certainty that the most recent episode – exceeded in severity only by the sharp declines witnessed during the 2008 financial crisis – will offer the same outcome. But one thing is certain: if the past is any indication, the future looks very bright for high-yield investors.
ICE BofAML US High Yield Indexv
Decline period (peak-to-trough)
|Returns following bottom after double-digit decline
|U.S. commercial real estate crashvi
Aug. 1, 1990 to Nov. 9, 1990
May 1, 2002 to Oct. 10, 2002
|2008/09 financial crisis
May 20, 2008 to Dec. 12, 2008
|U.S. debt downgrade by S&P
Jul. 26, 2011 to Oct. 4, 2011
|Oil price collapse
May 31, 2015 to Feb. 11, 2016
Feb. 20, 2020 to Mar. 23, 2020
Source: Bloomberg LP. Total returns in US$. Returns for periods greater than one year are annualized
Having a flexible pool of capital leaves us in a great position to identify and capitalize on the exceptional opportunities that we’re seeing today. We have always proven our conviction by investing alongside our clients and continue to be among the largest investors in our Portfolios today. EdgePoint itself and EdgePoint employees, including members of the Investment team, have increased their investment in the Portfolios during this period of volatility.
iSource: Morningstar Direct. As at August 31, 2018. Total returns, includes reinvestment of dividends and in US$. Average trough-to-prior peak recovery time only incorporates declines greater than 10%.
iiThe ICE BofAML US High Yield Index tracks the performance of high-yield corporate debt denominated in U.S. dollars and publicly issued in the U.S. domestic market. The S&P 500 Index is a broad-based market-capitalization-weighted index of 500 of the largest and most widely held U.S. stocks.
iiiThe ICE BofAML US High Yield Master II Option-Adjusted Spread is the calculated market capitalization-weighted spread between US$-denominated debt rated lower than investment grade (based on an average rating by Moody’s Investor Service, Standard & Poor’s and Fitch Ratings) and the spot U.S. Treasury curve. Option adjusted spread measures the spread of a fixed-income security adjusted to account for embedded options.
ivSource: JPMorgan, “High Yield Credit: Find the Baby; (“Prematurely?) Searching for Value In BB Land”, JPMorgan North American Credit Research, March, 19, 2020.
vThe ICE BofAML US High Yield Index tracks the performance of high-yield corporate debt denominated in U.S. dollars and publicly issued in the U.S. domestic market.
viThe early 1990s U.S. commercial real estate crash is attributed to the failure of savings & loan institutions in the late 1980s to early 1990s due to inflation of those properties. Source: Geltner, David, “Commercial Real Estate and the 1990-91 Recession in the United States”, Massachusetts Institute of Technology – Department of Urban Studies &Planning, MIT Center for Real Estate, January 2013. https://mitcre.mit.edu/wp-content/uploads/2013/10/Commercial_Real_Estate_and_the_1990-91_Recession_in_the_US.pdf.