April 2, 2020
The markets remained volatile as the COVID-19 pandemic continued to evolve at a rapid pace over the past week. China appears to be recovering from the initial phase of the crisis, even as it tries to prevent a potential second wave, while cases and deaths in Italy and Spain have started to decline from critically high levels. The U.S. has become the global epicentre of the infection as more states implement lockdown measures in light of the significant increase of confirmed cases. In addition, the combination of simultaneous supply and demand shocks has had a significant negative effect on the global price of oil, which continues to trade at levels not seen for well over a decade. It was startling to see that a barrel of Western Canadian Select traded at a price below that of a pint of micro-brew beer earlier this week, before it rallied by over 20% on news of a potential deal between Russia and Saudi Arabia.
Against this backdrop, our team continues to do what our clients trust us for: staying focused on building quality portfolios that provide sustainable, long-term value creation. To that end, our portfolio managers and analysts have spent a great deal of time talking to companies and management teams over the past few weeks. They are in regular contact with the companies they follow, assessing the resiliency of our holdings while the crisis continues. To answer questions that we have been receiving from clients, we wanted to share some of the insights that we have gained from companies in some specific sectors – Financials, Information Technology and Health Care.
How do we think Financials will fare?
A combination of low interest rates, declining oil prices and rapidly declining GDP is not a good combination for the world’s banks, which frequently behave as close proxies for the economy. Canadian banks entered this period with significantly more capital than during the Global Financial Crisis, and their high pre-tax, pre-provision earnings is very strong compared to any provisions they are expected to take for credit losses. As a result, we believe it is highly unlikely that any will need to issue shares or cut dividends. In Europe, the situation is different as a postponement of dividend payments for banks was just announced, which will obviously concern income investors; however, we think that there is a low likelihood that Canada, the U.S. or other jurisdictions will follow suit. Valuations are at trough levels (or below), reflecting deteriorating fundamentals for most of the world’s banks – situations such as these have usually offered excellent opportunities to build positions in the high-quality players.
On the insurance side, companies are negatively impacted simultaneously by lower equity markets, low interest rates and unforeseen increases in claims. The quality of an insurer’s securities book and its skill at underwriting are elements that differentiate the highest quality players from the others, and we have confidence that we own some of the most solid and resilient property and casualty and life insurance companies. Due to computer-driven selling and passive funds being forced to sell, the whole group has underperformed, offering the potential to buy fundamentally sound companies at discounted values.
In general, the downturn has been quick to sell off financials but we believe the defensive character of quality financial names will shine through as the situation matures and will recover well when the crisis subsides.
How is the Information Technology sector holding up during this crisis?
Up until this point the global IT sector has generally performed relatively well during the crisis. For many of our IT names, the combination of an insulated business and the lurch towards lower interest rates has really helped the performance of higher multiple stocks. Our philosophy has emphasized companies with a recurring revenue base that are likely to see less of a hit to revenue during an economic downturn, and this has been a positive attribute over the past few weeks. We have also favoured companies that are part of the transition to cloud-based storage, and we expect to take advantage of the pullback in some stocks to add to this area. On the negative side, any companies that are exposed to transaction volumes or travel have been under selling pressure, and as with many other areas, any company with above-average leverage has tended to underperform. We expect there to be more opportunities to add to our holdings in the IT sector as the crisis continues.
Why has the Heath Care sector not been as defensive in this downturn?
The Health Care sector has usually been somewhat insulated from market corrections as the majority of the sector’s products are for the most part seen as “essential”, i.e. demand moves independently from the economy. This is one reason why our foreign portfolios usually carry a meaningful allocation to the sector. During the current crisis, while the sector has done better than the broader averages as a whole, there has been further segmentation into those companies that are producing products related to COVID-19 or needed on an ongoing basis (e.g. pharmaceuticals) and those that have products necessary for procedures that tend to be elective. The difference in performance between the two types of companies has been striking, with the first group beating the benchmark handily while the latter has materially underperformed. Quality companies in the latter group should be able to remain resilient through the period of time during which the need for acute care driven by COVID-19 takes precedence.