Founder & CIO
March saw the worst market decline since 2008. In his latest commentary, CIO Scott Morrison discusses how he is protecting capital by sticking to his number one investing principle.
It became official during the month of March that equities have, unfortunately, entered a bear market, similar to what we experienced in 2008. However, the fund’s balanced approach to investing has allowed it to materially outperform equity benchmarks and exchange traded funds (ETFs) mimicking those benchmarks. Many of these ETFs have holdings that are severely impacted by the current crisis, such as airlines, oil, leisure, retailers and restaurants. Unlike those industries, the Wealhouse team is in full operation mode for our clients and each other.
Careful execution of our investment checklist process has proven its worth in this scramble to exit the equity markets. The number one rule on our checklist is the liquidity of a company’s balance sheet. By avoiding companies with too much debt, our investments have outperformed. By ensuring that we follow our risk-management process around liquidity of the securities we own, we were able to pivot faster out of businesses that will suffer most from this deep recession.
For example, we sold our investments in travel-related businesses once we saw the virus spread and international borders being closed. We also sold our longstanding holding in Stryker, an incredibly well-managed company that has leading franchises in hip and knee replacement surgeries. This was prompted by an obvious and necessary shift in healthcare and hospital priorities, rendering the majority of hip and knee surgeries as “elective”. Instead, we have rotated into cardiovascular-leading business franchises from Abbott Labs and Edwards Life Sciences, based on the presumption that people can most often live with a painful hip longer than a defective heart. We will likely reinvest in Stryker once we have better clarity and see more progress on virus-testing capabilities and respirator capacities – both of which would begin to allow for elective surgeries.
For those who have visited our offices in downtown Toronto, you will have noticed that I keep on my office wall an extensive set of binders. Each binder has a company’s most recent financial reports, management circulars and investor business plan presentations, as well as other reference materials that we can use for research and dialogue. Some of the binders are blue and some are red. Blue binders signify companies that we believe can control their own destiny regardless of economic circumstances. Red binders are reserved for companies that we feel will not do well during such times as we are experiencing right now. Although the information is also backed up digitally, so that we all can have remote access to them, I have always liked having visual reminders for myself and our team to be prepared for that which I have often discussed: “When Bad Things Happen”.
Other images in our office include a series of photographs from around the world, hung up in order to encourage our team to think globally. I also have in my office a print of a famous painting entitled, “The Bear Dance”, painted by William Holbrook around 1870. It illustrates bears dancing in celebration of a stock market drop. I bought this print in 1994, and it serves to remind me that markets can and definitely do go down during recessions. Most of these people I have spoken to throughout my career manage money based on a presumption that markets will always go up. Our investment style is designed to outperform in these environments and be better positioned for a recovery.
Although there are similarities, we do not believe that this crisis is the same as a 2008-type recession, which was caused by sub-prime bankers behaving badly. This is also not a technology bubble-burst like we saw in 2000, in which companies selling at ridiculous valuations and no earnings and free cash flow collapsed in price. Nor is it a currency-induced crisis, which occurred in Asia in 1997 and subsequently spread around the world’s credit and commodity markets. This is a pandemic that caught health care systems around the world unprepared with neither the necessary equipment nor the capacity to deal with the fast-spreading and deadly virus. As a result of having to shut down vast swaths of economy in order to allow our heroic frontline workers the opportunity to battle COVID-19, there are many businesses suffering a catastrophic decline, with no cash flow to service in-place expenses like salaries and debt.
The subsequent shift from bull market to bear was the fastest on record. It helps to illustrate a point that we have discussed in the past – the reality that more and more money is being run by fewer and fewer managers. Indeed, the advent of ETFs has forced managers to run more and more money, in that they have had to take bigger and bigger stakes in their companies. One lesson that I took away from 2008 was the realization that I did not want to run so much money at Wealhouse, that I would be forced to own 5%, 10% or 15%+ of a company, just in case an investment thesis might be proven wrong and I needed to shift my approach for the sake of my clients. I was well-trained in the 1990s to understand who owned my stocks, so that I could judge if they were in favourable hands. Thus, I have always studied the publicly-disclosed-holders lists very closely. Unfortunately, I can see there are some much larger money managers that are essentially trapped in some now-structurally-challenged companies and if they try to get out, the prices could go much lower still.
March was a month in which the equity markets collapsed to a point not seen since the Nazi invasion of France in June 1940. This is prompting many to compare the current battle against COVID-19 to those fought in WWII. The President of the United States has even enacted The Defense Production Act, a Federal protection act which was originally instituted in 1950, in response to the initiation of hostilities in the Korean War. In this fight against the virus, the President used the Act to designate ventilators and PPE essential to national defense. All this has reminded me of my 2007 visit to Pearl Harbor, when I travelled to Hawaii to give an investment update speech to a conference of insurance brokers. While most attendees went to play golf, my wife and I visited one of the most important sites in the history of World War II. My wife is a historian and has therefore encouraged me, as I subsequently try to encourage others, to be a student of history. At times like these, it pays off more than the work on my short game in golf.
I particularly remember an incredible set of mosaic murals set into a memorial wall at the “Punch Bowl” – The Military Cemetery of the Pacific – commemorating important Pacific battles of the era. Similar to the surprise attack at Pearl Harbor, this virus has pounced upon the Americans and, indeed, much of the world. For stock market investors, I would offer up the hope that we are all now fighting back, in many ways and as best we can. As a reminder of this, I keep the image of those murals uppermost in my mind. They poignantly illustrate how the U.S. military pushed back after Pearl Harbor, and ultimately emerged victorious – as I am sure we all will.
Unlike the events of World War II, however, we are not bombing each other and purposely intent on the destruction of populations. Certainly, we are becoming witness to increasing signs of nationalism and selfish acts; however, incredible stories of heroism and selflessness also abound. I would also point out that equity markets around the world reacted very negatively when Nazi Germany invaded France, and then again when the Japanese bombed Pearl Harbour. Once the allies began to make progress and win subsequent battles in the Pacific, however, stock markets began a period of recovery long before the war was over. We hold out hope that markets can recover long before we eradicate the virus and find a vaccine. As you can see in the below chart, there were more positive return years than negative in the 1940’s.
We are very proud that many of our companies are financially strong enough to provide care for their employees, who are going the extra mile for their customers and honouring their counter-party agreements. It is a positive sign that we have seen our central banks reflect lessons learned from the mistakes of 2008 (i.e. allowing Lehman Brothers to go bankrupt), and instead, respond with trillions in financial support of their respective financial systems. In my opinion, our governments are finally moving in the right direction. The longer they mandate us to stay home in order to support our medical system, the more governments will have to increase fiscal support. If they do not collectively sustain and increase support, the world will face a deep recession and perhaps, officially, depression.
It is my personal opinion that we will have to digest a great deal of very bad news in the month of April and May, most of it surrounding tragic losses of life from ordinary citizens and frontline medical workers. We will also unfortunately witness the highest unemployment numbers and personal bankruptcies that we perhaps have ever seen. We will see unbelievable declines in earnings and free cash flow from companies as they report results over the next few months. In anticipation of the above, we have anchored the portfolio to companies that have outstanding business franchises that are still generating cash flow. We believe that these companies can best position themselves for an economic recovery and come out the other side in a position to strengthen, versus peers who are less well-prepared to weather such a storm.
Unfortunately, there are some industries right now that are not analyzable, and into which we will not invest. If there is a rapid miraculous recovery, then these businesses on the brink of bankruptcy will skyrocket and outperform our quality holdings. We will avoid investing in the equity of businesses that need financial support from the government, since the transactions will likely be highly dilutive, and we generally do not like investing in businesses dependent on government equity ownership or onerous debt terms.
When you look at our Top 10 holdings, you will see that 9 out of the 10 companies have net cash on their balance sheets. The only company with some debt is Intercontinental Exchange (ICE), who actually benefits from increased volatility in the capital markets. Volatility measured by the VIX index during the month of March reached levels that surpassed 2008 extremes. We quickly added to our ICE holding in early March during the selloff. We anticipate that their debt ratios will improve, since they will generate growth in free-cash flow and earnings in Q1 and Q2 this year. This company is a global operator of exchanges, listing venues, and clearing houses across multiple asset classes. Half of its revenue is from transaction-based trading, which is counter-cyclical and benefits from the recent volatility with February average daily volumes up 39% year-over-year. The other half is from stable, subscription-based, recurring data and connectivity fees. This has allowed it to sustainably grow earnings every year since going public in 2006, even through the recession in 2008-2009.
The company was founded in May 2000 by the current chairman/CEO, Jeffrey Sprecher. He has since built the company into the second-largest global exchange in the world, through both acquisitions and leveraging the distribution and infrastructure to create new solutions for customers. We like entrepreneurial, founder-led companies with significant insider ownership (Sprecher owns >$350M in equity), as they are aligned with equity owners. Intercontinental Exchange is an attractive long-term holding, as it has high barriers to entry, 58% operating margins, a strong balance sheet, and sustainable free cash flow. This gives it the ability to opportunistically buy back its stock during times like now, when the market is selling off. My colleague, Colin, listened to the CFO speaking at a conference on March 2, where Scott Hill, ICE’s CFO, stated: “In a world where we’re setting records in our revenue in January and positioned well for February, and the share price is going down, we’ve got flexibility to be opportunistic and buyback stock.”
I was actually scheduled to have dinner with the ICE founder in Florida at a conference in early March, which was ultimately cancelled. Instead, I joined a remote conference call they organized from their offices in Georgia. It was incredibly eerie to be sitting in my hotel room in Florida, listening to people by the pool who did not realize what was coming their way. Fortunately, I returned home the very next day on a half-full flight, just over a week before the U.S. and Canada closed the border. Despite the conference cancellation, I decided to stay in Florida because I had arranged to meet with senior management of NextEra Energy, the best-performing energy utility company in the U.S. They also happen to be the largest renewable energy company in the world. NextEra is a core holding for our Fund because of its incredible track record of earnings and free cash flow growth. They have achieved this in part by converting more and more of their power grid, and the grid of those companies they have bought, from fossil fuels to renewable energy.
As a Canadian, I am saddened to see fuel prices collapse to such uneconomical levels for the energy-producing regions of Canada. Fortunately, our only investments in energy were in natural gas companies that we believed benefitted from less oil production, and the fact that we still needed natural gas to heat and cool our homes. During the month of March, natural gas prices were relatively flat versus the collapse in oil prices. Unfortunately, I have never seen worse fundamentals for oil — this due to a near-complete collapse in demand from airlines and automobiles, and an idiotic increase in supply strategy from Saudi Arabia. They will be forced to reverse this in short order after someone shows them a very simple supply/demand analysis.
It is important to realize that, with regard to oil, there will be a very important difference in the economic and stock market recovery trajectories versus what we saw following the 2008 collapse in oil prices. Many Canadian analysts seem to be missing the fact that oil prices bounced back and stayed between $80 and $100 until the end of 2014. I am an investor who has been travelling to Alberta for over 25 years, having visited firsthand many drilling rigs and oil sands projects. I believe that there is a failure to understand that Canada is a very high-cost producer versus other supply sources. We do not believe a return to high prices will happen anytime soon, since the airline industry will not demand as much fuel as it did in those years. Furthermore, the U.S. has become the largest producer of oil since that time and are lower-cost producers than Canada. Recall that we never like to invest where there is increased supply and decreased demand. The only good news is that it is difficult to imagine how it can be any worse from a demand perspective, than what we are currently witnessing.
Another big headwind for Canada will be interest rates. The financial service-heavy domestic Canadian indices are dominated by life insurance and banking businesses. A “lower for longer” or “lower forever” interest rate environment will make it very difficult to generate as much earnings growth as they did coming out of the last recession, when interest rates were much higher. Recall that the Bank of Canada was one of the only global central banks not to lower interest rates in 2019. Therefore, most financials in other geographies had already been dealing with lower rates, while ours are just now coming to grips with this new reality.
As a result, you have seen our holdings pivot in the fund significantly outside of Canada, in order to better preserve our clients’ capital. We have rotated investments to our approved list of holdings in companies levered to China, as we did in 2009. In particular, you will hear us talk in the months ahead about Asian companies that I have visited over the last 25 years. When I first travelled to Asia for research in the 1990s, it was to better understand how China, especially, would impact the supply/demand equation for Canada’s resource companies, which I was invested in through energy and mining-related industries. I went back to China after 2008, as they marched towards the top of the economic charts, in order to determine which companies would become their domestic leaders.
Today, I strongly believe that China will win major market share globally coming out of this crisis. I clearly remember visiting companies in China in 2009 and seeing firsthand how their national and local governments subsidized and supported so many companies, not only to take market share from western companies domestically, but in international markets as well. Chinese leaders do not sit around debating policy with opposition parties. China does not have TV debates for leadership of political parties. China does not redirect monies from their wealthiest lobby groups towards negative TV ads. Chinese leadership thinks about long-term strategic plans to make China the largest economy in the world and consistently grow the standard of living for their billion plus population, in order that they can avoid Western-style democracy. I am not saying this is right – I am simply saying that it will win market share globally for its companies and the citizens employed by those companies.
For those fans of Hockey Night in Canada, you may have noticed Huawei is a lead sponsor. Slowly but surely, Chinese companies have planted their flags in countries outside of the U.S. – in Canada, Eastern Europe, Africa, South America, etc. Unfortunately, I believe that Canada is without much true-scale, knowledge-based companies and will struggle to compete and stay as relevant on a global stage. I hope I am wrong.
In the post-WWII era, the U.S. march towards global economic supremacy took shape, as they literally kept their flag flying at many military bases in Europe and the Pacific. As we saw after 2008, I believe that there is a very strong chance that we will see a rapid acceleration in China’s climb to the top globally, from an economic perspective. Stay tuned for how the Americans respond and the volatility that this will cause in the global markets.
Japan is taking a different approach, but one that demands attention. I have travelled often to Japan, over the course of my career, in order to meet companies. It is fascinating to study how they recovered so well from their defeat in the World War II. For anyone who wants to delve deeper into the subject, I recommend a great book entitled, “Saving the Sun”. I read it over 15 years ago and it does a great job of chronicling that journey. Today, Japan has many very strong global companies, such as Toyota, Sony, Komatsu, etc., and they have a distinct view of the threat to these leading companies posed by their Asian neighbour. We find it very interesting that Japan has decided to allow their central bank to buy equity in their companies in the stock market, no strings attached! They now own close to 10% of their largest companies. This has huge potential implications for the cost of capital advantage of Japanese companies moving forward. Their central banks have already given them a cost-of-debt advantage by manipulating their bond market for many years into negative rates, and now are stepping in to bid for their stocks! As such, you see that our holdings in Japan have climbed.
Our deepest thoughts and prayers go out to all those impacted by the Coronavirus. I sincerely thank our team who is working so hard to keep Wealhouse functioning normally. Wealhouse continues to operate as usual except that we are no longer doing research trips and hosting meetings in our offices. Instead, we are communicating with our companies over the phone and/or internet and leaning on our many past research trips to decipher which businesses represent the best future opportunities.
In this profession, our efforts are most needed in times of crisis, and so we thank everyone for their trust. Wealhouse has decided to contribute money to local food banks in our various communities, in order to help those in need during these difficult economic times. Everyone on our team is healthy and benefitting from the past investments that we have made in advanced and mobile technologies, and are making good use of those tools to work remotely and safely.
I am pleased to report to clients that our entire team has invested in units in our funds this month, in order to take advantage of the long-term opportunities being presented. None of us knows whether we have seen the bottom, but we do believe that our companies will recover, grow earnings and free cash flow in the years to come. We will focus on taking care of existing clients and being responsive to new ones who want to invest alongside us in our balanced approach.
In 2008, I often told clients that I did not know whether we were in the Don Valley (a small Toronto thoroughfare with a depth of 75 metres) or the Grand Canyon (which has a depth of 1875 metres). As much as I hate to say it, I do believe that we are currently more likely somewhere in the depths of the Grand Canyon. Hence, we will face an incredibly steep climb to make it to the other side. I also believe, however, that allocating capital to assets with improving fundamentals and avoiding companies with deteriorating fundamentals, will continue to protect and grow our clients’ capital full-cycle.
Please do not hesitate to reach out.
Panorama Fund strives to maximize capital appreciation by investing only in securities that we believe offer above-average returns on a risk-adjusted basis. The fund employs a variety of strategies including investments in equity, bonds, currencies, commodities, and publicly traded real estate. The fund also makes prudent use of derivatives to generate yield and enhance or protect our positions.
As Wealhouse Capital’s flagship fund, Panorama takes advantage of market inefficiencies across different geographies, industries, market capitalizations and asset classes to build a balanced portfolio. We actively analyse different risk factors in the markets to better diversify and safeguard our clients’ capital.View Fund