Commentary, Panorama —

Lifting the Barbell Economy

Scott Morrison

Scott Morrison

Founder & CIO


In this latest commentary, CIO Scott Morrison discusses both ends of what’s shaping up to be a barbell economy: industries and companies who got a boost as a result of COVID, as well as businesses that got left behind.

Since the arrival of COVID-19 earlier this year, and subsequent societal shutdowns, we have had hundreds of virtual conference calls with management teams from around the world. One major theme common to these conversations is the level of surprise experienced by each management team with regard to how business fundamentals have played out between April to July, versus expectation. For the most part, the companies we own have outperformed expectations, and a cohort of companies have been positively impacted by the virus to extremes.

It is our view that this current recession is a very abnormal one. Some companies never experienced a recession at all, some experienced it for 2 to 3 months and some will likely stay in a recession for at least 2 or 3 more quarters. Unfortunately, there are also many who will just not make it through to a recovery. Indeed, in our opinion, there are structural aspects of our business world that have been forever changed.

One example of a company that has experienced a 2-3-month recession is the well-known global package and freight delivery company, FedEx. We invested in FedEx over the summer as it became abundantly clear that many supply chains were running low and needed to be replenished as quickly as possible. We always get excited when we find a business where demand is increasing, and competitive supply is decreasing. Those with overseas travel experience will likely recall looking out of the airplane window and seeing large pallets of goods being loaded into the underbelly of our commercial flights. The good news for FedEx has been that with decreased levels of global business and leisure travel, there is decreased competition for this underbelly capacity. Businesses with declining competition tend to find themselves in a position of greater pricing power. So, when FedEx recently reported results that DOUBLED Wall Street’s expectation, we were only surprised by how much others were surprised!

The FedEx example helps to illustrate a company that is WINNING in the environment created by the difficult realities of COVID-19. Now we are tasked with the assignment of how best to adjust for our portfolio of companies’ earnings and free-cash flow assumptions in the quarters and years ahead. When we spoke to the CFO of Air Canada back in June, he informed us the only flights on which they were breaking even were those with overseas cargo. We can see in the earnings database from Bloomberg that back in June, Wall Street analyst expectations were $1.80/share for their competitor FedEx. By the time that FedEx actually reported last week, those expectations had climbed to $2.70. That is a very big move for a company with a market cap of over $50 billion. Instead of coming in with top-line sales of $17.5 billion, they reported sales of $19 billion and earnings of $4.87. That is called earnings leverage for a business that we all know has high fixed costs — certainly, we see their trucks on the road and planes flying overhead every day.

I chose FedEx to help illustrate how it is not only digital businesses that are generating positive surprises, and that digital business can actually still stimulate extra demand for physical infrastructure.  Yes, high fixed-cost businesses such as airlines, casinos, hotels, restaurants, etc., are seeing the negative impacts of earnings leverage as they burn through cash reserves and lines of credit, but there are other fixed-cost businesses that are doing very well. The above high fixed-cost businesses are the companies in a recession for at least 2 to 3 quarters, as demand has fallen off a cliff, thereby creating an environment of excess supply for the near future.

We at Wealhouse know that there are huge contrarian investment opportunities developing in the out-of-favour businesses mentioned above, as the supply/demand equation will eventually move towards a new point of equalization. We have not, as of yet, placed huge investments in airlines, amusement parks, casinos, cruise lines, hotels, restaurants, ski hills, etc. However, we have started to pivot some of our gains from healthcare and technology companies into these out-of-favour domains, as we are seeing anecdotal evidence that treatments for COVID-19 are improving even if we do not find a vaccine. It is our intention to add to our chosen “survivors” in these obliterated sectors on setbacks with the second wave fears that will surely come again and again over the coming months.

You should also note from our geographic mix that we have clearly seen certain overseas jurisdictions that were much better prepared to handle the pandemic than we were here in North America. From discussions I have had with healthcare companies, it has become clear that countries such as Denmark, China, South Korea, Germany and Switzerland were much better prepared with the necessary tool sets to manage hospital capacity. In particular, these countries were more able to test their populations for COVID-19, which obviously helps with track-and-trace measures and reassures the population that the government has the illness somewhat under control. Unfortunately, as I talk to people here at home and in important G-7 countries such as the U.K. and U.S., I continue to hear of long wait times for tests even six months after borders were closed. Obviously, this is not a good situation.

As a proud Canadian I was disappointed to read in August a Canadian Press article which states: “Only a fraction of the 40,000 new ventilators Canada ordered for hospitals last spring have already been delivered… In all, Canada ordered 40,328 ventilators, for an estimated $1.1 billion, and as of Friday, it had just 606 in hand.” According to the same article, “In March there were about 5,000 ventilators nationally, and another 500 in the national emergency stockpile.” The trouble stems from Canada’s chosen domestic assemblers to navigate global supply chains and arrange procurement of the necessary parts not made in Canada to make a ventilator. As the chosen domestic players look to find the parts from other countries to help our heroic front-line workers, we anticipate that some of these parts will arrive via our investment in FedEx.

It wouldn’t be a Panorama commentary if I did not somehow sneak in an illustration on interest rates. I come back to interest rates again and again because their levels often drive asset prices in so many parts of the economy. As you can see in the charts below, the 30-year mortgage rate in the U.S. has hit all-time lows. As a result, you may observe in the next chart that the supply of single-family homes is at a very low level and falling fast. This, in turn, is leading to house-price appreciation across the U.S. — a state of affairs unlike those experienced during the 2008 crisis, when I recall touring distressed housing development projects in sub-markets like Phoenix, Arizona, which is now seeing the strongest price appreciation. Once again, this industry only experienced a 2 to 3 month recession. We have been avoiding investing in real estate companies with exposure to coastal markets with higher tax rates that are in part causing poor demographic trends because we feel they will experience a 2 to 3 quarter recession, at least. COVID-19 is accelerating an already existing secular trend towards companies and employees moving away from higher-cost regions, such as the states of New York and California. The reality of this dynamic has been confirmed by many companies based in these locations, with whom we have dialogued. We have been happy to see our investments in Tricon Residential and American Homes 4 Rent benefitting immensely from these trends, since they hold housing assets in the Sunbelt markets. Both companies, which rent single-family homes largely bought up in the aftermath of the last financial crisis, help illustrate our preference for owning assets in which supply is decreasing and demand is increasing. They experienced a 2-3 month recession.

30-YEAR MORTGAGE RATES HAVE DROPPED TO NEW ALL-TIME LOWS
Source: Freddie Mac, Goldman Sachs Global Investment Research
SUPPLY OF HOMES LISTED FOR SALE CONTINUES TO GRIND LOWER
Source: Zillow, Goldman Sachs Global Investment Research
YoY DECLINE IN INVENTORY OF HOMES FOR SALE BY MSA
Source: Redfin, Goldman Sachs Global Investment Research
YoY HOUSE PRICE GROWTH BY METRO JULY 2019 TO JULY 2020
Source: Zillow, Deutsche Bank

Another industry that is experiencing very low levels of inventory is the auto sector. Since many auto companies shut down manufacturing plants between April and June, they are now starting to see inventory at very low levels on the dealer lots. It came as a surprise to many auto companies that the work-from-home trend, population migration to the suburbs and anxiety over taking public transit would lead to cars flying off the lots when unemployment levels are so high. We believe that this bodes well for future re-stocking efforts from the auto food chain, and we have been steadily investing in companies from the semiconductor, chemical and auto parts sectors that we believe will benefit in the coming quarters from their recoveries. As you can see in the chart below, used car prices are rising. As well, we spoke with the CEO and CFO of Subaru from Japan recently and they highlighted that they currently have 17 days of inventory on their dealership lots, though they usually like to have 30 days. We believe that the auto sector is an area from which we shall see improving fundamentals heading into 2021.

ANNUAL MANHEIM USED VEHICLE INDEX AVERAGE
Source: Manheim

One company that benefits from the above-mentioned trends in auto replenishment is Shin-Etsu, from Japan. I first visited their headquarters just outside Tokyo fourteen years ago. Despite coming from the notoriously cyclical and commoditized chemicals industry, this is not an ordinary chemicals company. They are world-wide leaders in a few sub-sectors of complex chemicals that have amazing secular tailwinds in areas exposed to demand from smartphones, data storage, internet of things, etc. We find that some of the best values at present are cyclical companies like Shin-Etsu, with secular tailwinds. The company trades at a pre-teen multiple of earnings on the back of its 20% market cap in cash. Its free-cash flow yield is in the mid-single digits, with a dividend yield of 1.56% that has grown at 17% over the last five years.

Shin-Etsu is a low-cost and leading producer globally of Polyvinyl Chloride (PVC) and Semiconductor Wafers, along with other important building-block compounds society uses every day. Unlike many of their chemical peers, the company has never lost money in the twenty years that I have followed them. There is much PVC that will be used to re-stock housing and car inventories, as discussed earlier in these comments. Over the years they have taken their profits from PVC to redeploy into capacity expansions for more leading-edge and higher-margin applications, for instance that of silicon wafer production, in which they are the world leader with over 30% share. This is important to note in an industry with only four other players, since barriers-to-entry are high and intellectual property is very important. When we last spoke to them at the end of this summer, management told us that they have many new applications that will benefit from the global electrification of energy away from traditional fossil fuels. We like to buy well-capitalized cyclical companies when the economic cycle is negative, and this company has a full-cycle profitable track record that will allow them to continue to take market share and expand margins in future cycles to come.

We have provided some above examples of companies that are benefitting from the challenging circumstances brought about by the difficult realities of COVID-19. However, we are of course aware of the fact that many businesses, communities and individuals are suffering terrible hardships during this current state of our world. With this in mind, Wealhouse continues to donate funds to those in need, most particularly in the areas where our Wealhouse team live and work.

While so many individuals and small business are in desperate need of funds in order to survive, large corporations are raising funds through the capital markets in unprecedented amounts. August was by far the busiest month for the undertaking of new capital that I have seen in my 25-year career. We feel that the catalyst for this occurred back in April, when the U.S. Fed announced that they would buy junk debt for the first time in its history. As a result, it was a summer like no other, as people assumed that the U.S. Fed “had their backs” so to speak. This assumption is illustrated by a recent article in the International Business Times, that noted: “Year-to-date through September 10, there has been about $1.493 trillion in investment-grade corporate bonds issued, while $277.3 billion in high-yield bonds. Through September 10of last year, the corresponding amounts were $867.4 billion and $172.2 billion, respectively.” This is happening in the corporate sector while governments are running up record deficits and seeing their bonds increasingly monetized by their central banks.

Unfortunately, I believe that there will be increasing amounts of geopolitical volatility and societal backlash against these big businesses, who are able to access capital and make their businesses stronger as a result of this crisis. This will undoubtedly result in larger, publicly listed corporations being able to squeeze out competitors without the same access to capital-raising tools. This is a risk that bears closer monitoring and will likely result in increased taxes, regulatory pressures and competition bureau investigations. Capitalism as we know it will increasingly come under attack.

It was sad to read in an August article published in the Financial Times: “According to recent data from Yelp, the reviews site, more than 70,000 businesses have closed permanently since March. A survey from Goldman Sachs found that 84% of businesses that received loans under the government’s $660 billion Paycheck Protection Program — one of the main vehicles for funneling coronavirus stimulus cash to companies — said they were on track to exhaust the funding by the first week of this month.” It will be very important for workers from depressed sectors to re-skill and pivot into those industries that have recovered faster. This will not be easy for many workers and their families and will likely take years to accomplish. I am not sure how many of our readers work in a city centre setting but what I can tell you is that when I head down to our office on Bay Street in downtown Toronto, it feels very eerie. There are empty parking lots, closed-down mom-and-pop shops at street level and in the underground concourses. I also feel horribly for those brave entrepreneurs who have re-opened their stores, since the downtown core remains almost deserted. I truly do not know how they will survive the winter months if workers do not come back to the office in the fall. I struggle to see why many will return during a season that normally forces everyone indoors.

The world has seen unprecedented amounts of fiscal stimulus being pumped into the economy in order to help consumers and businesses pay their bills and find new work. Unfortunately, we anticipate that for many with too much debt, the inevitable reality of personal and corporate bankruptcies will eventually spike. This confirms why we are less excited about re-investing in the banking sector. According to the Canadian Press: “CMHC estimates about $1 billion worth of mortgage payments were deferred each month during the pandemic, and fewer people will get ahead of their payments this year than in 2019.”  As a result, you can see in the below chart how the amount of increases in mortgage delinquencies has not materially increased yet. We will be interested to see how banking retail clients do with the large amount of mortgage deferrals set to expire in the coming months. Canada’s largest bank, Royal Bank, said that: “$23 billion of loan deferrals have expired, and 80% have resumed regular payments, while 19% have extended their deferral period for an additional two to three months… and only 1% will become delinquent.” Our thoughts go out to these families who are worried about their ability to take care of their homes.

CANADIAN PRIME MORTGAGES
Source: Canadian Bankers Association, The Mortgage Bankers Association

It is very likely that we all know multiple people who are struggling and have heard of many corporates having trouble servicing their debt. We believe that the losses will worsen going forward as government support eventually declines.  As you can see in the charts below, which are based upon the study of past cycles, downgrades that are assessed by rating agencies such as Moody’s and Standard and Poor’s foreshadow eventual payment defaults by corporations in financial trouble.  Due to the lack of balance sheet transparency, it is very difficult to know which banks will have the wrong counter-party exposures at the wrong time. We prefer to invest in businesses that have clearer counter-party visibility.

U.S. LEVERAGED LOAN ANNUAL RATE OF DOWNGRADES
Source: S&P LCD, Goldman Sachs Global Investment Research
LEVERAGED LOAN ANNUALIZED DEFAULT RATES
Source: S&P LCD, Goldman Sachs Global Investment Research

Once again, there are macro risks ahead — not the least of which is the U.S. election, tensions between the U.S. and China, and fears of a COVID-19 second wave. We will do our best to navigate risk-versus-opportunity, by remaining focused on owning businesses with improving fundamentals. We do believe that the worst of the virus is behind us for more geographies, industries and companies than not. We also feel that unemployment peaked in the spring and will have more improvement than deterioration from here. We do not know if there will be a vaccine and therefore cannot forecast month-by-month or quarter-by-quarter market returns. I would not extrapolate the previous few months of very positive returns in our fund into the next few months since the degree to which we will be positively surprised going forward is starting to get discounted in asset prices. We believe this fall/winter could be very choppy in the markets since there are still some very tough issues and problems for the world to solve politically and financially. As a result, we do feel that there will continue to be elevated levels of volatility in capital markets and we will thus use these times to add to or establish new investments in businesses that meet our approved checklist. Fortunately, our team has travelled the world in the past and completed firsthand proprietary due diligence on many global leading companies, as well as having been able to stay in touch virtually. Typically, at this time of year, I would be on plane ride after plane ride to attend company analyst days or industry conferences. Instead, we are adding to our past research through virtual meetings. Those past research miles logged gives us a competitive advantage in a world of uncertainty and our team will continue to embrace the volatility.

Panorama

Panorama

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.

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