Commentary —

The Light at the End of the Tunnel

Scott Morrison

Scott Morrison

Founder & CIO


Now that we can see a distant end to the pandemic, is it time to buy back names investors shed back in March? Or are some COVID trends here to stay? CIO Scott Morrison sees both sides in his latest commentary.

This month I searched the internet for the origin of the phrase: “It’s always darkest before the dawn.” Credit is given to the English theologian and historian Thomas Fuller, who lived in the mid-1600s. Coincidentally, this year we set our clocks back on the day after Halloween; hence, an aborted Halloween coupled with the impending U.S. election led to equity markets seeing setbacks during October. Outside of fears over the election, understandable fears around COVID-19 cases increasing were also a negative catalyst.


NEW VIRUS CASES AND DEATHS HAVE SURGED
Source: JHU CSSE, Goldman Sachs Global Investment Research

As I sit down to write these comments, I can say that your investments have more than recovered from October’s setback in November so far. This is due to the fact that we now have election certainty, however difficult it is for some to accept. The stock market is telling us that its October worries about a hung election and constitutional battles dragging out into 2021 are quickly disappearing, despite the lack of a concession speech.

During my 2020 research efforts into the world of science and vaccines, I often heard from many accomplished doctors who said: “There is no guarantee that a vaccine for COVID-19 will be discovered and produced.” However, in back-to-back weeks so far in November we have noted vaccine announcements from Pfizer and Moderna. Sadly, the market is recovering this month while various virus metrics approach new highs. Hence my comment “it is often darkest before the dawn.”

Now that the sun is rising, what should we do? Should we go all-in for Panorama Fund and buy deep value and cyclical stocks such as cruise ships, office buildings and oil stocks, each of which got hurt the most over the past year? The answer is no — we are still balanced across our highest-conviction ideas. Our goal is never to be the firm that goes down the most in the kind of crisis that we saw this year or in 2008. Obviously, this balanced discipline for Panorama Fund means we will rarely be the fund that is up the most either.

It continues to surprise me how long this crisis is taking to play out. I have spent many a moment since March sitting by myself in the empty Wealhouse office space, debating whether I should ask our team to return to work in downtown Toronto. I have carefully held some face-to-face meetings in the office with small numbers, had teammates visit my home and had some meetings outside on local restaurant patios. But now that the city of Toronto has shut down again and the weather has turned quite frosty, I am left feeling that it is in the best interest of our team and our clients to have everyone work safely from home, and continue to collaborate through virtual means.

The lack of normal travel has allowed the Wealhouse team to spend more time into putting thoughts and content onto the Wealhouse website, in order to better illustrate our investment process. By now I hope that you have had a chance to see some of the very profitable ideas that have come out of our newly launched Amplus Credit Income Fund. I could not be happier at how the addition of Andrew James Labbad, CFA, has provided a new perspective and expertise to the investment team. Andrew expects to have a fund that is focused on hitting singles and doubles month-by-month. My family is very happy that we stepped up and invested alongside him and his many contrarian value ideas.

Andrew follows the new Lions Bay Fund that we seeded for Justin Anis, CFA two summers ago. Justin is much more focused on North America than the Panorama Fund, which invests more globally. I would encourage clients to speak with Justin about the strategies he deploys to manage volatility through the disciplined use of derivative strategies. As I always say, you never know where you have a leak in the roof until it rains. Certainly, this year you can clearly see that Justin’s strategies have helped weather those storms that arise from time to time.

I would like to remind our investors that if they are eternally optimistic, high-risk orientated and willing to be less balanced than the above-mentioned funds, then Voyager Fund is where the most aggressive investments are being made. Voyager owns smaller companies with less liquidity and therefore more volatility. For my family, I am balanced across all four investment choices and depending on how each fund is performing, I re-balance accordingly. Do not be surprised if Jane Yang, our marketing head, politely encourages you to learn more about these different opportunities. All of us at Wealhouse own units in all the funds and we truly believe this diversified approach will help to grow all our savings.

I mention all this to ensure that everyone knows where I am personally invested and that Wealhouse is not only investing in outside talent but inside analytical and money-making talent as well. I truly believe in my teammates and their investment acumen. I do not have a crystal ball to foretell the future, and so I believe that being well-diversified across these different opportunities will help our clients and families. The positive news about the vaccine is a true acknowledgement that technology and its scientific applications can offer up amazing payoffs for the future of humanity and allow us to better handle the adversities that we may encounter.

One reason why we added an experienced debt investor like Andrew to our team was because there has never been a time where there is more global debt. By default, the opportunity set in debt has grown materially this year. We fully anticipate that, as corporates can see to the other side of this crisis, we will see a major uptick in Mergers and Acquisitions which will often be funded with additional debt.  According to a recent article from the Financial Times:

“Governments and companies took on $15 tn more borrowing in the first nine months of 2020, says IIF. The Institute of International Finance expects total debt to reach 365% of global GDP by the end of the year. Global debt rose at an unprecedented pace in the first nine months of the year as governments and companies embarked on a ‘debt tsunami’ in the face of the coronavirus crisis, according to new research. The pace of debt accumulation will leave the global economy struggling to reduce borrowing in the future without ‘significant adverse implications for economic activity,’ the Institute of International Finance warned on Wednesday … Debt burdens are especially onerous in emerging markets, having risen by 26 percentage points so far this year to approach 250 per cent of GDP, the IIF said. The share of EM governments’ revenues spent on repayments has also risen sharply this year, according to IIF data. This week Zambia became the sixth developing country to default or restructure debts in 2020. More defaults are expected as the cost of the pandemic mounts.”

It is not only debt issuance that is spiking. In the below illustration, you can see that equity issuance in the way of Initial Public Offerings (IPOs) is also taking place. In the most recent quarter, the U.S. IPO market followed suit with the most capital raised through IPOs in a quarter in the last 10 years, with 165 IPOs raising $61 billion. A large part of the increase is due to the growth of Special Purpose Acquisition Companies (SPACs), which represented 47% of the total IPO proceeds for the quarter.  In fact, SPAC issuance was higher in Q3 2020, than it was in all of 2019. As we discussed in last month’s commentary, SPACs are created as blank-cheque companies given to management teams, with the sole purpose of acquiring another existing business within the next two years and bringing it public.  We would view the ease with which companies are now raising equity capital as a sign of potential froth in the market and reason to stay balanced in our Panorama Fund approach. It is difficult to tell when the market will develop “deal fatigue” but both debt and equity issuance move in cycles. For now, the cycle is climbing up and the buy-side and retail investment community is wide open for business. 

We look selectively through IPOs for new companies that hit our checklist in terms of long-term growth opportunities, profitability, free-cash flow, leverage, and valuation.  One example of a recent IPO into which my colleague Colin McPherson, CFA, recommend we participate was Dye & Durham, a Toronto-based company that provides critical cloud-based software and technical solutions to a blue-chip clientele that includes law firms, financial institutions, and government organizations. 

The software aggregates public records into an easy-to-use format, allowing its customers to validate and process transactions faster and more accurately.  This provides considerable value for its clients, allowing DND to earn >50% EBITDA margins and deeply embed its product within customers workflows, creating a loyal customer base.  As a result, the company benefits from high customer retention with 109% net revenue retention, high-net promoter scores, and an average customer tenure of 16 years among its top 100 customers. The business is also unique in that the majority of fees incurred by its customers are passed on to end-customers as a flow-through disbursement, which represent only a small fraction of the total invoice price.  In our view, this results in increased pricing power across its product set.  Management is also well aligned with shareholders, with insiders owning over 27% of the float, including CEO Matt Proud, who owns approximately 16% of outstanding shares.  Going forward, we believe that analysts will continue to show an upward bias to their consensus estimates.  Since its IPO in July, the company has already completed a $50 million acquisition of a UK business and raised capital giving it a net cash position of $168 million.  With net cash and significant free cash flow, we expect the company to continue to execute on its growth strategy both organically and inorganically, by consummating additional acquisitions from its pipeline of over 35 complementary targets.

$DND Price History
Source: Bloomberg
Source: Wealhouse Capital Management
Source: Wealhouse Capital Management

Another company in which we have built a position is Siltronic from Germany. It manufactures silicon wafers that are in-turn used in computers, data-center servers, smartphones, flat panel displays, automotive systems, and robotics. Its many other applications are expanding as the world continues to require advanced technologies and rapidly accelerating digitization on the back of the COVID crisis. As we have said previously, we do believe that there are opportunities to be contrarian in our investment approach, with a portion of our investments a result of the COVID sell-off. Accor, which is headquartered in France, is another thesis we have on the post-COVID world. Accor is one of the largest hotel managers in the world and the largest in Europe. They are responsible for 39 different brands worldwide. Since November has brought the world good news in the form of positive progress on vaccines, I cannot tell you how many people I have heard say they want to travel to Europe on the other side of this crisis. This gives us confidence that in the next 2-3 years we will see hotels recover.

When we started buying Accor, it was trading over 50% below its all-time high despite the fact that it has not had to issue equity like many of its competitors. However, we think many investors overlooked a very important asset they own on their balance sheet, which is an equity stake in the Huazhu Group listed in Hong Kong. They partnered with this Chinese hotel operator in the last decade and respectively took equity stakes in each other’s businesses. Fortunately for Accor, Chinese travel trends have returned almost completely to pre-COVID levels, and they have a 3.3% equity stake in this company that is China’s second largest hotel operator. The future desire of Chinese residents to travel the world is reason enough to buy Accor. They have over €3 billion of cash on their balance sheet and marketable securities to get them to the other side of the COVID crisis.

It is difficult to predict how much money is still willing and able to buy debt and equity deals. But as you can see in the below chart, a lot of money flowed into money market funds after the crisis started earlier this year. A former mentor once told me: “the most money will go to wrong place at the wrong time.” In retrospect, putting money into money market funds in the spring was a case to his point. It is especially the wrong place to be according to this quote from Tiff Macklem, the head of Canada’s Central bank: “We have lowered our policy interest rate—the target for the overnight interest rate—to 0.25 percent, which we judge to be its effective lower bound. And we have used exceptional forward guidance to indicate that we expect it will remain there for an extended period. Specifically, we have committed to keeping our policy interest rate at its effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved. In our current outlook, this takes us into 2023.

CUMULATIVE FUND FLOWS ACROSS ASSETS
Source: Datastream, Haver Analytics, Goldman Sachs Global Investment Research

The illustration at the top of these comments was negative in that it showed the rising COVID-19 cases in the U.S. Hopefully, social distancing measures will slow the spread and we hope the vaccine production and delivery will go as smoothly as possible for the world – especially for countries like Canada that do not have domestic production capabilities. I firmly believe that what drives stocks is earnings and free-cash flow. So, let me leave you with three charts that show a dramatic change in earnings expectations since the depth of the crisis. The good news is that earnings look set to rebound in 2021, though we are mindful that earnings expectations may oscillate in the coming weeks and quarters. We fully anticipate hearing the words “double-recession” mentioned more and more as winter progresses. However, we believe that the big move in earnings is up from the lows of the second quarter of 2020. As a result, we expect to see many companies reinstate dividends that they previously cut. Businesses that went into cash preservation mode and stopped their growth plans through organic hiring, or growth capital expenditures and acquisition strategies, will begin to redeploy. This should help the world rebound economically in 2021 and 2022.

EARNINGS SENTIMENT
Source: Datastream, I/B/E/S, Goldman Sachs Global Investment Research
2020 CONSENSUS EARNINGS EXPECTATIONS OVER THE PAST 12 MONTHS
Source: Datastream, I/B/E/S, Goldman Sachs Global Investment Research
GLOBAL EARNINGS TO RISE 34% IN 2021
Source: Datastream, I/B/E/S, Goldman Sachs Global Investment Research
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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