Speaker 1 (00:02):
Hello, and welcome to actively speaking. I'm your host. Steve Bleiberg join us each episode as we discuss current issues concerning capital markets and portfolio management, from the perspective of an active manager.
Speaker 2 (00:15):
Welcome back everybody. To another episode of actively speaking. You know, we talk about this podcast as being about the issues regarding capital markets. From the perspective of an active manager in the last 18 months, have been a very interesting time for active managers. And I think for people who don't do this themselves, you know, who are not portfolio managers themselves, they often wonder what goes through the minds of a portfolio manager during a time. Like COVID where things, some, something very unexpected comes on and markets are sort of thrown into turmoil. And how does a portfolio manager reacts? We thought this would be a really good kind of case study at this point, 18 months into this pandemic to talk to one of our portfolio managers about what's gone on in the portfolio and how he has approached the task of managing through this pandemic or for the last 18 months. So I am joined today by David CNO, who is the lead portfolio manager on Epix quality capital reinvestment strategies, um, on which I am actually a co portfolio manager. So a welcome David,
Speaker 3 (01:17):
Happy to be here.
Speaker 2 (01:19):
So, uh, let's, let's cast our minds back 18 months ago, March of 2020. And you know, this news comes along and breaks over the course of a few weeks. I remember, you know, traveling and early, late January, early February of last year and know being very aware I was in Europe and being very aware of people wearing masks in the airports and so forth at that time, but it hadn't really hit the U S in full force yet. And suddenly it did. And to everybody, you know, mid March, we all suddenly started working from home and it was gonna be two weeks to slow the spread. You know, that was the thinking at the time. So try to put yourself back in what you were thinking at that time and give us a sense of how did you react to this and people, I think often feel again, who aren't used to doing this on a day to day basis, that, you know, you just, oh, you react dramatically. You make all sorts of buy and sell decisions cause you know, what's going to happen. But of course that's not really the way it is. So tell us, you know, what it was like in March of 2020 for you. Sure.
Speaker 3 (02:18):
Thanks Steve. So as you know, Steve, and for the benefit of our listeners, our strategy invest in companies that have a sustainable long-term competitive advantage, which gives them sustainably high returns on capital. Those principles are timeless through market cycles, through bull markets, through bear markets. We're still looking at the same types of companies. And if we do our jobs and judge correctly, that these modes are durable, whatever happened in the market won't necessarily cause us to react. And I'm glad you use that word because that is something that we don't do. So looking back to March, 2020, when the pandemic first hit, I think it was the worst month for benchmark returns that I can remember. I, the benchmark MSEI index was down 12 or 13% just for the month. And it felt a lot like September of 2008, when the world seemed to be imploding, AIG Lehman, brothers Fannie, and Freddie Merrill Lynch, et cetera.
Speaker 3 (03:15):
So in the case of our strategy, we did not trade all that much. We asked ourselves a simple question. That is how much does the pandemic structurally change the industries and the competitive advantages? We think we've identified through our fundamental research process and the answer far more often than not was nothing has changed. And I don't say that lightly because the world has certainly changed in many ways as a result of the pandemic, but the competitive advantages, the physical assets, the moats around companies, businesses were not breached by and large by the pandemic. In fact, in many cases, the companies that we own, that, that those competitive advantages were surfaced and they were emphasized and intensified through the course of the pandemic. So with some exceptions and travel related sectors, we concluded that for the intermediate future, at least for example, business travel, wouldn't come back to prior levels. Anytime soon, consumer travel less of an impact, but certain hospitality sectors would have been the wrong decision just to do something because the world is in a flux. That's not how we run the strategy.
Speaker 2 (04:22):
Yeah, that was a good point. See, I'm reminded of a couple of things from my own experience, you know, 30 years ago, back in 1991, I think it was, this was after the fall of the Soviet union and Farsi Yeltsin was I believe for the president of Russia. And there was an attempt by a bunch of, uh, you know, sort of the line communists old guard to take over again. And there was that famous picture of Yeltsin standing on the tank and red square. I'm pretty sure that was the summer of 91. And, you know, I think markets reacted quite negatively when that happens. There was a sort of a merged downward at six or 7%, I believe in a very short space of time. And I remember thinking at the time, you know, wait a minute at the time, the company now known, for example, as an alt-right, I think is still known as Philip Morris back then, I just remember thinking explicitly about them because, you know, they also owned at that time, uh, you know, Miller beer and cigarettes.
Speaker 2 (05:10):
And I was just thinking, how is this going to affect the amount of Marlboro cigarettes and beer that they're selling? It's probably not going to have much impact, why should markets just people marching down or in reaction to this. And I think that's always, I've found helpful to keep that kind of thing in mind that people often do think that these sorts of things, should they just sort of panic, which is understandable because there's a lot of uncertainty that there's always uncertainty in markets. That's a point I always like to make. There's never a certainty, but at times the level of uncertainty ramps up and people sometimes just want to get out of risky assets. But, you know, if you kind of think about it and say, well, how is this really going to affect the, like you say, the competitive advantages that some of the businesses in the Capri portfolios, it's probably not the other point you make about, you know, the pressure to do something.
Speaker 2 (05:55):
I remember also in the 1990s, I was managing Japanese equities and used to go to Japan once or twice a year, just on research trips. And I always felt when you came back, there was sort of an unspoken pressure to do something well, you were just there. So naturally you should be doing something either raising or lowering the portfolios, weight in Japan. This was part of a broader non us portfolio. And one of the points that you've made to me offline on before this conversation was, you know, doing nothing is still an active decision, you know, just because something has happened doesn't mean you have to react that choosing to not react is in fact an active decision. And so it sounds like, you know, in most cases, what we did in this portfolio was an active decision of choosing not to change the portfolio.
Speaker 3 (06:37):
That's a fair statement and it's not to discount what happened in the market. And as I think back, I was not standing on a tank. I was sitting in my basement at a table with a deck chair. It's fair to say that the future free cash flows of the business become more uncertain because we certainly haven't had anything like this happen in our lifetimes. So the level of uncertainty went up when the level of uncertainty goes up, the equity risk premium should go up and stock prices should go down. That's a short term reaction anyway, but I found that some of the worst decisions that you make for emotional ones in the market. And again, in hindsight, I think we chose the correct course.
Speaker 2 (07:13):
Yeah. That's another good point about, about hindsight. I mean, I, as I mentioned earlier, people, I think from the outside, looking in to a portfolio management, uh, underestimate that level of uncertainty about the future we know now, and there is this hindsight bias. Okay. So 18 months later we've seen how things played out, but you know, putting yourself back in the shoes of February, March, April 20, 20, people really had no clue that it was going to turn out this particular way. This was obviously one of the options of how it could turn out, but there were many options of how this could turn out and things that are always obvious in hindsight and people think they should have been obvious in anticipate you should have been able to anticipate this, that it was that obvious, but it's almost never the case that it was in fact obvious in advance. It's always obvious after the fact. So you say that by and large, we did not do much, but that there were some names that you mentioned some traveling. So what names did we buy or sell, uh, in reaction to the early months of the pandemic?
Speaker 3 (08:08):
Sure. So, so the pair I'd like to mention to you are both airlines. So one is Southwest. One is Alaska. We decided to hold on to our Southwest and even as a physician. Well, the flip side of that, we sold our Alaska air position and contrasting the two boats, very similar in terms of the level of returns on capital. They generate returns on capital is a very important metric for us. And it was also ingrained in management compensation. Policy managers were rewarded for earning adequate or very good, I should say more than adequate returns on capital. Now I mentioned the distinction before between business travel and consumer travel and what have you. So if you're thinking about the reason why we entered our position in Southwest or the strategy, the company had a very consistently a high level of return on over time, return on capital is a very important metric for us and our strategy and how are they able to do that?
Speaker 3 (09:01):
Their footprint is fairly unique. Their network Australia needs in that they largely fly out of their second tier airport in a given market. So for example, Houston, they fly out of hobby. They don't fly out of Bush in Chicago up until recently and not get into that. They flew out of midway, not O'Hare. So a very difficult to replicate network that was underserved by the large network carriers. And they were able to create a very profitable niche serving these markets, largely consumer markets, largely leisure markets at a very low cost. So you aren't going to get a luxury at first-class experience on Southwest. You were going to get a very good value for your money. Alaska had a similar model in terms of return on capital, very high returns on capital for an airline, which is a very capital intensive business. They have a hub in Seattle, which they dominate on at moat has eroded a little bit over time, but they are still fairly dominant out of that hub.
Speaker 3 (09:56):
And their footprint was really along the west coast of the United States based out of Seattle in 2016, I want to say they or thereabouts. They acquired another airline Virgin America, which gave them additional exposure to California. They could serve that tech business traveler who's flying between Seattle and San Francisco, a higher end clientele. They got access to a very attractive credit card program, which is a good source of profit for airlines. So Alaska had a different model than Southwest, but nevertheless, it was unique. So the pandemic comes along and again, we asked ourselves what's changed permanently or at least for the foreseeable future. And our view was that Alaska given its reliance on business travel and the future growth of the airline was reliant on growing the franchise between Northern California and Seattle. We thought that that had been impaired in part by the pandemic.
Speaker 3 (10:52):
And we could not foresee a scenario where they would earn an adequate return on capital, which we require for a strategy. Now you look at Southwest, both sold off all the airline stocks and travel-related stocks sold off quite a bit. They all required government aid and government guarantees and so forth. But Southwest went into the pandemic with no debt on its balance sheet. It had plain leases, which is debt, but no traditional balance sheet debt. Whereas Alaska still had some leverage from the transaction that I mentioned. Southwest used the pandemic to reinvest in its business opportunistically, but use planes at a discount price. It bought slots at O'Hare for example, which did not have access to previously. So we held onto our Southwest. We sold our Alaska and it ties back to what I said initially in that we tried to judge what has changed permanently and what has changed temporarily. And as we fast forward, 18 months, we're seeing the consumer travel return more rapidly than business travel. Steve, you and I have been on a number of WebEx and zoom calls, perhaps that takes the place of traditional business travel going forward. We'll see. Uh, but it really is a judgment and that if the analyst judgment, the portfolio managers judgment, and we judge at least in this instance with these three lines, that for the one, nothing had changed for the other, something had changed and that influenced our decision making.
Speaker 2 (12:09):
So now let's move forward a bit in times, that was sort of the thought process we were going through spring of 2020. Now we go through the summer into the fall. Again, we start to get indications that, you know, we might get vaccines pretty soon then. And in fact, you know, the announcement of the successful tests started coming in second week of November from Pfizer, and then during the, and we began to hear during the fall, people began to discuss this notion of a quote reopening trade. And, you know, it strikes, it struck me as a little odd in the sense that it people, it gives the impression that there's kind of a binary on-off switch here. You know, Scott well is either, either your position for the continued pandemic or your position for complete reopening. And there's no in-between, but you know, reality is not binary like that. And the reality was much more fluid. So tell us, you know, what was the thought process during the fall when people were talking about quote reopening?
Speaker 3 (13:03):
Sure. So in our case, we never closed, I think a stock like a booking.com, the preeminent travel website, a name like Amadeus, which is the dominant it provider for airlines and hotels globally. We love those businesses. We still love them because of their unique attributes, that level of return they can earn on their capital relative to their cost of capital and very wide moats around their business. So in the, in the case of booking an Amadeus, we never exited those names. I think in the case of Amadeus, we added to the position that in spite of the stock being down, I think 60 to 70%, both of these companies were not profitable. But looking through the other side, we can see that when travel did return, their positions in their respective marketplaces had not been eroded. So we held on and we added selectively and there was never a reopening trade for us.
Speaker 3 (13:54):
We did the same things we always did. It's fair to say that some of the sectors that perhaps were, were underweight in such as financials and maybe energy and, and some other sectors that are these traditional value quote-unquote sectors. We are underweight those. And that certainly did not help our performance over that period of time. But because we had not reacted because we held on to the two names, I mentioned to our restaurant names like yum and yum China. I think we were able to capture a piece of that quote, unquote, reopening trade, having not done anything prior to that, to prepare for such an event, which was largely transitory. I think growth has come back and is now outperforming value year to date our strategy skews toward the growth side. So I probably sound like a broken record here, but we stuck to our guns. We held firm. So there was never a big bang moment where, oh, well, we've got to prepare for this reopening trade. We were already there by tomorrow.
Speaker 2 (14:46):
Right. And of course the reopening has proven to be very messy, you know, it's, as I say, it was not binary. It's not like, oh, okay. Pandemics just went away. You know, we thought we were out of the woods and then the cases started going back up again, even with the vaccine. So it's never clear cut. And so, yeah, that's just a good example of the kind of uncertainty that portfolio managers always have to deal with. That here's a case where people thought it was going to be clear, cut me if they fought, read him this quote reopening. And in fact, it's been a very messy reopening because a lot of activity is come back, but not necessarily to pre pandemic levels. And so it's messy. Okay. You talked about the fact that you had to think about what changes were temporary and which changes were permanent in terms of what we already armed.
Speaker 2 (15:31):
And there's kind of a flip side to that, which is, you know, we've seen changes in what's passing, but we started in the Capri strategy. We start with a, the first step that is a screen, which is based on ROYC and margins, and a few other things we've seen, uh, a number of names start passing the screen that obviously names we don't currently own because they hadn't been passing our screen for a long time. But we've seen because of the pandemic and the effects of the pandemic. We have seen some names start to pass the screen, but in most cases we've rejected them because of this issue of believing that it's temporary and not permanent said. And most, a lot of this has been in commodity related things. So talk about maybe some examples that we've seen. There are things that suddenly we're good on our metrics, but that we chose to avoid. Anyway.
Speaker 3 (16:16):
Sure. You mentioned my minors. I'd mentioned shipping container manufacturers, the shipping companies, themselves, all of these companies, whether it's Rio Tinto or neuros nickel or mirror score, or any of the companies that are involved in these types of industries. I like to say that they migrate through our screen once a decade. Uh, inevitably you get a burst of inflation in commodity prices, whether it's iron or Cola or something of that sort, or you might get a spike in shipping rates because of a temporary imbalance in shipping supply and demand. This is not what we're trying to capture with these strategies. Now there is a trade to be made there. If you had correctly predicted that those would have been spectacular trades for you. And I we've had some shipping companies pass through our screen that are up eight or nine X since the beginning of the pandemic, because a lot of shipping capacity was temporarily taken offline because crews got sick and companies were closing borders and consumers demand came back more rapidly, then did shipping capacity.
Speaker 3 (17:12):
So shipping rates went through the roof and these companies that are in spectacular returns on capital, we don't think this is a permanent situation, at least well, for the, for the good of all of us, we hope it's not permanent. Simply paying a lot more for anything that was by, you know, it would have been great to own a container ship during that time. But your ship is probably no different than the next guy ship. And you don't really have any sustainable long-term competitive advantage other than maybe size, you can weather storms on the punch better than the other shipping companies. In the case of minors, you have seen some bikes and some of the metals as China has increased their demand and had outstripped capacity for a period of time. But really these are not lead to sustainably high returns on capital, which is what we're trying to find in our strategy. These are just sort of temporary changes, which are not likely to persist.
Speaker 2 (17:58):
So let's, let's move ahead again in time now. And as we go into 2021, and so the spring and summer of 2021, we, you alluded to, we did see some periods, particularly right after the announcements of the vaccines. And then again, things around February of this year, there were periods where, you know, quote value stocks. And it was really just because it was financials and energy doing well. That's what was driving the out-performance of value versus growth during that period. And people did begin to question the valuation on some of the growthier names, particularly in tech healthcare, consumer discretionary. And at the same time, we began to see in the spring of this year, a pickup because of the pandemic and that supply chain disruptions, et cetera, we began to see a pickup in inflation, and that has an impact on valuation because the impact it has on discount rates, interest rates, and hence discount rates that people apply to future cash flows. So how have you thought about that in recent months?
Speaker 3 (18:55):
Yeah. So this may sound a little bit old fashioned, but it's all about the discount rate and the cost of capital know immediately after the pandemic kit. I think that the 10 year rate in the U S which is a proxy for the risk-free rate in our classic models, got down to 50 bets. It started to creep up through the rest of the year, but it really started to take off. Once the Pfizer data came out on November 6th of last year, the discount rate went up, I think at the end of the year, close to 1%, it got as high as 1 75 earlier this year. Um, fears of inflation and thought that, well, we're going to have a spectacular period of growth that both of those things are still likely to happen. And that we've had sort of a super, uh, uh, above trend growth in the U S or certainly not a five or 6% growth economy, but we've had months and quarters where we've seen that post pandemic inflation is depending on how you measure it's up to four or 5%.
Speaker 3 (19:45):
The risk-free rate has come down from the peak of 1 75 to now, as we sit here around one 30. So when we think about valuations, it really is what level of free cash flow does a company generate? How much can it reinvest and what can it earn on the capital that could reinvest? Because that ultimately influences the growth, the growth in cash flows and the long-term valuation of the company using the data we have today. So when that risk-free rate did start to go up, the equity risk premium went up. A lot of these higher, some of which we own were hit, that their evaluations came down, but they certainly had a Renaissance as that risk-free rate has come down and people's future impression of where the risk-free rate might go. That's come down. Inflation is still a concern, but that seems to have tapered a little bit, pardon that word.
Speaker 3 (20:35):
So it really is all about the discount rate. As that discount rate spiked up the longer duration equities or hit the hardest some of which we own. And as the discount rate has come back down, these docs have appreciated accordingly. So that's kind of how we're thinking about valuation and how we think about it going forward. We have to get the free cashflow, right? What we think you can do this year, and maybe next, what we think the company can reinvest, what it can earn on those reinvestments and what that spread is between that return and the company's cost of capital that determines the valuation of the,
Speaker 2 (21:09):
And we do have as well take a look at what's embedded in the price. What are we try to back out? What is the current price telling us about future expectations of growth reinvestment ROYC? And we do use that as a sanity checks.
Speaker 3 (21:24):
Yes, you're right. It's a two part exercise. It's predicting the future and moving out to the future and rewinding and seeing what the implication is in the interim. And that has to make sense. And if we think it makes sense, and we think the company's competitive advantages are durable, then we will invest in the stock. And the flip side of that is also,
Speaker 2 (21:41):
So let's, uh, wrap up with one last question lessons learned. So it's been 18 months, you know, by and large, you would conclude that not overreacting, emotionally was, was a good thing. It's all about, you know, deciding what, as you've said, a couple of times here, what's what has changed temporarily and what has changed permanently, if anything. So what lessons do you think we can take away from this experience of the last 18 months?
Speaker 3 (22:05):
So hopefully I never want to be able to use this, these lessons I've learned in this particular situation again, in my lifetime. So hopefully that this is a one and done as far as academics go. But I think the lesson to be learned here is that while we might not have a pandemic, we will have bear markets. We will have sharp drawdowns. And the quality franchises are the ones that will persevere because of their competitive advantages because of their balance sheet, because of their managers skill and allocating capital. Those companies will win. Those companies will outperform long-term over time. And in spite of short-term noise and short-term trading opportunities, we believe those principles will prevail. And that's the basis for our strategy?
Speaker 2 (22:44):
Well, my guest today has been David [inaudible]. Who's the lead portfolio manager on ethics, quality capital reinvestment strategies. David, thank you for joining me,
Speaker 3 (22:52):
Great to be here
Speaker 2 (22:54):
And to our listeners. If you wouldn't mind doing is favorite, please leave us a good rating or a review or comments on whatever platform you're getting this podcast from. And we will be back for another episode shortly. Thanks.
Speaker 1 (23:07):
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Speaker 4 (23:22):
The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment product information contained here in has been obtained from sources believed to be reliable, but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but as subject to change any performance information referenced in this podcast represents past performance and is not indicative of future returns. Any projections, targets or estimates in this podcast are forward looking statements and are based on epics research analysis and assumptions made by epic. There can be no assurances that such projections targets, our estimates will occur. And the actual results may materially be different other events which were not taken into account in formulating such projections targets or estimates may occur and may significantly affect the return or performance of any accounts and or funds managed by epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not. They are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of security selected for clients and not all security selected for clients in the past year. We're profitable.
Speaker 5 (24:45):
[inaudible].
