Shaker's Fundamental Growth Weathers the Storm, Prepares for Uncertainty
The first quarter of 2020 was one of the most difficult investment quarters in the last 100 years of the US stock market. This was due not only to the magnitude and speed of the decline in the market, but also to the rapid change in the US economy. It went from an economic expansion with very low unemployment, to the likelihood of a very deep recession and the most rapid jump in unemployment that the US has ever seen.
In addition, recent stylistic trends among stocks accelerated as large caps outperformed small caps and growth outperformed value. In the first quarter, large-cap stocks (S&P 500) were down 19.6% and small-cap stocks (S&P 600) were down 32.6%. As you know, although we hold a mix of large and small companies, it is more heavily weighted in smaller companies than the overall market. Over a long-term investment horizon we believe this helps us to achieve better performance because we can identify under-followed and undervalued, high-growth businesses through our intensive fundamental research into the prospects of individual companies. Unfortunately, that long-term approach can at times go through painful periods, such as during the first quarter, when there is a wide performance disparity between large- and small-cap companies.
Nearly every stock in the market was lower in the first quarter as the market suffered an unprecedented wave of selling from mid-February through mid-March as investors processed the implications of COVID-19 and the associated sharp economic downturn. The S&P 500 declined nearly 34% from February 19th through March 23rd, which marked the fastest 30%+ decline from an all-time high in market history. We reduced our exposure during the decline by reducing or eliminating positions. With these changes we were able to slightly outperform the Dow Jones US Total Stock Market Index for the quarter while marginally underperforming the S&P 500.
While all segments of the market suffered losses, there was relative differentiation among sectors. Traditionally defensive sectors were relative outperformers, while more cyclical areas underperformed. In the S&P 500, Information Technology, Health Care, Consumer Staples, and Utilities declined less than 15%, while Energy, Financials, Industrials, and Materials declined greater than 25%. In your account, we benefited from very limited Energy exposure, but this was offset by an underweight in Consumer Staples. We were also hurt in the Information Technology due to our heavier weighting of smaller capitalization stocks in that sector, while the stocks that outperformed tended to be large-caps and mega-caps.
In terms of contributions from individual positions, given the widespread nature of the selling in the first quarter, our largest detractors from a dollar perspective tended to be our heavier weighted positions. The largest detractors were Axos Financial (AX), Citizens Financial Group (CFG), SYNNEX Corp. (SNX), Paylocity Holding Corp (PCTY), and The Trade Desk (TTD). All except Citizens had been big winners in prior periods.
While we noted that nearly all stocks were down in the market, there were some that gained in the quarter and we had several holdings that were positive contributors to the portfolio. The biggest gainers in the portfolio were Dexcom (DXCM), Livongo Health (LVGO), and Tandem (TNDM) in the diabetes treatment space; and Amazon.com (AMZN) in consumer discretionary. For individual positions during the first quarter, our contributors and detractors generally reflected overall market trends in terms of breadth of the decline, small-caps down more than large-caps, and sector relative performance.
The following is a summary of returns for the S&P 500 index and the Dow Jones US Total Market index for the first quarter and a full economic cycle (i.e. inclusive of the last great recession):
| 3 Months Ending 03/31/20 | Annualized Returns Since 01/01/2007 | |
|---|---|---|
| S&P 500 Index | -19.60% | 6.86% |
| Dow Jones US Total Market Index | -20.96% | 6.74% |
Investment Outlook
Currently, the investment outlook is uncertain. Market history of recessions indicates that the stock market will bottom before the economy, but it is not entirely apparent as to whether that already occurred on March 23rd or if equities will make new lows later this year as the economic data deteriorates due to the nationwide shutdown.
The Federal Reserve has acted aggressively to provide plenty of liquidity to the financial markets. Their response has been much greater and more rapid than in 2008 and so far seems to have effectively prevented the health crisis from becoming a credit crisis. The result has been a banking system that is flush with cash, as evidenced by the rapid narrowing of credit spreads from peaks a few weeks ago. In addition, the Federal Government has quickly passed legislation to provide over $2 trillion to offset some of the damage caused by the rapid reversal of the US economy. This is all positive and has helped to quickly stabilize the stock market to produce the rebound seen since March 23rd.
Still, much of the economy remains closed. Unemployment is increasing at a rate never seen before, and is at levels comparable only to the Great Depression of the 1930s. There are many difficult questions that have yet to be answered, including:
When will we be able to begin to “re-open” and return to normal?
How long will it take?
What will the “new normal” look like?
The answers to these and other questions, and how these will impact individual companies and industries, remain to be seen. The monetary and fiscal response has been winning in the last three weeks according to the financial markets, but that sentiment is likely not shared by many Americans facing personal health and financial crises.
The uncertainties affecting companies and industries will become more apparent in the coming weeks as companies report first quarter results and discuss their outlook for the future. We will get more information on the “new normal” as we approach May and June, when “stay-at-home” orders are expected to gradually be lifted and certain parts of the economy can re-open. These additional data points will help to inform our investment outlook and decision making process. Thus, we have been taking a cautious approach to putting investment assets to work in equities, especially in those companies for which it is not yet clear as to whether the company will be a relative winner, loser, or something in between.
We have been focused on the outlook for individual companies both from a short-term and a long-term standpoint. The economic downturn is broad based, but it is having different impacts on different industries and individual companies. Hardest hit areas include the travel industry, movie theaters, professional sports, concerts, and full-service restaurants. It is not clear when people will resume these activities. At some point, people will travel again and the industry will grow, but the timing and the longer term changes that may take place are uncertain. The industry has high fixed costs and very little revenue in the short-term. Further into the future, the way in which we travel and how companies approach operations and capital allocation may fundamentally reduce long-term profitability. At this time, it is probably prudent to be patient with investments in these areas.
For some companies this downturn will have relatively minor negative impacts on their operations and long-term outlook. Some, including grocery chains and producers of consumer staples, may even be positively impacted in the near term. Secular trends that have been in place for years are likely to accelerate, such as the shift in consumer spending from brick-and-mortar retailers to e-commerce businesses like Amazon.com (AMZN). Diabetic device companies are growing rapidly with recurring revenues, and COVID-19 does not change the need for such potentially life-saving treatments. Thus far, we have maintained our investments in companies that we believe will see little or no negative impact, or that we view as long-term winners despite some impact by this pandemic downturn.
The bulk of companies are in the middle category where the uncertainties are the greatest. Most retailers are in this category – temporarily closed to support social distancing but more likely to recover faster than areas such as travel. There are also many industries that are less directly impacted by the epidemic, but are more sharply impacted by the economic downturn. These include banks, advertising, oil & gas companies, and many manufacturers. The economic downturn is affecting almost every industry.
We are stock pickers and not traders. We try to stick to what we do best, and over the coming weeks and months will continue to work to determine the winners and losers to take advantage of investment opportunities that present themselves. We generated significant positive returns after the great recession of 2007 – 2009 as we identified numerous high-growth businesses selling at attractive valuations, and we believe that we will be able to do the same this time.
We look forward to updating you as the year progresses. As always, but especially in this time of stress, please call us anytime to discuss the status of your account or the market outlook in general. We are all working (remotely and practicing appropriate social distancing) and are here to serve you.
Sincerely,
The Shaker Investment Management Team
General Disclosures:
The information contained in these materials is as of 03/31/2020. This document is confidential and for the sole use of the intended original recipient. It is not intended as investment advice or recommendation, nor is it an offer to sell or a solicitation of an offer to buy any interest in any fund or product.
Risk:
An investment in any of our strategies is speculative and involves a high degree of risk, including potential loss of principal. There is no guarantee that the investment objective will be achieved, or that the investment strategies will be profitable. Investments in smaller companies may be riskier, less liquid, more volatile and more vulnerable to economic, market and industry changes than investments in larger, more established companies.
Performance:
Past performance is not indicative of future results. Returns in the current year are preliminary. The strategy’s overall return is a composite of clients’ separately managed account returns. Some clients’ investment returns were more or less than the overall strategy return. Not all our client’s returns surpassed the benchmark. The index return information herein has been obtained from public sources and we do not guarantee its accuracy. The following disclosures applies to information mentioned in this document:
1. Gross returns are net of expenses.
2. Net returns are net of expenses and a 0.25% quarterly (1% annual) management fee for the corresponding period.
3. Inception date for the Fundamental Growth Strategy is 10/01/1991.
4. The benchmark for the Fundamental Growth Strategy is the Dow Jones US Total Market Index, a broad All Cap index. However, the strategy is more concentrated and contains a higher percentage of growth stocks than the benchmark.
5. Risk metrics are estimated using monthly returns net of fees for the last 3 years, unless otherwise noted.
6. Sector allocations may not add up to 100% because of rounding.
Recommendations:
The specific securities identified and described in this report do not represent all of the securities purchased, sold or recommended for clients. It should not be assumed that investments in the securities identified and discussed will be profitable in the future. Holdings and sector weightings in any strategy are subject to change and should not be considered investment advice or a recommendation to buy or sell a particular security. Actual holdings may vary by client. A list of the stocks selected for any of our strategies during the trailing twelve months is available upon request.