Strong Quarter to End a Historic Year
Stocks and other risk assets experienced strong returns during the fourth quarter of 2020 as a relatively benign US presidential election outcome coupled with multiple COVID vaccine announcements encouraged investors to look towards better times ahead and in particular, a continued economic rebound in 2021.
The quarter saw a continuation of a trend that started mid-year. Stocks that benefit from an eventual economic recovery have been outperforming since June while stocks that benefited from the COVID “work from home” theme have started to meaningfully lag.
During the fourth quarter, Focus equity and credit strategies significantly outperformed their respective benchmarks. We will expand on the various strategies later in the letter.
2020 – a Brief Recap
2020 almost defies description, and we suspect that it will take years to fully grasp what occurred during the 12-month period. From an investment perspective, it was a year like no other. However, if we had to distill the year down, we would say 2020 was a story of two distinct investment phases.
Phase I – Panic and “WFH”
The beginning of the first phase was characterized by market panic, uncertainty and indiscriminate selling. Yet after a historically quick and violent decline in March, markets recovered, largely as a result of the extraordinary support from governments and central banks. To the consternation of most value-conscious investors, the stock market recovery was not very broad. It was dominated by a group of companies that were well-positioned for a pandemic. The technology sector in particular, which allowed people to “work from home” and keep much of the economy functioning during the initial lockdown, was rewarded by investors. In our Quarterly Focus for the second quarter, we presented the chart below on the left (see Figure 1) to illustrate the massive divergence in returns between the technology sector and the traditional economy (using Microsoft and JP Morgan as examples).
Phase II – The Recovery
Interestingly, the publication of this chart coincided with the end of the first investment phase of 2020 and the start of the second – the recovery. Although broad market indexes such as the S&P500 and S&P/TSX seem to have continued their upward march almost uninterrupted, since late June the leadership under the surface of the market has shifted away from the “COVID winners” and towards stocks that stand to benefit from an eventual global recovery. To illustrate this point, we have updated the chart to show the second half of 2020 (see Figure 2). As can be seen, JP Morgan staged a recovery while Microsoft is lagging.
The second half of 2020 has therefore been much better to long-term value-conscious investors than the first half. Yet despite the strong moves in the second half of 2020, many stocks are still trading significantly below their levels of a year ago. This is particularly true for some traditional areas of the market favoured by value investors. These areas include energy, financials and real estate. As such, 2020 was a surprisingly tough year for value-conscious managers, many of which had a reputation for doing well in previous market downturns.
Consider Fairfax Financial, a former holding. Fairfax is led by Prem Watsa, who is often referred to as “Canada’s Warren Buffett”. Fairfax shares were down by 30% last year, a reflection of the difficult environment for many “deep value” investors (see Figure 3).
As we look forward into 2021, we suspect that we will see a continuation of the “Phase 2 – recovery” theme mentioned previously. Many companies that have been affected by COVID are still trading at the low end of their historical valuation range and their businesses will likely start showing improving trends in the coming quarters. We will describe a few portfolio holdings that share these characteristics in the upcoming Core Equity section.
By contrast, many companies that have benefitted from COVID may have “pulled forward” demand for their products, resulting in much more subdued growth figures expected over the next year at a time when their shares are valued near their historical highs. To wit, Microsoft may be an excellent company, but it may not make for a good stock for the foreseeable future.
In hindsight, the stock market moves in the first half of 2020 were largely a reflection of a rush to the safety of a relatively small group of very large stocks that weathered the COVID pandemic well. Since midyear, we have seen a broadening out of market leadership and a material rotation away from “Phase 1 – work from home” and towards “Phase 2 – recovery” stocks. Despite markets being at or near all-time highs, we believe there are plenty of attractive investment opportunities for patient investors who are willing to look beyond the current admittedly-challenging COVID second-wave situation.
As we have recently communicated, the ongoing move in custodians to NBIN allowed us to offer our clients a more customized and tailored asset mix to better meet investment objectives. In 2020 we were busy preparing some new strategies for clients once they move. The following is a brief summary of the positioning of the different strategies during the quarter.
Balanced Strategy (Core Equity + Fixed Income)
The Balanced Fund is positioned in a manner that reflects our current investment stance of “cautious optimism.” The equity allocation (the percentage in stocks) is just over 55% with the remainder in conservative fixed income (bonds). The fund can be viewed as a combination of the following two strategies: Core Equity and Fixed Income. The Balanced Strategy’s gain of over 9% during the quarter was a reflection of the strong performance of the Core Equity component.
Core Equity Strategy
Core Equity had another strong quarter, reflecting a continued rotation towards the economic recovery theme. The strategy gained over 17% during the quarter, significantly outperforming its benchmark. Top contributors during the quarter in order of significance were:
- ATS Automation (+23%)
- Brookfield Asset Management (+16%)
- Element Fleet Management (+19%)
Only two positions declined by more than 10% during the quarter:
- Real Matters (-14%)
- Equinox Gold (-11%)
Real Matters is a software company focused on the US residential real estate sector. As is often the case with a new position, we were buying as the stock sold off.
During the quarter, three of the holdings in Core Equity were the subject of takeover actions, a reflection of the undervalued nature of our holdings:
- Great Canadian Gaming (+57%)
- WR Grace (+31%)
- IHS Markit (+23%)
When compared to the broader market, which we view as fairly expensive, the companies that make up our portfolios have reasonable valuations in addition to their solid fundamentals. And importantly, unlike many of the purported “value stocks” that litter the landscape, these holdings do not require heroic assumptions with respect to higher interest rates or commodity prices in order to realize their investment potential.
In the Company Spotlight section, we have highlighted two examples of interesting investment ideas that give us confidence with respect to future returns in the context of an otherwise expensive stock market.
Fixed Income Strategy
The Fixed Income Fund remains very conservatively positioned as it is the safest part of client portfolios. The fund has a short duration and modest yield for the following reason: Government of Canada 10-year bonds currently yield 0.7%, and should interest rates go back to where they were in January of last year, these bonds would lose approximately 10% of their value. Due to this poor risk/reward situation, we have positioned the fixed income portfolio very conservatively with low interest rate sensitivity. This has two benefits: should interest rates rise, the portfolio will preserve capital. However, it also allows the portfolio to pivot quickly and capture higher rates should they present themselves.
Enhanced Income Strategy
In our last quarterly letter, we were fairly adamant about the attractiveness of dividend stocks despite their lagging performance in 2020. We wrote:
- Valuations for many dividend-paying stocks are as attractive as we have seen in some time.
- The excess income return available on dividend stocks compared to bonds is as high as it has been in over a decade.
- The death of dividend stocks has been greatly exaggerated.
- As a result of the attractiveness of dividend stocks, we increased the equity weighting in the fund.
Element Fleet Management
One of the top positions in Core Equity is Element Fleet, the largest commercial vehicle fleet management company in North America. We like Element’s business model for its significant barriers to entry, high recurring revenue and strong free cash flow generation. Since joining the company two years ago, CEO Jay Forbes, who owns a significant amount of stock, has done an admirable job returning Element to its dominant market position by re-capitalizing the balance sheet, exiting non-core business lines, cutting costs, improving customer satisfaction and overhauling the corporate culture. Rapid growth in “mega-fleets” (e.g. Amazon is a large customer) and continued conversion of self-managed fleets by governments and corporations facing balance sheet pressures support an attractive revenue growth outlook. Margin expansion, higher returns on capital and strong free cash flow will go toward reducing debt, buying back stock and growing the dividend. Element is a high-quality compounder-type company, and we believe this stock could double over the next 3-5 years.
Bausch Health Companies
A more opportunistic investment thesis would be Bausch Health Companies, a medical device and specialty pharma company. Bausch is a diversified mix of high-quality, valuable franchises (Bausch + Lomb eyecare) and other more mature businesses, which combined do not resonate with certain healthcare investors who are looking for “pure-plays”. We have long believed that the sum-of-the-parts valuation was well above the current share price, but this was largely a theoretical exercise until recently when the company announced that it will spin off its eye care business in order to realize shareholder value. Conservative assumptions imply a value 50% above the current share price.
Enhanced Income delivered a stellar fourth quarter, gaining over 12.5% on the back of a 18% increase in the portfolio’s dividend equities. Top contributors for the quarter in order of significance were:
- NFI Group (+39%)
- Intertape Polymer (+62%)
- Bunge Ltd (+32%)
There were no positions that declined by more than 10% during the quarter. The preferred share holdings within Enhanced Income also contributed meaningfully during the quarter.
We highlighted NFI’s positive secular trends last quarter. NFI currently has electric buses in 60% of North American cities and a dominant position in the UK. The company should continue to benefit from the adoption of zero-emission buses. In addition to the company’s 3.7% dividend yield, NFI is positioned to benefit from a return to normal and from long-term secular trends with respect to the electrification of the transportation sector. Holdings such as NFI highlight the advantages of looking for dividend stock ideas beyond the traditional, low-growth and in many cases, expensive, yield sectors such as pipelines, banks and utilities. The Enhanced Income strategy takes a total return approach by emphasizing attractive dividend yields along with long-term stock price appreciation.
Credit Opportunities Strategy
As a reminder, Credit Opportunities seeks to provide a fixed income alternative with an attractive risk-adjusted return objective by investing in various types of corporate credit such as investment grade and high yield bonds, preferred shares and convertible bonds. The strategy seeks to provide steady income generation with better returns than traditional fixed income, coupled with lower volatility and risk than equities. Credit Opportunities also had a good quarter, gaining over 7.5%. Although credit spreads continued to tighten during the quarter (a positive for investment grade and high yield bonds), the strong quarterly performance was driven primarily by positive individual security selection within the preferred share and convertible bond areas. Despite low interest rates and low returns in traditional fixed income, there are still opportunities to generate attractive risk-adjusted returns in other areas such as corporate credit.
Focus Private Investment Strategies
As communicated in a recent video sent to clients, during the quarter Focus successfully launched two new strategies to enable clients to gain access to private markets – i.e. investments that are not “public” and do not trade on a stock or bond market. The private investment world has grown to a point where it now rivals the public markets, and private investments now make up a significant portion of portfolios for institutions such as Canada Pension Plan and high net worth families alike (see Figure 4).
The advantages of private investments to a portfolio include:
- Enhanced returns
- Lower portfolio volatility
- Inflation protection
The Focus Private Debt Fund and the Focus Infrastructure and Real Assets Fund have officially launched and we look forward to speaking with you about their suitability for your portfolio.
2020 was a busy year for Focus. We believe we are coming out of the COVID downturn energized and with positive momentum. We have introduced several new strategies to help clients navigate what may be a tricky investment environment in the future and we are working with clients from a planning perspective to help them realize their wealth management objectives. At the same time, our core investment engine is benefitting from a resurgence in fundamental investing, and we expect that to continue.
Although we are excited about our stock holdings, it is important to point out that we are currently observing a fair amount of frothiness in some areas of asset markets due to speculative behavior. These areas include e-commerce and cloud computing stocks, Bitcoin and anything alternative energy and electric vehicle-related. On that last note, perhaps the single largest example of this phenomenon is Tesla. Although we won’t argue with any fans of the cars themselves, what has occurred to Tesla’s stock will likely be one for the history books. It has recently been added to the S&P500 as the sixth largest company, and the largest stock ever to enter the index. At a total company value of almost $700 billion, Tesla is worth more than the nine largest global auto companies combined, while producing a fraction of the number of cars (less than 1%). How this becomes relevant for investors is that index funds will be buying the stock after it has appreciated eight-fold from its March low and at an extremely high price and extended valuation. Index fund buyers beware.
Although perhaps the most egregious, Tesla is but one example of excess. However, we don’t want to leave the impression that we are overly negative. Speculative stock market episodes have come and gone in the past without derailing the entire market. For example, in the two years following the last major “new economy” bubble of 1999/2000, the NASDAQ index declined by almost 80% while the average stock actually appreciated.
In closing, the most-asked question of 2020 was: “How come markets are doing so well when the economy is doing so poorly?”
This was an understandable question given the strange combination of buoyant stock markets and global unemployment levels not seen since the Great Depression.
In hindsight, for a good part of the year, only certain parts of the market were doing well, which had an outsized effect on the market as a whole. More recently, those areas are now starting to lag while the rest of the market has seen a significant improvement.
As the global economy continues to recover from COVID, 2021 might see the opposite dynamic as 2020. Major stock market averages could tread water even as many undervalued stocks perform quite well. After 2020, anything is possible.