After spending much of the first quarter preoccupied by worst-case scenarios related to COVID-19, investors switched to a risk-on stance and the major indices erased a majority of the damage done in February and March.
The more assertive tone was fueled in part by aggressive action by the Federal Reserve, which signaled a willingness to prop up equity and fixed income markets. Economic data and earnings reports that were less bad than expected added to the bullish tone.
While the move was welcome relief for battered portfolios, buyers appeared to be motivated by a fear of missing out more so than fundamentals. For example, as shown below, shares of companies with low returns on equity, materially outperformed their higher quality counterparts. Lower quality names often lead in rallies following selloffs, but the magnitude of the bounce back was noteworthy.
A FOMO Rally?
Source: FactSet; FTSE Russell; Jefferies. This chart shows companies held in the Russell 2000 Index. The 2020 bear market is representing data gathered during 1/16/2020 to 3/18/2020. The average bear market data is calculated based on bear markets taking place during 12/31/1985 to 6/18/2020. Bottom was on 3/18/2020. The average 3-month after bear market data is calculated based on 3 months following each bear market taking place during 12/31/1985 to 6/18/2020. Return on equity (ROE) measures the net income after taxes a firm is able to earn as a percentage of shareholders’ equity. A bear market occurs when the price of a group of securities is falling or is expected to fall.
Security selection was strong on an absolute basis, and holdings in Health Care and Consumer Discretionary boosted relative results. Our names in Energy and Materials were up but couldn’t keep pace with those in the Russell 3000® Value Index, and the portfolio lagged its benchmark for the period.
The ABCs of quality. Despite weaker businesses leading the charge for the broader index, our work of adding market leading names during the downturn of the first quarter began to pay off. For example, shares of Alphabet Inc. (GOOGL), the parent company of Google, snapped back after selling off earlier in the year due to fears of a pandemic-driven slump in ad sales revenue.
Wall Street analysts cut their outlook for Alphabet earnings for the next 12 months by roughly 15% during the first quarter, however, shares of the company fell by more than twice that amount during the height of the selloff.
Near-term economic challenges have muddied the picture for predicting digital ad spending, however, we believe that Alphabet is an excellent business that should be able to grow at a rate in excess of GDP growth in the years ahead. Additionally, the company’s balance sheet is a standout among public companies, and management is investing more than $25 billion per year on research and development, which should provide a catalyst for sustained, above-market earnings expansion.
Riding the rails.
As States started to ease stay-at-home restrictions during the quarter, investors showed signs of increasing confidence that the economy would bounce back quickly. The bullish sentiment boosted economically sensitive areas and helped portfolio holdings such as Canadian National Railway Company (CNI), a rail transport company with routes throughout the U.S.
Canadian National is an industry leader featuring a management team with a history of making innovative and forward-looking investments in the business. Under this approach, the company has built a rail network that spans coast to coast and from Canada south to the Gulf of Mexico. The efficiency and capacity gained through its rail network, in our view, provides the company with a competitive advantage it will be able to leverage for the foreseeable future.
When shares of Canadian National sold off late in the first quarter, we were quick to take a position at what we believed was a rare discount for an industry powerhouse. Our decision was rewarded this quarter as shares were up double digits from our purchase price.
Follow the money. Financials posted solid gains for the period with strength coming from a broad range of industries. Our holdings in the space were up soundly led by Raymond James Financial Inc. (RJF), a diversified financial services company offering wealth advisory, asset management, investment banking, and banking services to retail and institutional clients.
Shares of Raymond James began falling in February of this year as the market started pricing in the potential impact of COVID-19 on company profits. Raymond James earns advisory and management fees based upon client asset levels, interest income from lending activity, and banking fees based upon capital markets activity. As equity and credit markets continued to deteriorate and as interest rates fell throughout the first quarter, the stock fell more than 40% from its peak.
Despite the near-term headwinds for the company, we are attracted to Raymond James due to its impressive history of growing market share and the opportunity it has to penetrate new markets outside of its stronghold of the Southeast. The potential for growth coupled with the company’s ability to generate returns on equity that far outpace peers should serve investors well in the years to come. Despite its strong position, shares are trading at just 1.7x tangible book value vs. a long-term median of more than 2x.
The first half of the year has been tumultuous for the markets but has provided opportunities to add market-leading companies at significant discounts to long-term normalized multiples. As equities have recovered, the pool has narrowed, however, our team remains consistent in our approach of seeking financially sound businesses with favorable risk-reward profiles when viewed over a timeframe of 18 to 36 months.