LEVATUS Investments | Punctuated Equilibrium
Seeing and Seizing Opportunity During a Time of Intense Change
Punctuated equilibrium is a theory of biological evolution developed by Steven Jan Gould and Niles Eldridge. The hypothesis is that evolutionary development is marked by isolated periods of rapid change, occurring between fairly long periods of little or no change.
Seeing and Seizing Opportunity During a Time of Intense Change
The past six months have brought a barrage of seismic events - global pandemic, economic shutdown, social unrest, technological leaps, and an inflection point for biomedical research. Time has felt like it is simultaneously standing still and leaping forward, with ‘shelter in place’ locking us in a Ground Hog Day like playback loop, and technological advances catapulting us all forward into the land of Star Trek and The Jetsons.
In moments like this the variable of ‘time’ plays a prominent role. On the investment side, the speed of transition to new ways of doing things has left some companies running out of time, while others have harnessed the moment and accelerated into the future. Over the top fiscal and monetary stimulus has attempted to slow time, giving companies and people a window to recover. Individuals and families feel like they want to make more of their time, priorities gain clarity.
Our clients’ plans and strategy speak to each of these elements. A guiding mission statement that is continuously focused on elevating important priorities and well-being in the here and now, an investment approach that has always been intently focused on quality that gives companies flexibility in moments like this and a strategy that understands the importance of being able to sleep at night. Significant uncertainty remains, but visibility and conditions are improving from where they were only a few months ago.
Sectors, Stocks and Speed
The first quarter of 2020 was the worst quarter for stocks in the past decade. The second quarter of 2020 was the best quarter in over two decade for stocks. While markets remain lower on average for the year, the dispersion of returns is epic. The technology sector is up double digits through June, while the energy sector is down over 30%. Technology companies and companies that leverage technology were doing very well before the pandemic and it is these sectors and companies that are reaccelerating as the economy begins to reopen and recover. We expect this trend to continue. We also expect the pattern of rapid decline in sectors that have been negatively impacted by structural change to continue as well. This will leave significant pockets of risk in the economy.
Our clients’ Growth Portfolios are constructed to capture long term secular growth opportunities. Visibility into long-term growth is one of the criteria every investment in the portfolio must meet. Because we are always focused on growth in absolute terms (not relative) technology and the digital economy represent a very significant part of client portfolios. The acceleration of trends in favor of industries in technology like cloud computing, telecommunication and digital ecommerce have worked to the benefit of our clients. We are asked frequently, ‘How rapidly do you expect things to come back?’. Our view is that the answer to this question will continue to vary greatly by sector and industry and that the themes that have been working will persist.
While at times it certainly does not feel like it, the broad economic backdrop is in a better place than it was a month or two ago. Drivers have been:
• Significant fiscal and monetary support from the government
• Growing desire and understanding of how to get back to business
• Advancements in technology application
• Advancements in health care delivery
• Many different candidates and paths to a COVID vaccine
• Many candidates for COVID therapeutics
• Better understanding of how to take care of people with COVID
This has allowed consumer confidence to rebound and has also helped the United States to move toward an improvement in the labor market. All of this gives the economy time to build up the momentum necessary for a self-sustaining recovery. In our view, the next few months could be more positive than expected, while the medium term could be more difficult than expected. In both cases, we expect speed bumps along the way that will cause the strong companies to become stronger and the weak to become weaker.
Even in the face of negative sentiment, ingenuity has flourished in recent months. The speed of change has been a wind at the back of companies who have thoughtfully and prudently positioned themselves for the future. For these high-quality companies, market evolution that would normally occur over the course of years, has accelerated in months. Witness cashless payment via PayPal, grocery delivery via Amazon, touchless credit cards courtesy of Visa and Crispr Therapeutics’ DNA sequencing to address the pandemic. Microsoft CEO, Satya Nadella, captured the scope of change well when he categorized the environment as the “accelerating digitization of everything”.
We speak frequently with clients about the importance of the ‘quality’ criteria in our approach to constructing growth portfolios. The meaning of quality really comes to life during periods of stress like the pandemic. In normal times quality is a quieter term, with its power largely hidden below the surface. During a crisis quality is, in a nutshell, enough cash flow, business resilience and reserves to make it to the other side. It defines not only the survivors, but the companies with the strength to take market share and accelerate into the future. While this doesn’t mean the share prices of quality companies are immune to market volatility, it does mean that there is long term earnings visibility for companies like this, even when the world feels upside down. Earnings dictate price in the long term.
Cash Flow, Safety and Sleep
Our clients’ ‘Funding’ accounts are constructed to be their cash flow and liquidity reserve, the ‘sleep at night’ money. For the last several years we have deployed those assets very conservatively in a laddered T-bill strategy that nicely met the objective of positive annual results that beat inflation. During the period before the pandemic, corporate debt did not have meaningfully higher yields than T-bills. There was no premium for taking on the additional risk of corporate credit and therefore it was not in client portfolios. This positioning paid off in the first half of the year, as prices on corporate debt fell. As the same time, prices on US Treasury bills rose as market participants sought safety.
“Time has a wonderful way of showing us what really matters.”
Our view is that credit markets (bonds) remain the most important barometer of overall risk in the market. The amount of debt issued by governments to fund the rescue package is higher than during the 2008 financial crisis. Debt issued by corporations now stands at over 75% of GDP. That said, fear in the market has pushed up yields on even the highest quality corporate issuers. In our view, high quality balance sheets and significant cash flow in combination with higher yields now make this part of the market attractive and we have added to client accounts, taking profits in some U.S. Treasury bills to fund the purchase. The massive infusion of liquidity from the U.S. Federal Reserve has mostly been channeled through the bond market, where it has purchased over $1.7 trillion of Treasury bonds alone. Due to these liquidity measures and others, money supply is up 32% in the past several months. This is the biggest increase since World War II. All of this has given markets a window to find their footing in the wake of the economic shutdown and is also a positive for holders of quality bonds.
While the U.S. Federal Reserve has helped to stabilize debt markets, it will not be able to solve the solvency problem for low quality issuers. Companies whose services are no longer in demand because of structural changes to the economy cannot be saved through debt issuance. Stress will become even more acute when general interest rates begin to rise, a red flag that we monitor closely due to the high level of debt in the world. The speed with which a vaccine is developed will have great consequence for human life. It will also strongly influence when the economy can really stand on its own two feet. The number of companies that ultimately go bankrupt will directly correlate to this. Already the expectation is that default rates within the high-yield bond market will reach 10% by this fall. That is high by historic standards. If history is our guide, high-yield (‘junk’) bonds have significant downside risk from where they are today. In other words, in this part of the market yields do not compensate for the risks.
Punctuated equilibrium is a theory of biological evolution developed by Steven Jan Gould and Niles Eldridge. The hypothesis is that evolutionary development is marked by isolated periods of rapid change, occurring between fairly long periods of little or no change. Evolution, according to this theory, is not a slow linear process. The theory has been adapted for sociology and business as well. In business, periods of dramatic discontinuous change in an environment brings about great opportunities for gain or potential loss. We believe that COVID 19 was the catalyst that set off a period of punctuated equilibrium, moving us toward a short burst of fundamental change that will test many of the assumptions that have been held for decades. Humility and thoughtfulness are required in this environment.
Well-being and Winning
Our investment philosophy and approach are designed to take advantage of our clients’ most significant advantage in the marketplace, long term capital. Time can be a powerful ally, as it allows earnings to speak for themselves, outside of market induced volatility. For the six-month period ending June 30th global equity markets were down a bit more than 5%. An investor who missed the best five days during that period ended June down 30%. Taking a long-term view that avoids trying to guess what the market will do in the short term has proven itself to be a superior strategy time and time again. We believe that having a portfolio with earnings potential that allows for long term visibility, even amid a very unclear near-term environment, is critical to having the conviction necessary to stay focused on the things that matter.
Thoughts on the Future
We all know that time is valuable. While there are books and podcasts and courses that extol the power of getting control over our time, they are basically telling us what we already know. Time is a valuable non-renewable resource. People know this and companies know this as well, especially now. Technological change is now, more than ever, shaping the future. It is leaving behind clear losers and boosting clear winners. Navigating this landscape, these secular headwinds and tailwinds, is and has been core to our strategy for growth assets. While change is happening faster than expected, it is not unexpected.
Thoughtful Investing
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