First Quarter 2021 Capital Markets Spotlight - Lessons Learned & Looking to the Future
- 24 mins 43 secs
In this Capital Markets Spotlight Webcast, we talk about lessons learned from the COVID-19 pandemic and how that will shape our view of future investments.Channel: MFS Investment Management
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First Quarter 2021 Capital Markets Spotlight - Lessons Learned & Looking to the Future
Jon Hubbard: Hello, and welcome to the MFS Capital Market Spotlight. I'm Jon Hubbard from the Investment Solutions Group here at MFS. I'm really excited to be joined by Alison O'Neill and Kevin Schmitz. Alison is an equity co-CIO for the Americas as well as an equity portfolio manager with us. Kevin's also an equity portfolio manager and focuses most of his time on small- to mid-cap equities.
Now in our discussion today, Alison and Kevin, they're going to share some of their observations and lessons learned over the past year on what's been an absolute wild ride in equity markets, from the massive drawdown in risk assets from the February to March time period in 2020, followed by what's been a really impressive March, to new highs in equity prices.
They'll also be sharing some common themes that we're seeing today across sectors and across industries. And I want to get right into it because I know that Alison and Kevin, they've got a ton of great insight to share. So, Alison, maybe we can start with you and take a little bit of a look back. Just about a year ago, when the crisis first hit, take us through how you saw equity markets unfold from the seat of a CIO.
Alison O'Neill: Sure. Thanks, Jon. So when the crisis first hit and the volatility was extreme, and everybody was also thinking on a personal level, thinking about the safety of their family and their own health, there was a lot going on. We tried to make sure the teams were focused on the long term, separating the noise from the facts and working together collaboratively with our fixed income teams on liquidity, on cash needs, on what different businesses were doing to navigate the tricky environment and really making sure that we all stayed communicating.
There were a lot of really experienced investors who had been through downturns before, like Kevin, who were very vocal to step up to give advice to some of the newer investors. We really came together as the team to try to keep focused on that long term and focused on the best investments to make through that period of time, viewing it more as an opportunity rather than an insurmountable challenge.
Jon Hubbard: Yeah. There were some massive dislocations, but, Kevin, I know that you were on the financial services team, as were you, Alison, back when the global financial crisis hit. So tell me a little bit, Kevin, if you could, about what that experience from the GFC brought to how you handled this crisis and how'd you prep for the crisis that was unfolding in front of our eyes? Any lessons learned there?
Kevin Schmitz: Sure. Yeah. No, plenty of lessons learned. So I've been in the business for 25 years now, so I lived through the dot-com boom and bust and the global financial crisis and now a global pandemic, so I feel like I'm three for three at this point, but certainly there's — there's some things that were different, but there's some things that were the same. The things that were the same through all three crises is making sure that the companies that we own survive. You can't thrive postcrisis if you don't survive the crisis.
So what we did in the financial crisis and what we did this time around was going in and making sure that there was enough liquidity for the companies that we own, looking at debt maturities and see how staggered they were, looking at covenants as well. What's the leverage covenant, what's the debt service coverage and also, what kind of cash flow are they generating? And now that's stuff that we worked very closely with our fixed income team on. So they're obviously interested in all the same things, and so as soon as the crisis started unfolding the fixed income team, the equity team, all got on the same call, and at that point, it was still audio calls because not everyone was on Zoom, but checking in with management teams, literally just going through the portfolio top to bottom and checking.
Now, what I would say, though, is the best time to prepare for a crisis is before a crisis. So having gone through the financial crisis, none of us are really buying stocks unless we know that they can survive a crisis. So what we're doing in the depths of the downturn is not starting from a clean sheet of paper. It's rechecking our thesis. We're not going to buy a company that we think it's not going to survive a crisis, but you've still got to go in and test it.
There's some industries that — call it theme parks or movie theaters — that you'd think would sail through a financial crisis. And they did last time around because people still went to the movies, but this time around it didn't. So you try to prepare, but then you go through the exercise and check everything and make sure you've dotted all the I's and crossed the T's and adjusted for whatever nuance there is in this particular crisis.
Alison O'Neill: Kevin makes a good point. A lot of the foundation of how we approach the job throughout the year, every year, even without a crisis, is this collaborative back and forth between equities and fixed income. So a lot of our daily sector meetings, a lot of our talking with management teams, a lot of that normal foundation just functioned really seamlessly as we went through this crisis transition to working from home. So, it wasn't a new practice that we instituted working with fixed income. It really was just going to that playbook and then asking more specific questions, given the specific factors at play this time around of, okay, in a pandemic when people aren't traveling, where travel is restricted, etc., what are the implications given the specifics for this business? But that collaboration with fixed income is always ongoing and is an important part of our process.
Jon Hubbard: Right, right. So if you had this analysis done upfront and the crisis hits, you're now very familiar with the companies that you're owning in the portfolio, very familiar with all of the companies under your coverage. I guess one of my questions is, as the central bank stepped in, as policymakers stepped in with huge amounts of fiscal support, there was this really sharp bounce off the bottom that continues to today. How do you keep analysts, portfolio managers focused on the fundamental picture when it feels like a lot of the market is being driven by flows and by momentum and in some cases it feels like fundamentals are somewhat detached from equity prices? So can you talk to us a little bit about how you maintain that focus and how you keep the teams on point?
Alison O'Neill: Sure. I mean — a lot of that fundamental focus — look at the facts, look at the fundamentals, ignore some of those external factors and look for the companies that are the most well-positioned. Where some of the implications of those external factors, liquidity etc., come in is valuation. So what you saw coming off the bottom was a very extreme, quick recovery once it was really clear that governments were going to do whatever it took to provide liquidity and stabilize markets. What that meant was all of a sudden the market went from thinking some of these businesses were in very dire straits to, oh, off to the races because the government's going to bail things out, there's downside protection. And because the market recognized that fairly quickly, in some cases, it seemed that it was pricing in overly optimistic news.
And the reality is, there are still some fundamental challenges facing many of these businesses. So keeping focus on the cash flows and how those free cash flows are going to be facing some pressure and try to get a sense for the magnitude or the duration of those headwinds that cash flows are facing or maybe not, and then what the implications are for valuation.
So in pockets where there's some really good news, overly good news priced in, we can identify other areas where the market may be undervaluing some really attractive businesses because it's so enamored with the cyclical recovery and the snapback. So that's what our teams are focused on doing, is to identify where the market may be missing some things or maybe too optimistic in some areas, and we can see opportunity again, being long-term-focused and focused on the fundamentals and less so the technical factors and some of the hype and the noise that are in the headlines day to day.
Kevin Schmitz: I think that's an important point though, because the factors that you're talking about, they can impact the market or impact stocks on a short-term basis, right? (The flows, what's the short interest etc. etc.) But over a long period of time, the fundamentals always win. So the key of surviving an environment like we're in is to have that long-term time horizon. If you're worried about quarterly performance or annual performance, you're likely to chase these factors because you need to perform every quarter. You need to perform every year. But if you have that long-term time horizon, you can say, "I don't care what the short interest is on this stock. I don't care what flows are coming. Fundamentally, it's a challenged business, and I know it's going up right now, but I'm going to ignore that because I know over the next three to five years, fundamentals will win out."
And our whole investment process is about looking 3, 5, 10 years down the road, and it's not just culture. But when you look at, when you get reviewed by your manager at the end of the year, you talk about your 3-year numbers, your 5-year numbers, your 10-year numbers. So never do we get managed or compensated on a quarterly or a yearly number. And I think the combination of the culture and the way we're compensated, having that long-term time horizon allows us to look through these kind of insane scenarios and just focus on what matters.
Jon Hubbard: Right. Right. The insanity that we experienced a year ago, and the sanity that it feels like we're still experiencing now.
Kevin Schmitz: Still experiencing it.
Jon Hubbard: Just the other side of the coin. Now Kevin, I'd like to go into a little bit more detail here. I know you developed a framework around how to think about some of the industries and sectors that might thrive, and some that might be more challenged in a long-term basis. So can you talk a little bit about first of all that framework and how it came together, and then perhaps some of the industries and sectors that you see on either side of that equation?
Kevin Schmitz: Sure. Yeah. Like all of us, I spend a lot of time thinking about how COVID has impacted the world, so started developing, putting companies in buckets of COVID winners and COVID losers, so I think that's pretty straightforward. Our long-term investment framework: We're always thinking about long-term secular winners and long-term secular losers. Obviously we want to invest in the winners longer term. So I thought about putting together a two-by-two matrix — COVID winners and losers, secular winners and losers — and try to put all the companies that I'm interested in in one of these buckets, then think through what we should be doing in those buckets.
So I'll bore you to tears, but if you look at the upper right-hand bucket is COVID winners and secular winners, right? So that's video game companies, e-commerce companies, companies that are booming during COVID but also have long-term secular drivers that we like.
So in that bucket, the stocks have all done fantastic, but trying to force ourselves not to take profits and just let it run because you've got great tailwinds from both a COVID and a secular basis. The opposite of that is the lower left-hand quadrant, which is secular losers and COVID losers. So that's a brick and mortar retail, movie theaters, office REITs. So those are stocks that have been destroyed for obvious reasons. They'll look supercheap, but I personally worry that there's probably a lot of value traps there. And so they're cheap for a reason. You've got to be careful not to own too much of those things.
The upper left-hand bucket is secular losers but COVID winners. So companies in tough industries that have gotten a nice boom because of COVID, so that's packaged food companies, right? Because everyone's eating at home and not going out to restaurants. Trucking companies, because everything's getting delivered and Amazon's going crazy.
So those businesses are challenged long term, but they're seeing this nice little bump. So in those areas, we're kind of quicker to take profits. It's like: Don't look a gift horse in the mouth. These stocks have rerated dramatically, probably gotten too expensive, and we don't like the long-term prospects, so trim out of those.
Then the funnest bucket is the bottom right-hand quadrant, which is COVID losers but secular winners. So these are companies that we want to own long term but probably haven't had the opportunity, maybe because of valuation or whatever. But it could be travel leisure companies. It could be health care service companies, but they've been hit by COVID for obvious reasons. But long term, we like them. So that's kind of the pool that we're fishing in for new ideas.
Jon Hubbard: And you're seeing some of the biggest dislocations in those secular winners that are currently COVID losers that are being priced for us being in this state forever. Right?
Kevin Schmitz: Yeah. I think that was definitely true. I think that probably got tweaked a little bit after the vaccine came out. So from the beginning of this through the vaccine, I think there were huge opportunities there. Now, you had to do the liquidity analysis and the leverage analysis because you're not going to thrive post COVID unless you survive it. So there are opportunities there. Now post the vaccine announcement, some of those opportunities have gotten soaked up.
Alison O'Neill: And if I could just add on to what Kevin just illustrated, it was a great example of our collaboration globally across the sector teams and our investment platform. So Kevin brought that idea and that mental framework he was using to identify opportunities within his portfolio, and then each of the eight sector teams globally used that framework to identify stocks as a team to place within those quadrants. And we had some debate in some areas because it's not always extraordinarily clear and there could be some companies that we could debate the secular tailwinds or headwinds, but that idea that Kevin had then shared with the rest of the team and then circulated throughout each of the eight global sector teams was a great example of how we collaborate with ideas across the globe across different portfolios. So it was a really useful exercise in a number of ways.
Jon Hubbard: Now, Alison, I'd like to ask: In your discussions with company management and the team's discussion with company management, what are some of the sort of longer-term themes that you're hearing that are coming out of this? It could be sort of the work-from-home. It could be bringing supply chains back stateside. Are there any sorts of themes that you can think about that you're hearing across sectors and industries?
Alison O'Neill: Sure, one that comes to mind — and we've had some really interesting discussions with companies throughout this is because this was such a humanitarian crisis and it really affects all of us from a health perspective — there were companies that did the right thing in terms of sustainability, thinking about ESG and specifically with thinking about social, their workforce, their communities, and some companies said, "We want to encourage people. If you're sick, take that time, stay out for two weeks. You'll still be paid." There were companies that increased wages during this period of time because they recognized this was psychologically — it was a stressful time to come to work when you felt like you were potentially putting your health at risk. For businesses, people in manufacturing or factories and things like that.
So you could really differentiate between some management teams that were thinking about their workforce, that we're thinking about the communities, and they were doing the right thing for that long term, that the goodwill that they created because they cared about their human capital within their employees, who then will be more loyal and to stay and have lower employee turnover and have people willing to work and go that extra mile. Those are things that are going to help the cash flows of that company over the long term. Then you heard other companies that maybe weren't as focused on that. And they were more just focused on their profits and how it would be impacted in the short term. So we really had some very interesting discussions because it did illuminate which companies are thinking more sustainably about some of these issues than others.
Jon Hubbard: And that whole sustainability, that cuts across all the sectors that we cover.
Alison O'Neill: Oh, absolutely. I mean, thinking about as long-term investors, again as Kevin said, we're not interested in what's going to happen next quarter or what some of the short-term headlines are. Were investors thinking about deploying capital responsibly, investing responsibly over the long term? So management teams that are thinking in making strategic choices that take in some of these ESG factors are going to be in a better position to outperform because they have implications for the cash flows of these businesses over long periods of time. And those are discussions that we have on many different angles, and this crisis in particular allowed us to get more insight into companies that are really valuing their human capital, certainly.
Kevin Schmitz: The one thing that I was going to throw in there, Jon: You kind of mentioned supply chain. That has been a really interesting one, having a flexible supply chain. So you look at a couple of companies that I look at or own, that manufacture boats or RVs or recreational vehicles, the market exploded. But these companies have spent the last decade shrinking their supply chain, shrinking their inventory levels, then all of a sudden it explodes, the volume explodes and they can't keep up.
Alison O'Neill: Demand, and shock to the upside, right?
Kevin Schmitz: Demand shock to the upside, yeah. Positive explosion, and they can't keep up. So they're turning away sales, and if COVID all of a sudden goes away and this demand for boats goes away, they've missed the sale. So they got caught flat-footed and they've been scrambling ever since to get their supply chain up.
Opposite is also true, which is companies that never thought they would have a demand shock where revenues go down 80% or 90% did not have a flexible cost structure to keep up with that or adjust for that. So just the range of outcomes that you thought you might have in a normal kind of garden-variety recession or crisis or whatever just got pushed to either side. So this ability to think through a wider set of outcomes I think is something that different teams are going through right now.
Jon Hubbard: So, Alison, I'd just like to come back to you and just ask any sort of closing thoughts about how to be thinking about the current market and to be just cognizant of where valuations are, where companies are in the cycle, just any closing thoughts you might have.
Alison O'Neill: Sure. I mean, specifically in thinking about some of the activity that's gone on in the last couple of weeks and some of the well-publicized retail investors and hedge funds and that sort of activity where it is more technical factors in a separation from fundamentals, I mean, that all does speak to just being able to, as we've talked about throughout this conversation, focus on fundamentals which will prevail over the long term and being active managers.
So those bubbles that are created for ephemeral reasons that are going to unwind, for people who are passively buying an index, they're buying into some of those negative technical issues that are bubbling up, and we can avoid some of those, and we can focus on the companies that might be left behind, as some hedge funds are having to close out some of their long positions for no other reason other than covering their shorts.
For those companies that we either own or have been on our radar screen, but we had been waiting for a better valuation point, we can take advantage of those with that long-term view. So that's — viewing this period of time or any sort of point in time where there's a dislocation or a big disparity between groups, like Kevin was saying — that's opportunity for us, and we have to stay focused, and we have to be talking to management teams, focused on those fundamentals and implications for long-term cash flows, anticipating change, etc., but as long as we do that, that's going to provide us some really attractive opportunities over the long term. So, it's what we do, and it's why we love what we do, and it's been presenting some interesting discussion and opportunity for us as we view it.
Kevin Schmitz: So Warren Buffett's famous for saying, "You should be greedy when others are fearful and fearful when others are greedy," and so I think one thing that we tried to do in the depths of the crisis was make sure companies are going to survive right? That's sort of square one. But don't necessarily focus on how low the stock could go. Focus on how high it can go when things get better. So when stocks are going down, people want to focus on how bad it can get, not how good things can get. And when things are going well, no one focuses on the downside. I think we think it should be the opposite.
So during the downturn, okay, if things get better, how high could these stocks go? The market's up. The Russell 2000® Value Index is up 100% off the bottom. So now we're sort of pivoting, some of us certainly pivoting in the other direction, like, "Okay, things are really good. Everyone's focused on the upside. How high can the stocks go?" I feel like we're sort of stepping away from the cliff a little bit and saying, "Okay, if interest rates go up, corporate tax rates go up etc etc., if things get bad, how much downside protection do we have?" So I feel like this moving opposite of what the market is is important, and I think probably it's served us pretty well in the rebound. Because when other people were thinking about the end of the world, we're trying to think about — we're trying to be greedy when everyone else was running around. And certainly there's a lot more greed in the world right now than there was February, March of last year.
Jon Hubbard: For sure. So taking my towards a more cautious approach right now.
Kevin Schmitz: Yep. Yes.
Jon Hubbard: Well, Alison, Kevin, I really appreciate you sharing all of your insights and views here with our clients. And I would like to thank everybody for joining us today for this Capital Market Spotlight, and hope you have a great rest of the year.
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