MASTERCLASS: Small Caps - October 2020
October 7, 2020
Jenna Dagenhart: Welcome to Asset TV. This is your market volatility and investment strategies masterclass. In addition to the human toll, the Coronavirus pandemic has sparked historic volatility in markets. Joining us today to discuss investment strategies during turbulent times, we have three expert panelists, Greg Squires, Fundamental Senior Research Analyst at Causeway Capital, Jai Jacob, Managing Director, Portfolio Manager and Head of Multi-asset Investments at Lazard Asset Management and Joe Montgomery, Managing Director Investments at the Optimal Service Group of Wells Fargo Advisors. Gentlemen, thanks so much for joining us.
Gregory Squires: Thank you.
Jai Jacob: Thank you.
Joe Montgomery: Glad to be here.
Jenna Dagenhart:So, this is quite a crazy time for investors. It'll certainly be in the history books with this historic volatility. Greg, what steps are you taking in the current environment?
Gregory Squires: We're finding that this crisis is giving us the opportunity to invest in companies that are pricing in severe and permanent value destruction. So, we're getting a great opportunity to buy quality companies at prices that are quite attractive in the long-term. So, one of the things that we're really focused on right now is, given the breadth and the uncertain timing of an eventual recovery, it's really important that we have confidence in the liquidity profile and the balance sheet strength of every company that we invest in. Because again, we're not here to call the exact timing of an eventual recovery, but what we are focused on is understanding, not just what the earnings outlook looks like on a 12- or 24-month view, but beyond that. It's interesting, if you look at some of the more beleaguered parts of the market right now within cyclicals for instance, that discount, it has really widened to historic levels versus defensives as investors understandably wants the comfort of investing in more defensive stocks.
Gregory Squires: But, we find that that price discrepancy has simply grown too wide in many cases. If you look at the cyclical universe, the top quintile of cyclical stocks, and dis-aggregate the growth factor that's implied by current prices, you're finding negative terminal growth on the order of 3%-6%. At the company level, you're finding some even more draconian examples than that. So, we're looking at parts of the market that have been subject to some of the eye of the storm type things that are going on right now. So, financials, industrials, including parts of aerospace complex, consumer discretionary.
Gregory Squires: Again, a critical precondition given the uncertain timing I would say is liquidity, balance sheet strength. But, if we're confident that the company is able to resume operations, generate cash through the cycle, then we're willing to invest. So, I think one of the things we're trying to do with Causeway's value investors is, take advantage of opportunities where we find that the fear is simply unwarranted.
Jenna Dagenhart: Be greedy when others are fearful?
Gregory Squires: That's right.
Jenna Dagenhart: Joe, how would you summarize the current environment?
Joe Montgomery: Well, I think this to me, looking back over since the mid '70s, this is the only engineered recession that I'm aware of. So, it's clearly unique, but that presents opportunity. I think a surfer would call it gnarly maybe, if somebody was a surfer of any quality, which I'm not. But it's exciting and can be difficult, but I think it presents a lot of opportunity particularly because, so many asset classes are finally participating both up and down.
Jenna Dagenhart: I've heard the word opportunity a few times here. Jai, how do you turn volatility from your enemy into your friend?
Jai Jacob: Well, I think as both Greg and Joe have mentioned, there is an opportunity that's inherent to volatility. I think what we found, one of the interesting characteristics of volatility as a measure is, unlike return, which is extremely difficult to predict using historical numbers, volatility does have a certain persistence to it. For example, if you looked at the correlation between previous returns and future returns, which is often correctly, it usually says this at the bottom of most presentations that, past returns don't predict future results. So, that certainly is true for correlations of returns. They tend to be zero. For volatility, the relationship is a little bit more stable, believe it or not. It's around 35% of future volatility can be explained by past volatility.
Jai Jacob: Now, 35% may not seem like a great set of odds, but if you consider placing a bet somewhere, placing a bet with a 35% better chance of winning is actually a nice benefit. So, I think in terms of the way you phrased the question of turning it into your friend, it's really looking at volatility as something that could be a more predictable way of investing. It's investing around risk first as opposed to just pure return seeking.
Jenna Dagenhart: Greg, what impact has the COVID-19 crisis had on dividends and what have you seen so far and what do you expect going forward?
Gregory Squires: I would say this crisis, as Joe pointed out earlier, is pretty unprecedented on just about every level. So, you have a rapidly spreading global pandemic, you have the shutdown, you have travel restrictions between countries. Likewise, on the other side, you have a massive wave. I'm sure we'll speak about the fiscal and monetary stimulus on the other side of it, but in the near term, what we've seen is a significant deterioration in the cashflow profile of a lot of companies. So, unexpectedly we have seen some dividends suspensions as a result of that. I think there's still been some indiscriminate selling associated with fear around this. It's important I think to note that typically, equities tend to underperform well in advance of the actual announcement itself, of a dividend suspension.
Gregory Squires: One example I think it's worth highlighting in this instance is, when you look at European banks and the recent suspensions in dividends, which has come down from the ECB and similar announcements in the UK, really, when you look at the banking sectors in Europe and also in the US, you see capital levels that are two to three times higher than they were at the onset of the global financial crisis. Yet, the stocks are trading, at crisis levels already. So, when we think about that capital build, when we think about the dividend paying capacity that these institutions will have on the backend of this, we get excited at these prices.
Gregory Squires: So, it was an important distinction I think, that the PRA, which is the UK banking regulator put out there, which was, these suspensions right now in some cases are a reflection that we just don't know what we don't know in terms of the duration of this economic crisis. But, in not all cases is a dividend suspension necessarily indicative of permanent financial distress. Again, those are points in time when you have to be willing to take a counter-consensus view and look a little bit longer term and think about which franchises will be positioned and some won't, but a lot will be positioned on the backend to resume dividend payments.
Jenna Dagenhart: Joe, what do you think is most important for investors to recognize right now? I mean, there are a lot of unknowns, unknown unknowns.
Joe Montgomery: Yeah. I was smiling when Jai was saying about returns. You all may remember Benjamin Graham's comment about the essence of portfolio management is the management of risk, not the management of returns. That pretty much is what I think is going on now. If people were smart, they're focused on where they can be protected, where they can be diversified. It's not a light switch. It's not going to be automatic, but it's going to all lead up to greater diversification because, we're going to be working for those better risk measurements. Finally, somebody's paying attention to risk.
Jenna Dagenhart: Jai, I see you nodding your head a little bit over there. Anything you want to add to that?
Jai Jacob: Yeah, I mean I agree. I think that we were coming off a period where volatility, it's not just that volatility is extremely high or has been in this recent period, it's that volatility was extremely low. I think that, that enabled a lot of investors to get away with very little diversification or risk management, and not really have to pay the cost. I think that Joe's exactly right is that, risk management over time is really what pays a more consistent result in a pattern of performance. So, now that risk is back in the picture, I think Joe called it gnarly if you're a surfer, I might have to use that one as well. I don't think I can do better than that.
Jenna Dagenhart: Yeah. Perspectives are very important here. Greg, what have you learned from history and how does this Black Swan event compare to others? I know you entered the industry right after the financial crisis.
Gregory Squires: I did. Every crisis is different, is the age-old adage and that seems particularly apt in this situation. I think we're seeing some conditions that are really unprecedented in any of our investing careers. One thing that I think is a little bit different this time around versus prior crises is just the speed and the breadth of the policy response on the other side. So, on the fiscal side, you've seen direct payments to consumers, you've seen rollout of expanded unemployment benefits, you've seen government guaranteed loan programs with increasing, I guess, generosity, attached to them throughout much of Europe. On the monetary side, you're seeing a lot of the same toolkit that was employed in the great financial crisis, expanded upon. So, we've never seen the Fed step into the non-investment grade portion of the bond market. But these are some unprecedented times.
Gregory Squires: I would say that, when we look back at the last three major dislocations in the market, so look back at the tech bubble, the global financial crisis and then the European crisis, the epicenter of each of those was a big difference. So, that leg down looked different in each of those. But, one commonality, that held and we think will be the case once again is, the out-performance of cyclicals on the way out. Again, the timing of that is uncertain and balance sheet liquidity are extremely important because of that. But, some of the most appealing investment opportunities we're finding today, are in the cyclical parts of the market. If prior experience through those crises is any guide to us, it's that investors have to be willing to own out of favor stocks and investment styles, before the recovery is evident, otherwise they will miss out.
Jenna Dagenhart: Jai, anything you'd like to add here about historical context and any parallels you'd like to mention?
Jai Jacob: I think in terms of historical context, this is worse in many respects than the financial crisis. it's worse than '87, any of the reception recessions that I would say I've seen in my professional career. I think looking at the tape, we go back and I think probably the closest analog is World War II. it's something that's drawn out. It's something that is not going to be a quick flash in the pan, and importantly, it's not something that's created by the financial services industry. It becomes a lot harder to address those kinds of issues when you're dealing with the end demand at the point of the consumer. It's not something you can deal with only using monetary policy, or even fiscal policy.
Jai Jacob: I think the good news for those of us who've looked through and the market history in World War II is, really the market bottomed several years before the end of World War II. I think it's important that investors keep that in mind. The turning point that some have pointed out was really after Pearl Harbor, the US Navy mounted an attack, called the Do-Little Raid. It was really something that turned the balance in terms of providing hope or a way forward, for the world, and then saying that maybe that there was a chance that the axis powers could be defeated. That is really when the market bottomed. There were still three years of very hard fought, fighting left to have, before the war was over. But, that glimmer of hope I think comes a lot before the end.
Jai Jacob: I think that that is a little bit encouraging when you're looking at this. I think that we're looking at it similar to what Greg said, there are really three points to the triangle here. The first one and the most important one of course, is the health crisis that we're seeing. But then, there is a monetary response angle to it and a fiscal response angle to it. It can be helpful I think for investors to try to separate those three from one another, because they'll have different impacts on different segments of the market as we go through this.
Jenna Dagenhart: We'll certainly cover the other points in the triangle that you mentioned Jai. Joe, anything that you would like to add? How do you think that this pandemic is impacting the way that people invest?
Joe Montgomery: think Jai said something really, really important that was great about a World War II because, the way I've been viewing this is, this again, it's unique. As I said, it's engineered. But it also puts people in the position of having an opinion. So, if you go back to the financial crisis, people were dumbstruck. I mean, they didn't understand the math, they didn't understand what was being hit. They just didn't really understand it. But you're watching people glued to the TV, whether it's lunchtime, dinnertime, whatever. They're watching people talk about this virus. People have opinions, because they're out there. They're picking them up and they are talking about it.
Joe Montgomery: So, that leads them... In some cases, I actually think the challenge is they're paralyzed. We actually had an institution who historically was, I would say almost brilliant at their, not timing the market, but following their policy, which they did a great job of. In February of 2009, they rebalanced. If you remember how that felt in February of 2009, not many people were stepping up and rebalancing. So, this time around we were very excited because we thought, "Well, they'll just follow their policy." Well, let's just say they had some folks on there that had definite opinions about what was going to happen related to the virus, not to the markets. But they felt like the virus was so unknown and they weren't going to be able to tell what to do. They actually put it in neutral, which was incredibly disappointing to me. Because, as it turns out, they would have hit the most recent bottom again if they had just rebalanced.
Joe Montgomery: So, I think the challenge is, is getting people to have a correct opinion about going ahead and rebalancing, adjusting their portfolios, not knowing what's going to happen, the next report about the medical activities. I think today, we've had what's happening in the world, you're seeing people react to it every time they see something on the news. On days that there's a bit of good news or somebody thinks something's happening positive, markets go up. Likewise, they go in another direction. It's going to be an educational thing for us to solve for that, I think.
Jenna Dagenhart: Yeah. To your point, this is a very, very tangible health crisis that impacts so many people globally, not just in the US but all over the world.
Joe Montgomery: Very unknown.
Jenna Dagenhart: Very unknown. Greg, REITs have historically been a ballast in volatile markets. How might the COVID-19 crisis impact that?
Gregory Squires: I think no sector has been immune from the carnage, some more so than others. REITs historically have been one of the more traditionally defensive areas of the market in the sense that, often exhibit a negative correlation to cyclical factors like global PMIs. Typically, you think about a Real Estate Investment Trust, it's a product that's built on the idea of paying dividends, that's core to their ability to maintain their structure. The reliance that investors have come to have on some of those dividend streams is significant. So, REITs, what they have working for them is long-term leases, and most tenants tend to pay their rent. But, so far in this cycle as we've discussed, there are elements that are pretty unprecedented. So, the extent of the shutdown has been such that rent receipts, we've seen them fall significantly. Some of the most obvious examples that come to mind are things like malls that have been shuttered. So, the retail side which was already suffering before this crisis, is now under even more pressure.
Gregory Squires:But also, in some less obvious areas of the market that if I told you there was going to be a recession, you wouldn't have necessarily worried about traditional parts of the office market or parts of healthcare real estate. Senior housing is one of the areas right now that's under immense pressure in terms of rising costs, and what's likely to be a period of very low movement activity. So, if you had taken a very broad-brush approach to thinking about real estate investing or your allocation to real estate, you may have missed some important points. I think this is something that is in favor of active management. That is, only with active management do you get the opportunity to know these companies on an intimate level and understand the tenant base in detail, and find opportunities where those rent receipts are likely to come in, and areas where there's weakness and draw that contrast versus more truly defensive parts of the market like healthcare for instance.
Gregory Squires: One of our healthcare investments very recently, it's a Swiss pharmaceutical giant, talked about increasing their dividend payment based on higher top line growth prospects. So, not painting things with a broad brush and getting to know companies in detail I think is important. So, that one size fits all approach, certainly does not apply in times like this.
Jenna Dagenhart: Taking a closer look at different investment strategies for this crisis, Jai, for investors asking themselves what level of volatility do I want, how does the risk first approach fit in?
Jai Jacob: Well, I think that it is really an evolution of something like a target date fund or some of those conservative to aggressive models that have been used historically. It just doesn't presume that the relationship between stocks and bonds is constant. Which is I think an important lesson, that many asset allocators have had the recent opportunity to learn. I think that when choosing a level of risk, it's really saying if you look over long periods of time, a 10% volatility might equate to about a 50-50 equity fixed income allocation. You can use that as an anchor and say, do I want to take more risks than that and less risk than that. What that translates into if one is targeting volatility as opposed to a static allocation is that, when volatility picks up, you'll have more of the defensive asset whichever that asset might be.
Jai Jacob: If you think about the last 40 years and what interest rates have done and try to extrapolate that to the next 40 years, it doesn't work. We should be very, I think, reluctant to assume that the risk off asset will always be the same thing. So, if we use something like volatility which will capture whatever happens to be the safer asset or whatever happens to be the more aggressive asset at different points in time, I think that the end investor has a smoother experience in terms of gains and losses occurring to their retirement accounts.
Jenna Dagenhart: Greg, you mentioned Causeway's value investing approach earlier. How does that differ from other value strategies?
Gregory Squires: I think one of the common threads that you tend to find with value strategies is, you're trying to own businesses that have a free cashflow profile that's misunderstood or underappreciated by the market. I think one area that sets us apart is our intense focus on capital allocation at the management and board level. That's a critical piece because, often we're investing in companies that are X growth in mature industries, and we expect these management teams to have a discipline strategy to in many cases return a lot of that capital to shareholders. In other instances, I think something that also sets us apart is having a longer-term horizon. So, that gives you the ability to invest in some restructuring or operational self-help stories that may take time to play out.
Gregory Squires: If you're working on a quarter to quarter type view, you're not going to have the patience to see some of those restructuring initiatives play out. So, when you look at the market right now and say, where are those opportunities, again, we're increasingly finding them within some of the more cyclical sectors. I think as I touched on earlier, those discounts for cyclicals versus defensives are at historic levels, if you look at a PE multiple for the most cyclical versus the most defensive parts of the market.
Gregory Squires: Maybe to give you a tangible example of that, right now you can invest in one of the best run, best managed European banks. It's got franchise in Italy, in Germany, Austria throughout Central and Eastern Europe. It's trading at a 70% discount to its tangible book value. It's trading at sub five times it's normalized earnings figure. So, the amount of value destruction that those types of evaluations are pricing in, is immense. We think on the other side of this, whatever that may be, it's very likely that this company will be able to re-institute its dividend policy, which is part of its discipline capital allocation approach. With a 50% payout on a stock that's trading at sub five times normalized earnings, you see an implied yield that's well into the teens. So, those are the types of opportunities we're able to capitalize on because we're willing to take that longer-term perspective, and because we're willing to do the work to look at parts of the market that have quite a bit of fear attached to them for the near-term outlook.
Jenna Dagenhart: Do that work and have that patience. Joe, what are you telling long-term investors right now?
Joe Montgomery: I had to smile. The active part is so true. But it does come down to the sequencing I think, that has, we were mentioning earlier, I guess that hasn't been as necessary. Diversification matters. The broader allocation matters. It's actually documented to show a faster rebound historically, so it plays into the risk. Then you have I think, very evident examples just as Greg just gave, of things that represent an active decision that really adds value. We've not really been operating in that environment for about the last 10 years. So, it's game on.
Jenna Dagenhart: Jai, walk us through managed volatility versus targeted volatility strategies.
Jai Jacob: Sure Jenna. I think when you look at volatility strategies, managed volatility, which is something that we do with our quant team, is something that allows the investor to access a dampened version of the market volatility. So, if there's a 1% risk in the market, which we'd call a beta only about 0.7 or 0.6 of that would be in the managed fall approach. It's a quantitative approach that says, "I don't want to bear the full impact of the market return up or down," and it provides a smoother experience for equity investors.
Jai Jacob: Target volatility is something that is implemented through asset allocation. So, we have strategies like that, and we have a volt series that you choose a particular level of volatility or a global dynamic multi-asset, which is about a 10% volatility. Think about a 10% volatility target. What that means is that, as the market dynamics change, the asset allocation will actually shift, to keep the absolute level of volatility constant over time. It's something that makes the overall strategy a little bit easier for the end asset allocator to place in a broader portfolio, because the results are a bit more predictable on an absolute basis.
Jenna Dagenhart: Greg ESG Investing is garnering more and more attention. How do you factor in those considerations into your process?
Gregory Squires: This is a topic that's been gaining more and more attention as you mentioned in recent years. It's something that we've spent a considerable amount of time understanding at Causeway and how we can best incorporate some of these factors to our investment decisions. I think points in time like this where there's immense market volatility, also underscore the importance of just sound corporate governance. So, we have developed an in-house tool that helps us systematically evaluate that for every single company that we're considering investing in. What we really want to see is A, is the capital allocation, does it make sense for this company in a mature industry? Is it returning capital? If they have growth prospects, are they investing responsibly and attractive returns? But also, importantly on the other side of that is, our incentive structures, are they really aligned to deliver on those capital allocation priorities that management is laid out?
Gregory Squires: What that helps us do is really avoid investing in companies where there's a disconnect, where you can find yourself in a situation that a company has a sub optimal capital structure. If it's just hoarding capital, that can often be a recipe for disaster in terms of overpaying for growth assets. So, I would say that governance component is really important in times like this, knowing that there are steady hands at the wheel so to speak.
Jenna Dagenhart: Joe, anything that you would like to add to that? I know you mentioned the role of governance earlier.
Joe Montgomery: Well, governance in general I think is going to be the direction. You're just going to have to, because people are going to question you on a lot of fronts. What's going to be important when it comes to the social environmental may change, but we think that's going to get wrapped up into governance.
Jai Jacob: I think it's going to be a real opportunity space as well. I think as the investor's preferences start to shift, that will impact how capital is allocated I think throughout the world. I think priorities are shifting. The consumer behavior is shifting. That's going to that's going to offer I think the ESG investment strategies a lot of new pockets of opportunity, and it's something that we've been looking at very closely as well in the last few years.
Jenna Dagenhart: Now Greg, what are your thoughts on some of the companies shifting from cash dividend payouts to scrip dividends?
Gregory Squires: We have started to see more of this. It's maybe another sign of the times of distress on that underlying cash flow generation that some of these businesses have. Ultimately, we think that dividends should be a reflection of that free cash flow generation. So, a scrip dividend where a company is effectively returning newly issued shares to investors in lieu of cash runs the foul of that core premise. It's diluted by definition, unless the company is then neutralizing it with repurchases on the other side. I think an example of this where you're seeing companies that are desperately trying to maintain the appearance of dividends is in the energy sector, so, under immense pressure right now. A lot of these companies, that's been one of the core parts of their value proposition to investors has been look at our track record in maintaining dividends through decades and decades of volatility, when the reality is that at today's oil price, very few are positioned to generate the cash necessary to actually sustain real cash dividend payments.
Gregory Squires: So, when we see something like that, the important question we have to ask ourselves as a value investor is, what does it look like on the other side of this for that company, on the other side of this immediate crisis? When we look at the energy sector, it's a very fragmented industry on the supply side. On the demand side, going back to some of the ESG topics we were just discussing there are some clear structural headwinds. The combination of those two, I would say it means you should have a very selective approach in jumping into opportunities in that particular sector. You could contrast that with where we maybe have a more constructive view longer term. So, within my materials coverage, one of the largest diversified copper producers in the world, low cost assets, reserve life of 30 plus years recently suspended its cash dividend payment, which we think is prudent given the volatility we've seen in the price of copper, and to preserve that flexibility.
Gregory Squires: But ultimately, this crisis has not changed our longer-term view on the demand for a commodity like copper. So, I would just highlight that distinction, where a dividend suspension is potentially okay to the extent that your confident medium to long-term, the company is going to be able to resume paying cash dividends.
Jenna Dagenhart: Pivoting now to the economy, I want to take a closer look at the triangle that you mentioned earlier. There's the public health element, the monetary policy and the fiscal stimulus element. So, Jai, how do you see fiscal stimulus measures playing out for the markets and for investors?
Jai Jacob: Well, I think that at this stage we have to look at the gap in the economy that's been created by the virus itself, by that first a vertex of the triangle. I would say that the fiscal stimulus it's maybe a little bit of a misnomer. It's really more of a fiscal relief at this point. I think this is really about the government intervening and intervening quickly. I think that's something that Greg pointed out earlier in his remarks. With very aggressive response, it's taken them much less time to implement fiscal relief measures than it did in the financial crisis for example, where it took a couple of months with one party controlling all three houses.
Jai Jacob: I think here, the fiscal stimulus is really about just bridging the gap. I think that there are very real concerns about how businesses can survive, particularly those businesses that don't have the luxury as we do, of being able to conduct their businesses from home. I think that those measures have largely been in line with what is expected. I think that when we move forward now, it gets interesting because, there are other potential fiscal stimulus measures that could impact the commodity complex, particularly when you look at things like infrastructure spending.
Jai Jacob: I think that infrastructure for fiscal, from a government perspective, it's almost like toilet paper, right? If you can get it, just get it, you will eventually need it. It actually can get things going. It's not a bad way of actually getting the economy started again. I think different governments will look to that. China historically looked at that after the financial crisis. The Chinese administration was criticized at the time for spending so much on infrastructure, but I think as you've seen, if you build it, they will come. Infrastructure is something that that is a good long-term investment. Given where commodity prices are today, it's actually a pretty reasonable investment to expect. So, I would say we've so far been very much in fiscal relief. The next stage if we do move into fiscal stimulus, could open up some nice opportunities.
Jenna Dagenhart: Certainly very interesting times that we're living in Jai. I do believe toilet paper is returning to the shelves now. But that being said, as we move forward with this recovery, Joe, do you think that the economic recovery will be just as unknown as a selloff?
Joe Montgomery: I think so. I think it will be less dramatic, but it'll be unknown I guess, if you define that as not being able to really tell when it started, when it's over. I mean, we hear V shaped, U shaped, WLs, who knows. You really won't until you're in into it, I think. But I do think it will be less dramatic, is the way we view it. Because, you've got day to day swings based on what's going on medically, what's rumored medically. Until you get the virus a vaccine, I think it's going to be very hard to reach conclusions. Because, we know we don't know now what happens when you start spacing. Okay, you're going to open up, are you going to be able to go to a football game, whatever? We know none of that. We have no idea what's going to happen to those folks.
Joe Montgomery: As Jai said, some of us are fortunate we can work from home or from our office as an essential participant in the economy, but for a lot of people, we're just not anywhere close to figuring it out yet.
Jenna Dagenhart: I know the football's very important to you Joe, as someone who played.
Joe Montgomery: Well, I like to watch these days, but if you think about it, it's a trickle down of what happens to people. Same thing with musicians. A lot of these people that are out there that they can't do what they do and get compensated for it. You're going to have to come up with a cure, most likely it would seem to me.
Jenna Dagenhart: To try to combat some of this economic damage, the Fed has stepped in with very aggressive measures/rates close to zero. Greg, do you think that dividends will become more important if rates remain low?
Gregory Squires: I think they will. I think in a very low rate environment, you find a lot of yield starved savers out there, and that should support companies that are able to pay dividends and generate free cash flow. I think the massive fiscal measures that we've seen, to Jai's point earlier, in a large part, they're trying to plug a really big hole in GDP, and that's why the scale of some of these measures is pretty overwhelming and it's been met with monetary stimulus on the other side, that's helped keep those borrowing costs quite low for governments. So, when you see the US tenure well below 1%, a lot of European yields, the German yields deeply in negative territory, Japanese rates pegged at zero, I think cashflow and dividend paying capacity of companies’ medium to long-term, will be extremely attractive.
Jenna Dagenhart:Yeah, when you're not getting those yields on treasuries.
Gregory Squires: That's right.
Jenna Dagenhart: Jai, what do you make of the Fed's aggressive monetary policy actions that we've been discussing to help restore liquidity into the markets?
Jai Jacob:Well, I think in many ways it was a relief to see that the Fed had learned the lessons from the financial crisis. I think that the Fed was ready with the measures. They knew what to do. They acted quickly. One of the things that we noticed in markets towards the end of February, which was I think disturbing to many participants, was that stocks and bonds were both going down at the same time. That the long duration, the 10 year, the 30 year, these bonds were not acting as defensive ballast as they typically do. That really, cash was the only place to hide. We did take advantage of that to some degree. But, the interesting thing about the Fed's timing and the seriousness with which they took that is, they did restore faith in the investment community on the 10- and 30-year bonds, and the long... The idea of lending to the U S government is a safe thing to do.
Jai Jacob: So, you started to see when equity markets corrected, that flight to quality, that move towards more defensive traditionally defensive assets like the long bond, that started to work again. I think that had a lot to do with the Fed's intervention. Not only I think with their purchase programs, which they announced, but their willingness to move outside of the traditional government bond complex, signaling that they'd be willing to purchase corporate bonds, to purchase high yield bonds to some degree. Those are all about restoring relationship between equity and fixed income from an asset allocation point of view. So, I have to say that I think the aggressive monetary policy it did restore function and liquidity to the market. I think one of the hardest things we can see as investors, is a market that doesn't function as we'd expect. As difficult as this has been, we haven't seen that impairment that we saw for example in 2008.
Jenna Dagenhart: Greg, what catalyst do you see for the markets right now or in the near future?
Gregory Squires: I think as we've discussed earlier, all eyes are firmly on the health crisis. I think, resolution of some sort there is a precondition to really a full economic recovery. Perhaps never before have so many of us who don't have life science or healthcare experience, spoken with such fluency terms like R naught, and case fatality rates. I think positive news could take many forms on the healthcare crisis, from some of these serology tests that are indicating an infection rate that's many multiples higher of the reported numbers, which suggests a much lower mortality and morbidity rate than were previously feared, to progress on different therapeutic approaches to dealing with the virus. And ultimately to progress around the vaccine, which some of those companies are now entering human trials.
Gregory Squires: The key point I would say is, the timing of these types of catalysts are well beyond my ability or most market participants ability to really predict with any certainty. Given that uncertain timing, I think you have to be focused on liquidity, on balance sheets. But, when companies meet those preconditions, you have to be willing to own out of favor parts of the market before that news is evident. Otherwise, you will not participate in the full recovery.
Jenna Dagenhart: Tough stomach?
Gregory Squires: That's right.
Jenna Dagenhart:Joe, how should investors be thinking about asset allocation? Especially as Greg mentioned, all eyes are looking to that point of the triangle with the healthcare. We've already seen swift action from the Fed and aggressive fiscal measures. So now, all eyes are on that third and most important point of the triangle.
Joe Montgomery: Yeah. Well it is interesting what Greg was saying about, you've got to be there when it happens, and that leads right into a broader asset allocation. As we were talking about earlier, as the market just went up basically since 2009 with some breaks, but pretty much up, you really didn't have to pay as much attention to other asset classes. So, this has now reawakened people's interest, I think, at least what we've seen. We think that probably is a benefit, because they're actually able to look at some of these asset classes when they are still down quite a bit. But they're acting differently than they've acted because of the volatility. Again, risk is going to drive it.
Jenna Dagenhart: Jai mentioned earlier how we saw bonds and stocks going down at the same time. Were you getting a lot of calls from clients saying, "Ah, correlations are going to one.”?
Joe Montgomery: Yeah, exactly. That's why the people that owned a broader mix than just what's called the standard 60, 40, if you go back to what happened in the past, the recovery was much quicker if they had a broader allocation. That's what's really happening here. When they looked around, they didn't go down as much, and they recovered I would say more rapidly. Generally speaking, it depends on model, but that really has been an awakening. Therefore, I think you're seeing more and more discussions, I'm sure daily on your programs, about asset classes that pretty much were set aside not too long ago.
Jenna Dagenhart: And using asset allocation to manage risk.
Joe Montgomery: Right, exactly.
Jenna Dagenhart: Jai, how would you say that you're managing risk?
Jai Jacob: I would agree with what Joe said and then what you summarized it. I think asset allocation is the primary way to manage risk. I think another point, just to touch on that Greg had mentioned, it's about uncertainty. I think that in a time like this, when uncertainty is prevalent in markets, it's critical to think in probabilistic space, and think about it as a statistical exercise because, there are a lot of emotional investors that are out there, there are people who are going to be responding in ways that are difficult to anticipate. That's not just limited to market participants, that could be government officials of various kinds and policy makers. So, probabilities are a very useful way of conceptualizing what's going in markets.
Jai Jacob: Because, it also when you consider things, if we look at something like where we are in the business cycle, if we look out a year from now, it is not possible for us to know with certainty where we'll be in that business cycle. What can happen is, people as they start discussing it and as they get into arguments, you can make very good cases that we'll be in a recovery, you can make a good case for we'll be in a recession. It's about the marginal strength of those cases, that I think is the real subject of risk management. It's about saying, "Not that I think this should happen, but that I think that this will happen," and that's an important emotional disconnection that I think for risk management is critical. Is that, there is a probability out there of something bad happening and something good happening, and try to size those probabilities as opposed to becoming attached to one of the specific outcomes.
Jenna Dagenhart: And acknowledging behavioral finance.
Jai Jacob: Absolutely. I think that when we're, and we have been in a bit of this for the last 10 or 12 years, it has policy, fiscal and monetary policy have a huge impact on markets. Policy makers are not thinking about our portfolios when they're making their decisions. It's for us to look at what they're doing and what they might do, try to understand the width, the size of that distribution if you like, and try to handicap really what is likely to happen, recognizing that a certain percentage of the time your point estimate could be wrong.
Jai Jacob: You've got to have, and this is where Joe's diversification point, I think is so critical, there are a wide array of asset classes that are going to respond differently. Picking one of them because you have a very strong and maybe almost irrefutable thesis about what you think might happen, is actually very dangerous. Because, irrational actors can come in, that could be behavioral as you mentioned Jenna, or it could be policy-driven, that can take that very sensible thesis and turn it on its head. That's I think where that diversification and the probabilistic investment as a philosophy are key.
Jenna Dagenhart: Greg, how do you think investors should think about capital allocation policies in cyclical versus defensive sectors?
Gregory Squires: Clearly, a progressive type of dividend policy or shareholder return policy in a crisis like this, it shows you once again, that's really only something that can be maintained in more defensive parts of the market. So, healthcare and utilities are good examples of that, and parts of telecommunications. By contrast, on the cyclical side of the market, so for industrials, materials, financials, prior crises and this crisis, are showing us once again that the notion of a progressive payout policy, it really doesn't fit. What we actually like to see from cyclical companies in times like this, is preserving cash flow. One of the things that that can enable management to do is hopefully deploy that cashflow counter-cyclically. That's what we aspire to do as value investors touching on this behavioral point when others are fearful.
Gregory Squires: So, that's an important part of capital allocation. I think again, the timing of this recovery is quite uncertain. So, if you're in a more cyclical business, if you're a bank right now, it does make sense to reign in the capital distribution to shareholders, because you just don't know the extent of the crisis. But then, position yourself to emerge on the other side even stronger and then resume those payments. I think those companies will be rewarded for taking those steps.
Gregory Squires: One other thing I would note is, not all cyclical companies are alike. So, to give you an example, we recently had the opportunity to purchase shares at a deeply discounted valuation, very high free cash flow yield, in a diversified iron ore miner, that has an extremely strong liquidity profile, next to zero net debt on the balance sheet, and assets that are so low on the cost curve that they've been able to generate very strong returns through a variety of commodity price environments. So, for companies like that, we fully appreciate investing in cyclical industries. It means, that underlying dividend may not be stable through the cycle, but experience has shown companies like that tend to lead recoveries coming out.
Jenna Dagenhart: Jai, any sectors that you'd like to highlight?
Jai Jacob: Well, I think actually we're in an interesting moment because, the traditional definition of sectors, I think a lot of the innovations that we've seen in terms of data and technology have let us maybe redefine the sectors to some degree. I think if you look at things a little bit more thematically right now, you could find some interesting companies that might not at first have seemed to have that much to do with each other, but may be participating in a bit of a broader theme. There are themes and the demographic space for example, that if you focus on those cohorts of the demographic pyramid that are not saving, so those that are just coming into the workplace and those that are just leaving, you would have gone in with that approach focused on things like video games and healthcare, and those would have done you pretty well in this environment, right?
Jai Jacob: Now, that generational or demographic investing, it's not necessarily a sector in the traditional sense, but if you think a little bit differently about how we tend to categorize things, I think now's a good time to find some of those themes and look through the supply chain. There's, I think another area which also touches this a little bit on the ESG side, in terms of the commodity space, and particularly in food security and agriculture. I mean, you're seeing I think what could be a pretty significant change that might last a lot longer than people think, about how we source our food, what practices we use and how we secure the entire food supply chain. That's going to have a lot of opportunity in it in terms of where the food comes from, what companies participate.
Jai Jacob: It looks past just a single sector of the marketplace. It's about who is supplying the drones for farmers, who are able to now go in and actually pinpoint specific plants, believe it or not, and actually just deploy small amounts of pesticide on a tiny scale, where he used to have to spray entire field. I mean, those types of innovations they sometimes are called, they're in tech, they're in pharmaceuticals, they're all over the place, if you can re-categorize the way you think about sectors, I think then it actually starts to resonate and it makes a lot more sense from a logical perspective, when you're trying to stack up these opportunities against one another.
Jenna Dagenhart: Especially in a crisis like this one, there isn't exactly a sector for Peloton, Netflix, Lysol, Clorox.
Jai Jacob: Well, this like a lot of other events, it almost creates its own sector, right? What you're describing is really the COVID sector, and you could add Amazon to it and a couple of others. I think that re-categorization, it's critical. Its really what asset allocation comes down to, right? It's constantly reclassifying what you're seeing so that it fits reality. It can be dangerous to get into the rigid structure that is provided by the index providers, which just say, "Okay, well this is a technology company and this is a bank." A lot of those things don't really make sense anymore, and we should as investors always be comfortably ahead of the index providers in reclassifying things.
Joe Montgomery:Great point. Great point. I mean, you had the same thing with emerging market debt years ago. People barely knew what emerging market debt was, much less what was dollar denominated and what was local currency. So, these things come along, you add them. Infrastructure, there's still discussion about whether that's an asset class. There's a lot to go there.
Jai Jacob: Yeah. These are fundamental factors, right? I mean, I think that's what it comes down to. The word factors end up being associated exclusively with quantitative investing, and that's not true. I think that a new asset category, infrastructure is a great example as well. It spans different traditional sectors. If you can create those fundamental factors, you're really investing in things that have a certain risk in common. If you want to invest in a specific risk, why have all the other risks that come with it? If you can isolate it a little bit better, then I think you can at least get a little bit more precise in terms of profiling your overall portfolios risks.
Jenna Dagenhart: Yeah. Looking forward, we discussed a lot of headlines going around today. There's economic data, fiscal stimulus, monetary policy. Joe, how are you communicating all these developments to clients?
Joe Montgomery: We're having even more conversations than usual. We're doing a lot with video, take your pick of the variety. We're trying to communicate with people about the value of active work, and just all the broader allocations we're talking about. We're reaching out almost every way imaginable. I think it's truthfully what we've always done I think as a profession, but it's even more so today. It has been very exciting to see the ways it can be done. Far reading on information, like the information you folks were putting out and sharing it with people.
Jenna Dagenhart: How are you all keeping in touch as well, Greg, starting with you?
Gregory Squires: Sure. So, there's obviously a laundry list of new developments that we're tracking on a real time basis. But, one of the things we're trying to do as we digest those is, understand the transmission of them to the real economy. So, to get that level of insight, we're spending even more time than usual engaging with management teams. In some cases, that's now meant a regular weekly video call with senior management, to understand, how some of these loan programs are working in practice, to help gauge those impacts. Then as Joe pointed out, communicating them through the wide variety of new media that we've all embraced in this work from home environment.
Jenna Dagenhart: Jai, anything you'd like to add here?
Jai Jacob: I think we also, I mean, I think the way that we've communicated in a time like this as we typically do with our clients, is to actually put out the probabilities around some of these key matters and say, this is what we're seeing from different scenarios, and this is how those probabilities shape out. Then, we try to give our clients as many of the different perspectives as possible. We try to avoid having a house view where everyone from the organization thinks the same way. Because, of course that's not true. We have people who are on both sides of the recovery path. As Joe mentioned, all the letters of the alphabet have been bandied around in the office, in the virtual office space. I think that debate is very healthy. Having the right forum for that debate and encouraging it I think is critical.
Jai Jacob: Increasingly, I think clients appreciate that. They appreciate that we are actually trying to find something that is more probable as opposed to just creating that good soundbite, which, there's plenty of those available in the other sectors of the world. So, we'll do the boring job of trying to just communicate in probabilities I suppose.
Jenna Dagenhart: Having those healthy debates, Jai.
Jai Jacob: I think the debates are really important, and even more now maybe than they were because of how polarized the way that people communicate has become. I think they'll look back at the communication changes that have been going on in the last couple of decades, in a few hundred years, and they will really see how it changed society. I think that you've gone from your trusted dispassionate news to really, you have to try to consume as much of it as you can, because there isn't really that right down the middle view. You have to create your own objective assessment of facts, and you have to get as data-driven as possible. Having those debates, I think it's critical. It's tough because people get passionate about these things, as you can imagine.
Jai Jacob: Being able to step aside and say, "Well, I'm going to take the other side of this argument." Those are really helpful tools to be able to say, to understand that that probability has some ownership, that scenario could happen and here's how it could happen, and you've got to be able to argue against your own arguments. I think that's just critical to a good risk management.
Jenna Dagenhart: Joe, anything you would like to add here? Final thoughts? Where do we go from here?
Joe Montgomery: Well, I think this too shall pass. I think we will come out of it stronger in the long haul. I think it's going to be more stressful in the near term just because of how the virus gets cured. But, as it does, I think it will open things back up. I think what'll come out of it, people will continue to broaden their mix. I do think they're more open to looking, and just from a pure investment standpoint, they will be better off in the long haul.
Jenna Dagenhart: Greg, any final thoughts on your end?
Gregory Squires: Sure. I think at the end of the day, we're optimistic that there will be solutions to the health crisis as we've discussed. It's anybody's guess, the timing, the exact shape of what that resumption of economic activity will look like. But I wouldn't want to bet against human innovation in the long run. I think this is going to be another example of that eventually. What we're communicating to clients, and what we're really focused on is, right now we are seeing opportunities as value investors to own high quality businesses at deeply discounted prices, that are implying severe value destruction in perpetuity. So, I think taking advantage of those opportunities in times like this is critical. As we've seen, we talked about prior crises, one of the common threads has been out-performance of some of the most beleaguered parts of the market in each of those crises, when that recovery does come. So, we're recommending that investors gain exposure ahead of that clarity on the recovery.
Jenna Dagenhart: Jai moving forward. Any final thoughts on your end?
Jai Jacob: I think that it's been, as both Joe and Greg have mentioned it. I think that this is first and foremost a health crisis. I think that the more monetary and fiscal policy recognize that it's a health crisis, the faster that we'll get through it. From an asset allocation standpoint, we're keeping our eye very closely on different measures of volatility. That means taking gradual steps back into the market, and being ready to act if we start to see things getting worse. But I would agree broadly speaking with what Greg and Joe have said, that we will get through this, opportunities will be made by this dislocation as they always are. I think it's just, we've got to solve that first point of the triangle, and the other two sides of it in terms of fiscal and monetary, have got to just be focused, I think on facilitating and providing that relief for the recovery.
Jenna Dagenhart:No matter what shape that recovery does take, as we discussed earlier. Who knows? There might not even be a letter for it, right?
Jai Jacob: I'm still waiting for that B shaped recovery.
Jenna Dagenhart:I've also heard maybe Nike Swoosh who knows.
Jai Jacob: I think that was the product placement, right?
Jenna Dagenhart: Yeah, yeah, maybe. Well gentlemen, it's been a pleasure hosting all of you. Thank you so much for your time and your insights.
Joe Montgomery:Thank you.
Jai Jacob: Thank you.
Gregory Squires: Thank you Jenna.
Jenna Dagenhart: Thank you for watching this market volatility and investment strategies masterclass. I was joined by Greg Squires, Fundamental Senior Research Analyst at Causeway Capital, Jai Jacob, Managing Director, Portfolio Manager and Head of Multi-asset Investments at Lazard Asset Management, and Joe Montgomery, Managing Director Investments at the Optimal Service Group of Wells Fargo Advisors, and I'm Jenna Dagenhart, with Asset TV.