With so much ink having already been spilled on the horrible year that was 2020, we see little reason to review the past year in any significant detail. 2020 was marked by a global pandemic, consequential economic carnage and, especially in the case of the U.S., increasingly toxic and divisive political discourse. Yet despite all these factors (and the market volatility that accompanied them), risk assets around the world generally performed quite well, with major U.S. equity indices posting double digit returns for the year. Though many were confounded by the dissonance, others were dismissive of it, quick to remind us that “the markets are not the economy”. While there is certainly some validity to that point, that markets were able to perform so well in a year marked by so much human misery, economic calamity and uncertainty about the future surely required a more satisfying explanation than that.
As such, it is unsurprising that there were many theories floated to justify this disconnect. Some pointed to the largesse of central banks and governments around the world, with the unprecedented monetary and fiscal response to the COVID-19 crisis providing significant support to markets. Others believed an explanation could be found in the rise of passive investing, which, uninterrupted during this year, meant that risk assets continued to find new buyers, regardless of their valuation or the situation at hand. Looking beyond liquidity or flows-based explanations, some pointed to innovation- whether it was telehealth, remote work, or ecommerce, many felt market gains were justified by the pandemic’s speeding up of digital transformations, and the value that was being created in the process. Finally, when all else failed, some opted for a simple, and perhaps rather optimistic rationalization: the forward-looking nature of markets meant that this dismal situation was merely being ignored, with eyes to the recovery and a rapid return to relative normalcy.
In our eyes, these explanations each have at least some degree of merit to them. Indeed, the real answer may lie in a combination of some or even all these narratives. Yet regardless of what truly drove the remarkable performance of risk assets in 2020, we believe it is most important to consider what it says about the market environment, and how best to navigate that environment going forward. To that end, though these somewhat logical and benign theories may have catalyzed the market’s recovery, as the year progressed, we feel the story became much more about “animal spirits”.
We have pointed to signs of froth in the market for quite some time now, even before the outbreak of the pandemic. Initially, we were of the belief that the market rout experienced early this year would rein in some of the riskier behaviors we were pointing to. Yet as markets not only recovered and surpassed their previous high-water marks, it became overwhelmingly clear this was far from the case, especially given that the recovery was led by the issuers with the most uncertain prospects, the dodgiest balance sheets and the most demanding valuations. At the same time, it seemed that the pool of speculators had widened significantly, as a new generation of retail day traders entered the market. This contingent seems to have a penchant for using options and other derivatives for leverage and, to put it charitably, appears to be quite “agnostic” to fundamentals. Though some have sought to blame every market anomaly or absurdity on these newcomers, we feel they represent merely a symptom, rather than the cause of, this frenzied environment.
While we have cited no shortage of examples of reckless investor behavior over the course of this past year, yet another cannot hurt: As initial public offerings (IPOs) require their subscribers to commit capital to generally younger, unproven businesses, IPO activity can be a useful barometer of investor risk appetite. With $155.95 billion in new equity raised (excluding follow-ons or rights offerings), 2020 was far and away a record year for IPOs- for some context, the previous year to hold that title was 2007, where a “mere” $86.38 billion was raised. While this is telling in and of itself, we also feel there is much to be said about the fact that an outsized proportion of this new equity capital was raised for SPACs. For those unfamiliar, a “SPAC”, or special purpose acquisition company, is a publicly traded shell corporation that is formed to raise funds for the acquisition of an existing private business. Sometimes referred to as a “blank check” company, the management team of a SPAC is effectively given the mandate (and capital) by its investors to go out and find an acquisition, usually within the management team’s circle of competence. For all parties involved, SPACs appear to have something to offer: private businesses receive access to public markets without going through the traditional IPO process, retail investors get access to deals normally limited to the private equity space and the SPAC’s management team is typically given a healthy portion of the acquired business’ equity (on average 20% of the business, known as the “promote”). While we certainly see some value to the SPAC structure, we also see it as one rife with potential for abuse, resulting in misallocated capital at best and fraud at worst. Yet despite this, an unprecedented 47% of the value raised in IPOs this past year came from SPACs:
For us, the notion that investors were effectively willing to write $73.45 billion in “blank checks” to the equity market in 2020 tells us a great deal about the state of the world today. We clearly are not the only ones in a state of incredulity at these activities, and as such, we are quite unsurprised that there is a growing chorus of market pundits who are calling this a “bubble”. While we might well agree, we do not necessarily believe such a label is even necessary to conclude this is an environment where one should tread quite carefully. Consider valuations, which only became more stretched in the back half of the year, by some measures even surpassing the levels seen in the late 1990s and early 2000s:
As such, we feel that now more than ever it makes sense to maintain our cautious positioning in client portfolios. Though our holdings certainly enjoyed plenty of upside in 2020, we have lightened positions in companies where the run-up in value was clearly detached from economic reality. The stratospheric valuations of those companies even tangentially related to areas like clean energy, industrial tech or chipmaking meant that taking some profits generally felt prudent. Though the question of opportunity cost, at least in the near term, occasionally came up, we felt this tended to pale in comparison to the potential for losses if/when valuations came more in line with historical averages.
The question of “when” such a normalization might occur was certainly a topic our team explored a great deal in the second half of 2020. Looking to past periods of market euphoria, we came to find that those who accurately call bubbles are frequently wrong in the short run (or early, depending on who one asks). While this review of market history reinforced our view that market timing is more or less a fool’s errand, it also reminded us that market froth can endure a good deal longer than any reasonable person expects. As such, while defensive positioning may be prudent, one cannot merely sit in riskless assets, especially when such assets frequently possess negative yields on an inflation adjusted basis. Instead, one must try to seek opportunities in markets that are distant from the red-hot excesses, and, ideally, possess a compelling risk/reward proposition.
Consider, for example, our recent investment in Equity Commonwealth (Ticker: EQC US Equity). Formerly known as CommonWealth REIT, the company is an internally managed and self-advised real estate investment trust that for most of its life has focused on commercial office properties in the United States. After years of mismanagement, shareholders opted to appoint a new Board of Trustees and management team led by Sam Zell as Board Chairman in 2014. Mr. Zell has been a leader in the real estate space for over half a century, and his firm, Equity Group Investments, has produced some of the largest REITs of the modern era. Much of the new management team comes from Equity Group Investments and has demonstrated their skill as they have adroitly stabilized and sold off the majority of Equity Commonwealth’s office portfolio over the past six years. Since taking the reins at Equity Commonwealth, this management team has created a great deal of value for shareholders, selling 164 assets for a total of $7.6 billion, with the proceeds used to repay $3.3 billion of debt and preferred stock and pay another $1.2 billion in special dividends to common stockholders. Though several high-quality properties remain, most of the business’ value now remains in the roughly $3 billion in unencumbered cash which management is looking to deploy. Our takeaway from earnings calls over the past year or so suggests that management is not taking this decision lightly and is leveraging the insights and experience of Mr. Zell and the Equity Group team to find just the right opportunity. While some have bemoaned the slow pace of this decision-making process, we believe being deliberate and thoughtful makes sense at a time when the post-pandemic world may in time yield great prospects for a skilled, well-capitalized real estate investor. Even if this proved not to be the case, Equity Commonwealth could simply elect to continue distributing cash to shareholders, which creates a meaningful backstop in our eyes.
While seeking out special situations with a seemingly positive asymmetry is one way to remain involved in risk assets while avoiding market froth, we also feel there is value in “flying under the radar” and seeking out those opportunities that are simply outside the purview of frenzied retail traders, and too small for most large institutional investors. We added one such investment in our Focused European Equity Strategy at the end of the year, taking a position in Picanol Group (Ticker: PIC BB Equity). Based in Ieper (Ypres), Belgium, the company has historically been known as one of the world’s largest manufacturers of industrial weaving machines. However, infighting amongst the founding family and the stresses of the Global Financial Crisis put Picanol in significant distress at the beginning of the last decade. Serial entrepreneur Luc Tack took majority ownership of the company and engineered an impressive turnaround, plowing the cash flow generated by this business into shares of Belgian industrial concern Tessenderlo, of which Picanol now owns the majority stake. Bringing Tessenderlo’s interests in agricultural chemicals, bio-valorization, industrial solutions and power generation into the fold, Picanol is now a conglomerate in its own right. By our estimates, the company trades at a significant discount to the sum of its parts, and we are confident Mr. Tack’s leadership and his ability to create further value in the future. Luc Tack’s majority ownership of Picanol means free float is limited, which likely explains some of the discount, but we believe there are transactions which could improve liquidity. While this would be an additional catalyst for the business, it is not necessarily a part of our base case. Come what may, we believe value can continue to be compounded by this impressive collection of businesses run by an equally impressive owner-operator.
While frothy markets mean one must be creative when it comes to finding compelling opportunities, risk management must also remain top of mind. In addition to thinking about the issues surrounding the timing of (or inability to time) a possible dislocation in speculative markets, we also considered some of the factors that may precipitate said dislocation. In the past, we have pointed to the possibility of further pandemic-induced financial distress amongst households, corporates and governments being a potential issue, albeit one delayed into 2021. While it remains to be seen whether this will be the case, we feel credit markets have been quite complacent about such risks, especially given the mismatch between credit spreads and forecast default rates in the coming year. At the same time, we also are of the belief that markets are frequently painting an inconsistent picture of the timing of a return to normal economic activity post-pandemic. While it is our sincere hope that we are nearing a “darkest before dawn” moment as cases and deaths again rise and vaccine distribution begins, the fact is the timeline of the recovery remains quite unclear, and markets may well be mispricing the ultimate outcome.
In addition, we have also thought a good deal recently about the question of inflation’s impact on interest rates going forward, especially in the U.S. Undoubtedly, investors around the world have constructed their portfolios operating under the assumption that interest rates will remain low for quite some time. Given the paltry yield of riskless assets, these investors are frequently forced to commit capital to increasingly risky equity or speculative credits, citing a lack of solid alternatives. However, despite the pledge of central banks to indeed keep base rates at, near or even below zero for the foreseeable future, we feel that the recent steepening of the U.S. yield curve suggests that investors may be wise to consider the prospect of higher rates. While some of this is driven by the potentially imminent return to more normal economic activity, we also believe there may be an inflationary component at play. The beginning of 2021 saw the breakeven inflation rate (the difference between the yield of a nominal treasury versus an inflation-linked government bond) cross 2% for both 5- and 10-year maturities. A measure of market inflation expectations, breakeven rates were not this high pre-pandemic, and had not breached the 2%-level since 2018. While some dismiss this as merely a reflection of “reflation” expectations in the face of a prospective return to normal economic activity, others (ourselves included) cannot help but wonder whether this may be the harbinger of a move towards more sustained rates of higher inflation. We have recently watched the prices of energy and various agricultural commodities rise dramatically, and though there are indeed signs of a recovery, we have seen cases where prices are actually surpassing pre-pandemic levels. Given that commodity “shocks” have spurred inflation in the past, we feel that, at the very least, some vigilance on this front is prudent.
Though the Federal Reserve has openly welcomed the prospect of some inflation, one would be remiss not to recognize the potential for a policy misstep. This past year, the Fed adopted a policy of “average inflation targeting”, meaning that the 2% inflation rate the central bank seeks to achieve would be a long-term average of inflation, not a hard cap at any given point. This signals a willingness to let inflation run higher than 2% for some time, and with the “red line” now blurrier, we wonder if it is possible the Fed could (as they have in the past) lose control of the trajectory of inflation. While direct interventions in the Treasury market could help keep somewhat of a lid on things, we would not be shocked if increased inflation (or expectations thereof) drove rates somewhat higher going forward, regardless of central bank targets.
As such, as the year drew to a close, we allocated a portion of client fixed income holdings to Treasury Inflation Protected Securities (TIPS) which, in our eyes, should offer some protection should inflation indeed make a comeback. As an added bonus, given that an inflationary environment would likely force a greater degree of price sensitivity on the part of investors in risk assets, we feel this position could also provide us with additional dry powder for future investments at more reasonable valuations. Yet even if rising prices do not materialize, we believe that the relatively low duration of the position combined with its lack of credit risk mitigates our downside. Here again, we seek to create opportunities by seeking out positive asymmetry.
This continues to be a difficult environment for investors who believe in the importance of fundamentals and risk management, and a comparatively easy environment for speculators who purchase assets merely with the hope of finding a new, higher bidder. This is not the first time we have encountered such an environment, nor will it likely be the last. As a matter of fact, investors have found themselves in periods of irrational exuberance for centuries. For those interested in learning about one such period, we highly recommend you read “Confusion de Confusiones” by Joseph de la Vega. Written in 1688 by an Amsterdam merchant following the establishment of what become the first modern stock exchange, and it details the life and times of speculators in shares of the Dutch East Indies Company. The parallels we found with Amsterdam in the 1600s and global markets today were as numerous as they were shocking. They also served as a reminder that the success of the speculator is often short-lived, while a fundamentals-based, rational investor can endure, so long as they remain disciplined and true to their methodology.
To that end, we would like to remind you that should you have any questions about aspects of our methodology, specific portfolio holdings, or your positioning going into this new year, we encourage you to get in touch. Similarly, if you would like further information on our higher-level views, and where we are seeing opportunity now or in the future, we welcome the conversation. We plan on posting your Investment Policy Report to your Drum Hill client portal shortly. This report outlines the current allocation targets and risk levels used to manage your portfolio. We encourage you to read it carefully and to reach out with any questions or concerns.
Undoubtedly, 2020 was a challenging year in so many respects for all of us. It is especially in times like this that we emphasize how greatly we appreciate your support and trust. We wish each of you all the best in what we hope to be a happier, healthier, and prosperous 2021.