In this monthly letter to begin the new year, we are hoping to offer you a look back at some of the worst days in market history and the adjustments in our thought process that ensued. Stay tuned for some forward-looking thoughts on the economy and equity markets in Part 2.
We are equity investors that adhere to the philosophy of value investing. In its most basic sense, all value-investing-as-a-philosophy means is that we are using our human judgment to buy stuff that we believe is worth more than what people are currently willing to pay for it. The broadness of this definition rivals the definition of investing itself. As overused as the label “value investing” is, the flavors of methodologies and critical thought that goes into estimating intrinsic value are highly variable and broad in scope. Towards the end of 2019, we had been accumulating a large cash position relative to our portfolio - not as a result of trying to maintain a defensive asset allocation - but more stemming from a dearth of opportunities in the equity market. Aside from pockets in commodity-based sectors, everything we screened for was richly valued. Our mantra at the time was an old-chess-saying: tactics are what to do when there’s something to do, strategies are what you do when there’s nothing to do. We kept busy by adding to a well-procured watchlist hoping that some of these names would go on sale at some point. Even though we did our best to keep an opportunistic mindset, we feared that the sales we were looking for would not happen for many years.
Enter COVID and the fastest 30% drawdown ever.
By the middle of February, the coverage around COVID was deafening. Our view was too quick to draw from precedent and we decided that the resulting market impact would be similar to the Bird Flu, MERS, or SARS epidemics. Given the media’s job is to drum up attention and not provide allcapbros with a sobering and objective view of the world’s current events, we ignored their sensationalism. Then the news around the epidemic kept getting worse and the market kept selling off……rinse and repeat.
Towards the end of February, the market sold off a quick 12% and the notion that we were dead wrong began to emerge. We dove into the COVID data and strongly believed that it wasn’t as dangerous as the coverage was making it out to be. Yes, the death rates for the average person were higher than the flu but we were not even close to Spanish Flu levels. Regardless of what the facts were, the societal fear was so strong at this point it had a momentum of its own and staggering real-world effects. A full-blown market crisis was upon us. Showtime. We wanted to take advantage of the selloffs but first wanted a rough idea of how deep the valley was in front of us. During mid-March, 20%+ daily sell-offs in certain names were not uncommon. Unlike other past market meltdowns, this selloff was highly discriminatory across sectors and debt profiles. The market was pummeling cyclical and leveraged companies but names in less cyclical sectors with moderate debt profiles were not hit to the same degree. Spray-and-pray was a risky strategy that we wanted no part of. Cash had become scarce again and before we put it to work we were desperately looking for some evidence or reasoning that might lead us to believe that things were going to be okay. Sadly, all our conclusions left us clutching onto cash even tighter.
At the very bottom, time to be bearish?
On March 16th, 2020 the S&P was down 12%, the third-worst day in the S&P’s history. There were wide-scale margin selling and total capitulation. You could feel the collective anguish in your gut. The day before, the Fed had announced their second rate cut since the onset of the crises. They were cutting interest rates from one to zero percent but how in the hell was this going to help solve the fundamental problem? The running joke at the time was that if we were invaded by aliens the first thing our government would do is lower rates. This pretty much captured our sentiment. Rate cuts are not going to solve the epidemic and get the economy moving again. As we previously admitted, the underlying nature of the disease was not so pernicious that it would completely arrest the production of goods and services but the fact that this wasn’t the Spanish flu was now beside the point because we had Spanish Flu type fear and panic. The king of animal spirits had gripped people across the world and it became apparent that a large population of people was taking precautions and staying home whether it was government-mandated or not.
Most of the corporate sectors directly affected by this could not afford to forego revenue for even an abbreviated period. Our corporate sector had been overdosing on cheap money for almost a decade. No revenue would mean an inability to service debt payments that would cascade into a wave of defaults and layoffs. This was well known by markets and it was clear the government was gearing up to distribute as much money as possible to the businesses and people in need, but, the real question in our minds was did the government have the ability to do so in time? Could they legislate the proper amount and fast enough and was there a mechanism for administration? How was the gym owner down the street that saw his membership go to zero in an instant going to get the money in time? Would fraud be rampant as people clamored for cash? Questions swirled. Our final analysis was that we didn’t think the government could do this with the speed and competence necessary. This caused us to be the most bearish at what turned out to be the bottom of the market.
We all know what happened next. On March 27th, 2020 Congress passed the CARES act that would subsequently shower citizens with over $2 trillion in stimulus and all a small business owner had to do to keep their business afloat was go down to their bank with some tax returns to receive a quick stimulus check. Also, the Fed started buying $120 billion of Treasury and mortgage-backed securities a month and with the help of congress created SPVs that allowed the Fed to effectively open the discount window to the large parts of the corporate sector. All unprecedented and done at lightning speed. Huh, well that was easy. One of the things we pride ourselves on is the ability to realize when we are wrong. We are not married to our ideas or theories and firmly believe that to be a great investor, the ability to “kill your baby" is needed. This is so ingrained in us that when developing a thesis, whether it be at the macro or company level, we have thought about different ways we may be wrong and how to pivot. It is important to do this before the fact to not get caught in an awkward denial dance when fallibility suddenly hits you in the face. Our process this time was no different. Yes, we were clearly wrong and the government had effectively covered the income shortfall and would likely continue to provide stimulus and lending, thus they successfully removed the largest obstacle impeding markets and the real economy. After this realization, we swung quickly from being bearish to bullish. We had started to miss the first leg of the upturn and we got in some names later than others might have, but we don’t ever attempt to call bottoms. When we finally did put cash to work, we had less uncertainty giving us more conviction in our sizing.
Our aggression was rewarded and by the end of the year, the S&P would surge by almost 70% since the bottom in what turned out to be the quickest upturn in market history. It is hard to believe that the S&P 500 had a peak to trough drawdown of 34% along with two daily drops of close to 10% then only several months later, the S&P 500 had rocketed back up to highs. To put this in perspective, it took the stock market 4.1 years to fully recover from the 2008 GFC, and 22.3 years to recover from the Great Depression.
From pandemics to unprecedented policy to markets in free fall and changing sociological trends, we hope to speak for all of you when we say wow, WHAT. A. YEAR. The question in everyone’s mind now is, with valuations seemingly stretched, debt levels at the government and corporate levels bloated along with continued excesses engendered by a sustained ZIRP environment, where do we go from here and what are the risks? We cover all this in Part 2.