We hope this letter finds you and your loved ones healthy and safe during the current pandemic. COVID-19 is first and foremost a human tragedy of vast proportion. As a society, we are adapting to challenging circumstances, the most important of which is the risk to our health and lives. The financial consequences have been an unprecedented worldwide economic shock and monetary stimulus to mitigate its impact.
This stock market correction was unexpected and painful, but our portfolios were already positioned to weather the storm: almost all hold high-quality US bonds and bond funds as a way to reduce volatility. Remember that during 2019’s rising equity markets, we were reducing the stock allocation to buy bonds. More importantly, for those of you depending on your investments to fund your retirement, this stable portion of your portfolio represents several years of anticipated spending. This is also by design: it allows more time for stocks or stock funds to recover before we need to sell any.
Holding a balance of stocks and bonds generally meant that portfolios’ values dropped less than various stock categories around the world (see table below under Capital Appreciation). During the 1st quarter, logically, the size and percentage of the decline depended on the relative size of the stock portion. However, our balanced portfolios lagged a similarly blended stock/bond benchmark (Note: your results may differ—please refer to your Quarterly Portfolio Review Report.) It was due to a combination of reasons, some expected and others less so. Let us review the three main allocation buckets, Capital Appreciation, Income & Preservation, and Other Assets:
Significant Disparities in Declines Among Stock Categories
The Capital Appreciation bucket includes stocks and stock funds. This is where your portfolio growth is expected to come from over time, but it is also the most volatile of the three. We attempt to remediate that by diversifying further among stocks from six types of companies: US Large, US Small, International, Emerging Markets, Real Estate, and Natural Resources.
Candidly, we knew that such diversification does not necessarily help during bear markets. It helps by smoothing out medium to long-term returns through different economic environments. During the 1st quarter, the US Large companies’ segment—as measured by the S&P 500—declined the least. While it dropped by about 20%, all other categories fell by 22% to 30% (e.g., US Small). And, logically, the capital appreciation bucket declined further as well.
We also emphasize valuation-sensitive strategies when selecting stocks and stock funds. As we’ve discussed numerous times over the years, this “value” approach is grounded in common sense (e.g. buying $1.00 worth for 70 cents) and supported by a long record of academic studies. Value has historically delivered higher long-term risk-adjusted returns than a broader index. However, it can also frustratingly underperform the overall market for long periods, and it has a mixed record during bear markets. For instance, value stocks dramatically outperformed the S&P 500 during the dot.com bust at the start of the 21st century. They underperformed during the down legs of the 1974 and 2007-2008 bear markets but outperformed during the first few years of the ensuing recoveries. In this most recent downturn, value stocks underperformed again, another reason why the capital appreciation bucket fared poorly.
High-Quality US Bonds Provided a Refuge from Volatility
The Income & Preservation bucket is mostly made up of very high-quality US bond funds or bonds maturing in 3 to 5 years (short to intermediate maturities) on average. Our primary goal is to minimize volatility and to preserve capital during bear markets. Thankfully, it worked as expected: performance was flat to slightly positive during Q1. This relative stability is particularly important to our clients who are retired and withdraw funds regularly.
Nonetheless, our investment selection for that bucket did lag the Barclays Aggregate Bond Index return of 3%, which we use in the calculation of your blended Global Stocks/US Bonds benchmark. The discrepancy was somewhat expected: while the index includes only intermediate US taxable bonds, our portfolios include a wider variety of fixed income securities more suitable to our investors. Some own municipal bonds, which have lower yields than the index, but provide higher after-tax returns. Other portfolios hold a significant proportion of short-term bonds to fund regular withdrawals. Short-term bonds’ prices do not benefit from lower rates as much as the intermediate bonds in the index. To conclude, our clients’ portfolios are designed to match their situation and goals, not a bond benchmark.
Other Assets’ Performance Was Right in the Middle
Finally, we have a 3rd more esoteric bucket called “Other Assets”. With interest rates declining to historically low levels, we introduced this category a few years ago. The goal is to provide moderately higher returns than bonds but also, potentially, offer more protection when rates inevitably start rising again. In this bucket, we own variable preferred securities, as well as arbitrage and event-driven equity strategies. Although labels might be unfamiliar to you, we expect these investments to be more volatile than bonds but less so than stocks. Indeed, during Q1, the category declined on average by about 10% to 15%, about half-way between the stock and bond buckets. Although expected, this ended up penalizing our portfolios’ performance comparison with the balanced benchmarks, which contain only two buckets, global stocks and US bonds. Other Assets’ investments are implicitly included with and compared to the bond slice.
Should the Tail Wag the Dog?
The first lesson to draw from this review is that market benchmarks need to be used thoughtfully when analyzing short-term performance. Your overall portfolio’s asset allocation is tailored to fit your situation and to meet your goals, not to track a simple stock/bond blend quarter by quarter or even year by year.
Over time, your situation and goals change. As your investment manager, we regularly make choices that put your portfolio at odds with benchmarks. For instance, we might recommend being more conservative or more aggressive as your circumstances change. Or, we might emphasize certain types of investments as your income needs or tax bracket change. These changes may have a negative impact on the relative performance of your portfolio, even if they improve your absolute after-tax returns.
Therefore, we fully expect that your portfolio will not track its benchmark and will go through cycles of lagging or exceeding, sometime by a wide margin. We anticipate being closer over your time horizon (10, 15 or more years) though. Still, in combination with the Required Rate of Return (margin over inflation) that we calculate in your quarterly statements, blended stock/bond benchmarks provide a useful bogey for the real, long-term returns that we aim to achieve in order for you to reach your goals.
Second, one might wonder whether this recent experience has implications for our views on diversification and value investing. It does to a certain extent and we always strive to keep learning. As steward of your capital, we continuously review and adjust our process. For instance, we introduced a dividend appreciation strategy to our US Large-Cap line-up a few years ago to reduce this segment’s value bias. The fund we picked (Vanguard Dividend Appreciation ETF – VIG) tilts towards shares of mature, financially strong and profitable companies. It helped overall performance since the fund shares outpaced the value benchmarks (and S&P 500) since then. There will be lessons to be learned from the current crisis as well.
At the same time, we refrain from making wholesale changes. Charlie Munger, Warren Buffett’s long-time partner at Berkshire Hathaway, likes to say that one of the keys to great investing results is “sitting on your ass.” Our principals have been through many recessions and bear markets, each triggered by different events. One enduring lesson is that investment categories that underperform have a very high likelihood to outperform subsequently. By selling those that lagged, we are more likely to compound our losses than see the portfolio recover during the next period (remember people who sold their stocks during the financial crisis?).
Although bear markets are painful, and adjustments are sometimes necessary, we are confident that this time won't be different. Having dramatically lagged US Growth stocks recently, we would not be surprised to see, US Value, US Small-Cap or International categories outperform going forward. Let’s touchback in 5 years.
Large-Cap Value (LCV) Stocks Review
(Not all clients of Bristlecone are invested in our Large-Cap Value Equity portfolio strategy, depending on the size of the overall portfolio, and the client's objectives and constraints)
The average LCV portfolio underperformed both the S&P 500 (-20%) and the Morningstar Large Value Index (-26%) during the 1st quarter. For additional context, the NASDAQ Composite, a technology heavy index was only down -14%. Top performance detractors for the quarter include Bank of America, Wells Fargo, Anheuser Bush, GCI Liberty, and Hanesbrand, while top performance contributors include Nestle, Cisco, Novartis, Intel, and Pfizer.
We already provided the broader context when discussing the Capital Appreciation bucket above. In the US, value stocks, and more particularly energy, financial, and consumer discretionary stocks suffered the largest declines. While we did not own any energy companies, our largest portfolio representations were in these other 2 sectors.
We added to our investments in Micro Focus (MFGP) and Anheuser-Bush (BUD) as their stock prices started declining in late February and March. In both cases, we acknowledge that the companies will see lower revenues in the coming quarters. Despite having significant debt on their balance sheet resulting from recent acquisitions, we anticipate that they will survive and may even come out more dominant on the other side of this crisis as weaker competitors pull back.
One company deserves a more in-depth discussion: Expedia (EXPE). We increased our investment back in February but sold it entirely on April 15 at a loss, a very unusual and quick reversal for us. It is hard to imagine, but a few days before we decided to add to our position, Dr. Anthony Fauci was telling readers of USA Today that the risk of coronavirus in the US was “minuscule”. No travel restriction, social distancing, or stay at home guidelines had been implemented in Europe or America yet. Since then, the business environment has deteriorated considerably, particularly for travel service providers.
Expedia is the leading online travel agent (OTA) in the US. It owns numerous digital properties such as hotels.com, Orbitz, VRBO, TripAdvisor, etc. Until recently, the company was growing revenues in the mid-teens thanks to the increased adoption of online booking by individuals and corporations. As of the time of this commentary, the company has borne the full brunt of the COVID-19 crisis. Revenues for hotels, flights, cruises, and other tourism dependent industries are down 70%, 80% or more.
We still like the OTA business, and we believe that people will travel again at some point in 2021 and later. But, despite being down significantly, we do not necessarily see the share price as an opportunity. Revenues will remain at decimated levels for a while, at least 2 months and possibly more. We do not feel comfortable modeling the impact of such a dramatic decline in revenue on Expedia’s balance sheet and liquidity. And, we no longer have enough confidence in our appraisal of the company’s value.
Expedia will be in survival mode for a while before participating in the eventual recovery. It has suspended share buy-backs and drew on its line of credit. If bookings remain depressed for long, it might be required to sell assets, issue debt or equity securities at unattractive terms, in order to raise cash and maintain its operations. Such transactions typically result in dramatically reduced returns for existing shareholders. The travel and tourism industries, alongside entertainment and restaurants, will be among the last businesses to re-open. We anticipate some horrid months ahead for these companies and their shareholders and felt it was prudent to liquidate our investment.
The unprecedented economic lock-down that we are currently enduring will provide investment opportunities. But we are not interested in taking advantage of undervalued shares of companies that might not survive. Higher quality stocks may not always bounce back as rapidly as the more speculative fare, but our experience is that they will provide very strong returns over the next five to ten years.
Thank you for your trust during these challenging times. Stay healthy.
Disclosure Brochure Offer
If you receive your 1st quarter statement by mail, a copy is included for your convenience. If you elected to receive your statements through our online portal, the disclosure brochure is available for download on the US Securities and Exchange Commission's Investment Adviser Public Disclosure website by clicking here, but we’ll be happy to mail you a copy free of charge (call 310-806-4141 or email email@example.com)
You may also find additional information about our firm at our website, and through the same Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov. We are also required to adopt a code of ethics and provide a copy of which to clients upon request.
Please contact us immediately if you have had any changes in your investment objectives or financial circumstances. Any changes could impact how we manage your portfolio and will become part of your client file. You should also contact us at any time during the year if your investment goals and/or financial circumstances change. Should you hold equity securities in your portfolio, you will be responsible for the voting of proxies with regard to those investments. We typically do not vote client proxies unless specifically requested.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.
Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.
This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.