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Children of the Revolution

May 2020

Categories: DIY Magazine

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By Thomas McMahon
Kepler Trust Intelligence

‘Good luck to anyone that just tries to copy an old playbook in this crisis. We think we had the last crisis all figured out, retrospectively, and so we think we’re so smart in the next one. It just doesn’t work this way.’ – Mark Spitznagel, hedge fund manager

One of the worst quarters in stock market history

The coronavirus pandemic is far from over, but perhaps we have seen the end of the first act; most of the developed world is in ‘lockdown’ after equity markets saw one of their worst ever quarters. It is a good moment to look at why certain trusts have outperformed, and ask whether we can draw any conclusions about how to invest in the aftermath.

The FTSE 100 suffered its worst fall since 1987 when it fell 23.8% in Q1 2020 after the likely scale of the pandemic in the US and Europe became clearer; the sell-off has been brutal and indiscriminate.

For equity trusts, sector and stock selection has had limited impact; the trusts which have done best in absolute terms are those which had built-in protection against sharp market falls or are set up to profit from volatility.

Star performers in the investment trust universe were Brevan Howard Macro (BHMG) and BH Global (BHGG); between 21th February and 27th March, FTSE All Share fell 24.7% but BHMG’s NAV rose an astonishing 25%, and BHGG 17.2%.

BHMG focuses fundamentally on rates (bonds and currencies) trading by a group of star traders; Alan Howard and his team look for trades with option-like payoffs, with minimal downside and huge upside. BH traders do not need to hold a particular view on the market, or the pandemic, to profit from the volatility; they look for trades with asymmetric payoffs, irrespective of market direction.

BHGG is a more diversified fund with an allocation to the same master fund into which BHMG feeds; it has just enjoyed the best first quarter in its history, with its rates portfolios paying off and major contributions by the volatility fund and the other asset classes invested in.

Ruffer Investment Company also generated positive returns in the sell-off, adding 3.5% to its NAV; its CDS position, the largest in the fund, returned 100% as a result of the sell-off. In addition Duncan MacInnes and Steve Russell have been picking up gold miners and cash, waiting for a better time to buy equities.

Pershing Square, the listed vehicle of Bill Ackman owns just ten stocks, all long, and so wouldn’t have been expected to do well in the crash. However, it had astutely built up CDS positions prior to the major sell-off, which made back any losses on the equity book.

Between 18th February and 31st March the trust’s NAV was up 3.9% as the S&P 500 fell 19.2%; Bill’s long-term track record is exceptional, with the share price languishing on a wide discount to NAV, and optimists will note he has started buying more of his portfolio, including reopening a position in Starbucks.


The internet of everything – technology’s impact

In more ‘vanilla’ equity funds, even the best performers have had a torrid time; however, some interesting patterns, such as the defensive performance of technology, may have implications for the future.

Technology is often thought of as being a ‘risk-on’; successful stocks trade on higher multiples than the market, making them considered growth stocks. However, trusts with high weightings to technology have done better in this crisis.

Technology indices themselves outperformed, but so did internet retailers and other online service providers which often appear in the consumer discretionary or communications sectors; Amazon, for example, was down just 6% in the sell-off.

Trusts run by Baillie Gifford in particular have done relatively well; in AIC UK All Companies sector, Bailie Gifford UK Growth massively outperformed, down 26.1% compared to an average loss of 35.6% and a worst performance of -40.7%.

In AIC North America sector, Baillie Gifford US Growth’s NAV was down just 19.8% when adjusted for its unlisted positions, which compares to a sector average decline of 25%, and the worst of -31%.

The best-performing AIC Europe trust was Baillie Gifford European Growth, down 17.4% against a sector average loss of 21.6% and a worst of -31.6%.

Even Scottish Mortgage, which entered the crisis month with 8% gearing, was a relative outperformer in its AIC Global sector; adjusting its 20% unlisted positions gets to an estimated loss of 18%, favourable to the 19.1% average peer group loss.
Tech has tech been defensive for two main reasons.

Firstly, the online economy has been critical in keeping society running during lockdown; online learning, meeting, chat services and ordering systems have surged and in our view, there is no going back.

Those who have discovered online groceries shopping are the aged told to self-isolate; they would have been less likely to shop online before, but are unlikely to go back to lugging shopping bags home on the bus.

There will be a permanent change of lifestyle for many people, and the online economy will be key; four hours a day on the train, or will Zoom et al retain many new users?

Second is the impressive way that logistics businesses such as Amazon have shifted their network to provide essentials to the self-isolating; it is so dominant in this sphere that the UK is handing it the task of delivering testing kits to citizens, possibly the ticket back to a normal life.

Accordingly, Amazon is behaving like a defensive consumer staples company on the downside and a high growth consumer discretionary on the upside, a potent combination. It is in a strong position; as is its Chinese peer Alibaba.

Amazon is a major holding in Mid Wynd (MWY), another relatively strong performer in AIC Global, down just 16.3% in the drawdown; its managers told us that many of the themes built into the portfolio helped relative returns in the crisis.

Alongside the online economy, healthcare has been a helpful theme, as has their bearish view on air travel; MWY managers believed that air travel would come under pressure for environmental reasons before the crisis.

We believe it is likely to be some time before the travel sector returns to previous levels, if ever.

Top performer in AIC Global sector has been Manchester & London (MNL), which has benefitted from both key factors discussed so far. Its top seven stocks are a list of technology winners from the crisis - Amazon, Alphabet, Microsoft, Alibaba, Facebook, Tencent and Salesforce.

It also benefitted from having a short book in ‘old economy’ stocks such as oil and gas exposed stocks and low quality and low credit rated names which all paid off; the trust lost just 14% in the drawdown.


Cheaper and cheaper – the underperformance of value continues

Another key reason behind relative performance is exposure to the value style; traditional value sectors of financials, energy and material have been particularly hard hit.

Banks suffer from lower interest rates hitting their margins and an inevitable spike in non-performing loans; we suggest they may take another step to being viewed as utilities deserving of greater state interference.

Energy and materials suffer from the shutdown in manufacturing and the coincidental price war between the Saudis and Russia; if the outcome of this crisis is less air travel, greater focus on domestic supply chains and a shift online, demand for energy and certain raw materials could become structurally lower.

In UK Equity Income the two top performers have been Finsbury Growth and Income (down 18%) and Troy Income & Growth (down 19.7%); sector average was a 29.8% loss and the worst - 55.7%.

These trusts hold high quality companies with defensive revenue streams and have a relatively low tilt to value stocks; worst performers were those with greater value exposure, the most geared and those with greater exposure to UK domestics.
In Asia and emerging markets, the key has been to be overweight to China and underweight to India.

The same trends have been important – favouring high tech businesses and consumer and business services distributed online, and away from the value sectors of energy, materials and financials.

Being earlier into the pandemic than the West, drawdown in this period has been much better than in the developed world – albeit still in the mid-teens.

Creditable performers have been Witan Pacific and Schroder Asia Pacific in Asia; in emerging markets, Fundsmith Emerging Equities has done well thanks to its highly defensive portfolio and JPMorgan Emerging Markets outperformed, with low gearing and high exposure to internet and tech.


How do we get out of this place?

We think this crisis will strengthen certain pre-existing trends , such as the shift of the economy online, keeping trade relations local, and regulatory interference in banks and major industry.

Technology will become more central to our lives and this will be felt in the stock market. However, much remains uncertain with different investment implications. We see two ways forward:




  1. Optimistic scenario

In the optimistic scenario, as our understanding of the virus grows, the fatality rate declines.

Restrictions on movement begins to be lifted in May, and retail and leisure sectors return to business; the number of defaults and business closures is limited.

There could be a short term rally in trusts exposed to UK domestics later in the year; these companies were cheap heading into 2020, thanks to concerns around Brexit, but had started to pick up as the outcome seemed likelier to be managed.

There could also be a quick bounce backs in trusts with energy and materials exposures, and our feared government interference in the banking sector could be limited.

The rise in UK government debt would be relatively limited and the government could take the ‘austerity’ route out (as it did after 2008 and the Napoleonic Wars).


2. Pessimistic scenario

In a pessimistic scenario, tests show that few of us have immunity from the virus.

Lockdown lasts for months, and more businesses exhaust government schemes before going under.

Restaurants and bars are less frequented, with this trend lasting for years as consumers remain frightened. UK government debt increases as firms taking government loans go bust.

We think the longer the lockdown lasts, the more likely potential GDP growth losses become permanent and the harder it is for the government to make nominal GDP rise higher than its interest payments.

Inflation would then likely seem the only way out for the state (as it did after the second world war) and cash savers would suffer.

The underperformance of value would be exacerbated, while banks and energy companies struggle.

Trusts with higher technology weightings would outperform, but may well do so in either scenario over the longer term; bonds would finally meet their nemesis.

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