The Great Deconfinement
Montreal, June 30, 2020
One of the most acclaimed role-playing video game from the genre’s golden era is Fallout. In the game, the player’s avatar is tasked to leave the relative safety of an atomic shelter, in which he spent his entire life, to retrieve an essential piece of equipment in the above ground wasteland, one populated by humanoid and animal mutants and where radiation poisoning is a constant threat.
Covid-19 is not anything like Fallout’s romanticized wasteland denizens that keep respawning but like them, it is a serious threat about which little is known other than the fact that it has not gone away. For this reason, while deconfinement is vital, immunology and infectious disease experts argue that the process of re-appropriating the outside world should be slow and guarded, or else the lockdowns of the last two months will have been wasted.
The Shape of the Recovery has been ‘unmasked’
In a prior post, we noted the growing dissonance between the swift recovery trajectory that the global equity markets implied and the underlying economy. In effect, since the late March lows, broad equity market indices have rebounded substantially while economic activity remains severely impacted. In retrospect, suggesting that the markets were implying a “V shaped” recovery may have been a premature conclusion. To this point, the stocks that had been leading the market advance comprised of a relatively concentrated group of large capitalization information technology, on-line communication and healthcare stocks. The common characteristics of those stocks were that their revenues were not expected to be overly impacted, their net debt was low, and they had high variable cost structure which could sustain a lower level of activity for longer.
More recently though, most of these same stocks seem to have reached a plateau while the broader market is now carried higher—at least temporarily—by financials, industrials, consumer discretionary, and, to a lesser extent, by energy firms. The stocks in this second group are more sensitive to the prevalence of social distancing measures, are sometimes heavily indebted and have little to no flexibility to reduce cost rapidly.
We note, interestingly, that this shift in sentiment is happening at the same time as European and North American countries have started to ease lockdown restrictions and that the number of deaths keeps declining in spite of a resurgence in the number of Covid-19 cases. In fact, there are encouraging developments on the therapeutic front. At the same time, higher frequency indicators measuring air traffic, passenger car miles driven, public transportation capacity factors, box office receipts, and restaurant and hotel bookings all suggest that the economy has bottomed. Lastly, while weekly unemployment claims remain elevated, continuing claims have started to decline, which means that corporations have started to rehire workers. In a sense, these positive developments justify the transition of market leadership away from companies which are less Covid-19 sensitive, to companies which are more sensitive to it.
As it stands, we do not know whether a sudden increase in Covid-19 cases would cause the group of stocks that benefitted in the early stages of the recovery to start outperforming again. Nonetheless, we do not think it is prudent to assume that large cap information technology stocks and ancillary plays will always constitute sound hedges against a severe recessionary scenario. For that, we believe that the US dollar, long-term government bonds and precious metals are better suited.
Ethical and Environmental, Social and Governance (ESG) strategies having their day
Asset owners have become increasingly interested in the ESG profile of their holdings. To this point, Morningstar reported that net inflows into sustainable mutual funds and exchange-traded funds more than quadrupled in 2019 from 2018. In addition to the general concern with climate change, we believe that the adoption of ESG conscious investment principles has been partly sparked by the strong performance of ESG strategies recently, which is seen as the confirmation of the premise that an ESG approach to investing does not force investors to sacrifice return.
However, an investigation into the approach utilized to construct ESG indices reveals that performance may have more to do with factors other than ESG factors themselves. In effect, taking for instances the popular MSCI ESG Leaders range of indices, we note that two sets of filters are applied. One filter in the indices construction methodology is an ethical filter, which leads to the exclusion of certain industries outright, such as the tobacco manufacturing industry. Since the connection between smoking and terminal lung diseases has been established, the tobacco industry has been structurally contracting. Consequently, notwithstanding the high dividend that most tobacco manufacturers are still able to pay, their stock price has declined substantially in the past couple of years. Other groups of companies that tend to be excluded are those involved in the manufacturing of firearms and those that are subject to various controversies such as child labor. Coincidentally, many of those happen to be industrial conglomerates which are facing their own challenges ranging from balance sheet stress to fundamental changes in the way contracts are attributed. The stock price of members of this industry subgroup has also trailed the broader indices considerably in the recent years. As a result, the decision to exclude a subset of stocks which happen to have been experiencing a secular decline on the grounds that such stocks do not meet socially responsible investing criteria, would have been enough to generate a noticeable positive contribution to performance.
Furthermore, the other filter applied consists in altering the weight of the remaining stocks, positively or negatively, as a function of their respective score on various ESG metrics. Invariably, companies with the highest carbon footprint tend to be penalized. Therefore, the energy and basic materials sector tend to be underweight and since the price of commodities such as oil and copper is hovering nearly their decade lows, all else equals, the underweighting of companies engaged in the extraction of natural resources has also been a positive contributor to performance. Conversely, companies in the information technology, healthcare and biotech industries which tend to have a low carbon footprint, tend to be favored and get overweight.
Essentially, by construction, these ESG indices and the strategies that are derived from them tend to be naturally underweight industries which are facing secular headwinds, and overweight information technology and healthcare sectors. Interestingly, the same characteristics are present in large-cap growth focused strategies. In fact, we have found that many ESG strategies have behaved like diluted versions of large-cap growth strategies. More cynically, to the extent that investors choose to adopt ESG strategies, it will be more a consequence of their large-cap growth stocks driven performance than the desire to invest in companies that are doing more “good”.
Moreover, we have another issue with ESG indices and strategies. It appears that in some cases, the E, S and G factors in ESG are mutually exclusive. For example, a Silicon Valley technology company may score highly on the environmental pillar because it causes little direct pollution through its activities but may score poorly on the governance pillar due to issues surrounding executive pay and ongoing questions about the protection of customer privacy. Conversely, a mining company that employs various chemicals that contaminate a nearby aquifer will score poorly on the environmental spectrum but may still gain index membership since it has a diverse board and pays its employees above average. In other words, it is possible for a company to score poorly on one or two of the three ESG pillars to acquire membership in an ESG index. Unfortunately, these are considerations that are not necessarily transparent to asset owners. Ultimately, we would conjecture that the E, S or G-only indices that have recently emerged—in an effort to target specific asset owner sensitivities and reduce the presence of inherent conflicts between the three pillars—may be the answer to an unfulfilled promise.
On our end, we believe that ESG concepts have fundamental merits. That being said, we are conscious of the pitfalls identified above and do not want to rely on recent performance to build an investment case. With that in mind, we continue to scrutinize the universe search for an implementation approach without too much compromise.
The Relative Passivity of Active Managers
Active portfolio management is defined by an investment approach that focuses on outperforming a specific market index through security selection, sector allocation, or market timing. The marginal value of active portfolio management strategy has been intensely debated in recent years and we doubt that their performance during the first quarter of this year will do anything to cause the debate to recede.
In essence, the performance of active equity and fixed income managers has once again disappointed in the first quarter. Notably, the median active Canadian equity manager underperformed the S&P TSX Composite Index and the median international equity manager underperformed the MSCI EAFE Index. On the fixed income side, the median manager underperformance relative to the FTSE TMX Universe was abysmal from a historical perspective. This has prompted many investors to question the purpose of active managers if, on aggregate, they largely failed to deliver superior performance in the years leading to the Covid-19 meltdown, and during the meltdown.
Admittedly, the empirical data makes active managers harder to defend. To this point, apart from a reduction in the count of non-core portfolio positions, which led to minor increases in the level of cash present in some manager portfolios, there were no broad reshuffling of portfolio exposures. In other words, active managers have been, on average, uncharacteristically… passive.
Nevertheless, we remain hesitant to condemn active managers based on the actions committed—or lack thereof—at the outset of the pandemic. We know that great managers may look temporarily out of sync when a new paradigm emerges. Please keep in mind that Warren Buffet’s Berkshire Hathaway had his worst performance in a decade versus the S&P 500 Index in 2019, and 2020 is not shaping up to be much better. We also know that mediocre or novice managers can look brilliant if presented with the right environment. Case in point, David Portnoy, the Barstool Sports founder who started to look at the stock market a few months back, is turning into an investment celebrity. We saw similar patterns in 1999 and again in 2007. It may be happening again.
Currently, we are prepared to dismiss active managers recent performance on the grounds that the market decline ensuing the Covid-19 trauma was unprecedented. We are even prepared to excuse the underperformance of active managers early in the recovery, on the grounds that it was more liquidity induced than fundamentally induced. Nonetheless, we think that active managers have just been granted an opportunity to outperform markets not seen in a generation. More specifically, now that so many publicly listed companies have suspended the communication of guidance for revenues, margins, and earnings, the basic extrapolation techniques that so many still cherish may no longer work. As such, analysts and portfolio managers, who can develop a deeper understanding of public companies’ operating environment and have superior insights about the companies’ relative ability to endure revenue decline or withstand margin erosion, may have the high ground. In a way, the active managers’ current crisis could be sowing the seeds of their catharsis.
Many industries have suddenly fallen in a precarious state. Restaurants, hotels, cinemas, airlines, theme parks, cruise line operators, and live entertainment content providers are among those. Sadly, Hertz Global Holdings, whose problems have become public recently, perhaps best epitomizes the situation. Hertz, which celebrated its centennial two years ago, successfully overcame numerous adverse scenarios since its foundation. Yet Hertz derives the essential of its revenues from short-term car rentals and is heavily indebted. From our perspective, given the Covid-19 outbreak and restrictions on business travels, a balance sheet restructuring became inevitable and indeed, the company filed for bankruptcy on May 22nd. Hertz is just one example of a company which saw its business model toppled by Covid-19 at a time when it did not have a sufficient financial cushion. It is not alone in this situation, as many companies face equally worrisome prospects. To reiterate our earlier point, we believe active managers have a unique occasion to redeem themselves by successfully identifying the winners and losers of the Covid-19 pandemic. As such, we have become more enthusiastic about the prospects of active managers than we have been in quite a while. To be specific, we are paying particular attention to managers who have delivered excess returns in episodes during which the distribution of financial asset price variation was wide and who have remained faithful to the investment beliefs and principles that have allowed them to outperform in the first place.
Dimitri Douaire, M. Sc., CFA
Co-Chief Investment Officer
 Fallout™, developed by Black Isle Studios and published by Interplay, 1997.
 Non-essential goods and services.
 John Hale, “Sustainable Fund Flows in 2019 Smash Previous Records”, Morningstar: Sustainability Matter, January, 10, 2020.
 Patrimonica, eVestment data for Q1-2020.
 Ibid. – Europe, Australiasia and Far East (EAFE).