“There are decades where nothing happens, and there are weeks where decades happen.”

We hope this letter finds you in good health. It has been just a few weeks since our last letter to you, but these days a lot happens very quickly. It now appears that the peak of the epidemic is just a few weeks away in New York, with much of the country just behind, and though it has been a difficult couple of months, the worst of the health crisis is now in sight.

The economic damage will linger longer as many companies have been forced to close and many millions of workers are without a paycheck. The economic data and earnings reports in the coming months will be both alarming and historic, given the total cessation of commerce across many parts of the economy, and the outlook for corporate profits is uncertain. Unlike a light switch, a nearly $20 trillion economy will not be as easy to turn back on once social distancing comes to an end. As an example, China is a few months ahead of us on the epidemic curve and the Chinese are finding it difficult to jump start consumption.

But as we said in our last letter and want to repeat to you today: this too shall pass.

The Federal Reserve and the government are pouring unprecedented amounts of monetary and fiscal support into the economy. For perspective, the Treasury’s $2.2 trillion stimulus is more than twice as large as Franklin Roosevelt’s New Deal spending program, adjusted for inflation, which stabilized the economy and brought an end to the Great Depression. The Fed has taken rates to zero and its balance sheet has already hit an all-time high, nearly $6 trillion, with many more asset purchases to come. All of this will provide much-needed assistance and takes the worst-case scenario off the table. The future implications of such a sizable fiscal deficit and encumbered Fed balance sheet are worries for another day. For the here and now, the government rescue will ease the short-term pain, fill the gap in demand and ensure that the gears of the financial system continue to operate.

A coronavirus treatment, and later, a vaccine, will be coming, which will give a boost to the American consumer’s psyche. Even so, the legacy of this pandemic will influence the way we live and work far into the future. One shouldn’t expect an immediate recuperation, right back to how things were in early February, after the most significant health and economic crisis of the past century. Households and businesses will need to repair damaged balance sheets and replenish savings. The recovery in stock prices will be a slow one, as the economic shock has been severe enough that it will likely kick investors’ buy-every-dip habit. With any luck, valuations and fundamentals will matter again.

We came into this crisis relatively well positioned given our view that risk was mispriced and underappreciated. We had dialed-up the quality of the companies we own with a more vigilant review of balance sheets and liquidity, and we were sitting on higher levels of cash than we have had in the firm’s 40-plus year history. While this defensiveness was frustrating when the markets were hitting new all-time highs, it provided some downside protection and more flexibility for when better opportunities were in abundance.

We are now getting ready to convert that cash into stocks that offer more upside. We will be doing so slowly and cautiously, though, as we recognize that time is on our side. In fact, while we have identified a number of companies that we would like to buy, we have pulled the trigger on only one new name, defense contractor Raytheon, and started small in size.

With high geopolitical threat levels and a constant need to surpass near-peer adversaries China and Russia, spending on defense modernization is an important bipartisan priority and historically resilient to the economic cycle. Raytheon is one of the best positioned American defense prime contractors, in our view, building missiles like the Patriot, providing high-tech electronics for Lockheed’s F-35 and Northrup’s stealth bomber, and leading in high-growth domains like space and cyberwarfare. Raytheon is also most exposed to the international market amongst the defense primes, and thus one of the biggest beneficiaries of NATO members fulfilling their commitment to defense-spending increases.

By the time you receive this letter, Raytheon will have combined with United Technologies’ aerospace business, Pratt & Whitney and Collins Aerospace. Raytheon Technologies, as the new company will be called, will be a diversified commercial aerospace (46%) and defense (54%) powerhouse, with high free cash flow, a strong balance sheet and ample synergies. The stock has lagged its peers due to coronavirus-related pressure on commercial aerospace, but we see this as temporary and an attractive opportunity that we expect to build in the coming months.

As noted above, there are many other great companies that we have our eye on and, with any luck, will be showing up in your portfolio in the coming months at outstanding prices.

In the meantime, we encourage you to focus on your health and enjoy the family time. There is certainly no need to worry about your investment portfolio; we are here to remove this burden for you. We are working hard to preserve your capital, first and foremost, and to grow it prudently for the long haul. We will navigate through this together, and we are always here for you, should you have any questions or concerns.

Penn Davis McFarland, Inc.
April 2020