“Over every mountain there is a path, although it may not be seen from the valley.” –Theodore Roethke
Without a doubt 2020 has been a very difficult year and we are only halfway through. For the most part, this difficulty does not show in your portfolio. In fact, if you looked at your statement on December 31, 2019 and compared it to the one enclosed with this letter, you might assume not much had happened this year. It’s a good reminder that, sometimes, waiting patiently is the best approach. At the present moment, the path ahead isn’t completely clear. After subduing the coronavirus in New York, it has come back with a vengeance in other parts of the country. Companies are unsure about employees returning to their offices, vacations are cancelled, and kids don’t know what school will look like next year. Frustration has boiled over into the largest civil rights protests our country has seen in sixty years. The virus and its aftermath have forced us to confront things we have ignored and to question much about how things operate versus how they should from the Center for Disease Control (CDC) to local police forces. We simultaneously have the most fiscal and monetary stimulus that has ever been provided to the U.S. economy and one of the deepest and quickest recessions in history. We have an election in just a few months. Anyone who tells you they know exactly how all this is going to turn out is delusional.
The first round of stimulus, which sheltered many of those who initially got laid off from economic disaster, was hugely helpful for many but will run out in July without additional legislation. The Paycheck Protection Program (PPP) gave a necessary, if temporary, lifeline to small businesses. Airlines got desperately needed support. One of the most divided Congresses we have ever had stepped up to the initial challenge. The Federal Reserve, to its credit, quickly identified a liquidity crisis (where companies are short of cash temporarily) and flooded the market with liquidity before it caused serious damage. These actions prevented countless solvent companies from unnecessary bankruptcies, but will not shield those who are insolvent from a reckoning eventually. That being said, no amount of liquidity can cover up a huge drop in earnings for most companies. While there have been a handful of beneficiaries such as grocery stores, video game companies, and companies catering to remote work solutions, most businesses aren’t set up to thrive in a pandemic. To get back to normal, we will need either a vaccine or naturally-acquired herd immunity. The vaccine is the faster route with some hope for one as early as this winter, but there are no guarantees. Herd immunity from infection becomes likely within a few years in the worst case. In the meantime, we are left trying to open the economy enough to keep businesses intact, but not overwhelm our healthcare system with COVID-19 patients.
So, we don’t see a clear path to immediate resolution of the present difficulties. However, we do know that eventually this will get resolved. Whether it is in six months or thirty-six months is the question. Unfortunately, only scientific studies of treatments can answer it, and those studies take time. We had the opportunity to buy a few new companies in the initial COVID-19 swoon, while keeping plenty of cash available to deploy if things deteriorate on the healthcare front or businesses struggle under the weight of a pre-vaccine, partially-open economy. Since the pandemic, earnings have dropped dramatically for most businesses and will remain depressed until things return to normal. The longer the economy remains at the partially open “COVID-19 stall speed” the more long-term value will be destroyed. With stocks hardly down for the year and S&P 500 earnings per share projected at $125 (down from $153 at the beginning of the year), stocks are more expensive than they were before the pandemic. However, interest rates have declined significantly, so this can be somewhat justified as future cash flows from companies look more valuable in a world where the alternative is a government bond yielding less than 1% for 10 years. The challenge with that thinking is that when things do recover, one might expect interest rates to normalize higher – especially if inflation emerges – so, that might prove to be a headwind for stocks despite improving fundamentals.
We did initiate a couple new positions this quarter. First, we bought a position in Royal Dutch Shell, an oil supermajor that has been providing oil and refined products to the world since the 1890s. The company made it through the Spanish Flu pandemic, and it is going to make it through this one, too. It was early to cut its dividend to a sustainable level of about 4% (other supermajors will soon need to follow suit), and we think its diversified business mix and efforts on clean energy projects are going to serve it well for the long-term. We purchased this icon of the oil field at a 20 year low in terms of price. If you can’t buy a leading oil company when crude literally trades for less than zero, then there will never be a time to do so. In general, we think big companies with access to capital are going to take advantage of smaller companies’ troubles during the pandemic, and we certainly think this is the case for Royal Dutch Shell as its smaller private-equity backed competitors face bankruptcy.
Another behemoth with access to capital that we bought this quarter was AB InBev, the world’s largest brewer and owner of notable brands including Budweiser, Modelo, and Stella Artois. With a strong global brand portfolio, the company has found real success selling its leading brands outside of their home markets. For years, the company has suffered as microbreweries slowly took market share from big brands in developed markets, and we think COVID-19 is poised to change that trend as many microbreweries will be closing their doors for good. Additionally, AB InBev, has one of the best emerging markets growth profiles of any brewer globally solidified by its 2016 purchase of SABMiller, with leading positions in key beer markets of China, Mexico and Brazil. While the company was left with a lot of debt as a result of that acquisition, it has abundant access to capital (particularly since the European Central Bank is buying debt directly from companies) and will eventually use the cash flows from its growing emerging markets businesses to retire this debt while paying a reasonable 2.3% dividend in the meantime.
We continue to patiently look for opportunities to buy additional great companies at attractive valuations as the market provides them. While COVID-19 hangs over the economy like fog in the valley, we remain steadfast in our belief that owning great companies at attractive prices is the best path to sustaining and growing your wealth long-term. With a little bit of patience, we remain confident that the climb in your wealth will resume as the sunshine once again breaks through the mist and the virus recedes.
At present we are back in the office after working remotely since March. We are available for socially distant in person meetings or video conferences any time you feel the need to have one. Thanks for the trust you place in us. Meanwhile, stay safe as we all look forward to better days ahead.
Penn Davis McFarland, Inc.
July 2020
