Client Investment Letter October 2020

“Healing is a matter of time, but it is sometimes also a matter of opportunity.” – Hippocrates

Time heals all wounds, as they say. We are now six months removed from the onset of the pandemic and economic seizure, and though things are far from healed, there is now a line of sight to something resembling normal.

As we see it, the post-March rally in stocks has been driven by three factors: the initial economic upturn just from the end of the lockdowns and a peak in virus cases, massive fiscal support, and unprecedented Fed liquidity. By the end of the third quarter, the underpinnings of the impressive rebound are fading. The reopening momentum has stalled. The government’s policy support has been exhausted while attempts to extend it are mired in political posturing. The Fed continues to be super accommodative, but other than guidance (i.e. talk), it has not used any new monetary tools.

While the Fed’s impact on the real economy is debatable, excess liquidity has clearly found a home in financial assets. Look no further than the dawn of new Gen Z day traders buying equity of companies in bankruptcy, or the rise of the hottest trend in corporate finance: IPO by reverse merger with a blank-check company. Valuation extremes are numerous as investors embrace the Fed backstop. At its most recent highs, the market capitalization of all U.S. corporate equities stood at nearly $39 trillion, almost twice the level of U.S. Gross Domestic Product, the highest multiple in history. And just five companies – Apple, Amazon, Microsoft, Google and Facebook – together make up roughly 20% of the market value of all U.S. stocks. While the market is concentrated in these mega cap tech stocks, there are other opportunities below the radar that are getting our attention.

Investors are starting to brace for volatility this fall, with fears of a contested election as the country has never seemed more fractured. What’s more important to us, from a market perspective, is the makeup of Congress and the Supreme Court. Thankfully in a democracy, the man in the Oval Office does not set policy on his own. While we acknowledge heightened risk in the coming months, as to the outcome of the election, we will simply play the hand we’re dealt. Either way, we expect the savvy managers at the companies you own will make the best of the environment they find themselves in.

Beyond the election, in the next six months or so, we believe there will be at least one but perhaps several approved vaccines. We expect the vaccination of frontline health care workers and at-risk populations will come first, hopefully before next summer, which will greatly reduce hospitalization and mortality rates. In turn, this will allow governments to begin relaxing social distancing regulations, providing the necessary environment for a sustained recovery. With any luck, by the end of next year the majority of the population will be vaccinated and we can return to a sense of normalcy.

As we look towards next year, with the election in the rear view mirror, attention will turn to vaccine timelines and annual growth comparisons will look good as companies lap the 2020 collapse. Not all companies will endure through next year; no doubt, we will see many more bankruptcies along the way. But the survivors will emerge even stronger as more feeble competitors vanish or are acquired.

Many companies are now trading at a significant discount to where they were pre-pandemic, providing a fertile hunting ground for where returns will come from when social distancing is a memory instead of a reality. In the wake of the 2000 tech crash, for example, plenty of left-behind real world companies that didn’t add “dot com” to their name performed quite well, and we can envision a similar scenario playing out this time.

In fact, we have already identified a half dozen or so high-quality, reasonably valued companies that we believe are well positioned for the eventual recovery, so stay tuned. Valuations and fundamentals do matter over the long-term, so we will remain disciplined, but we have plenty of cash ready to deploy. In the meantime, several holdings in the portfolio had noteworthy news during the third quarter.

After years of waiting for Gilead to pursue a large-scale acquisition, in September the company put its strong balance sheet to work in a major way, agreeing to spend $21 billion to acquire Immunomedics at a substantial premium for its promising breast-cancer treatment and access to a deep oncology pipeline. We like the deal, as it should reinvigorate growth and provide a platform for developing a solid tumor business that complements Kite. With oncology enabling a new leg of much-needed growth, we see plenty of room for multiple expansion.

With Boeing’s 737 MAX grounded and air traffic stagnating at 1970s levels, Spirit AeroSystems has been extremely out of favor as a key Boeing supplier that counts on the MAX for over 50% of revenues. While this has admittedly been a tough one, our long-term thesis is that global air traffic will eventually recover once there’s a vaccine, airlines will need the MAX to replenish aging fleets and, while some deliveries will certainly be deferred, the backlog is large. The bear case is adequately reflected in the current stock price, in our view, and we don’t believe there is any solvency risk. With FAA Administrator Steve Dickson, a former Delta pilot, personally flying the plane last week, we believe the ungrounding and a return to service is imminent, which will be positive for sentiment. Meanwhile a planned $420 million acquisition was terminated, further improving liquidity.

Our original eBay thesis centered around the intermediate-term growth drivers of the development of its underpenetrated promoted listings business and taking over the intermediation of payments on its platform following the expiration of the company’s agreement with PayPal. We also saw potential opportunities to realize value through divesting non-core assets. Fortuitously, right before the pandemic hit, eBay sold its secondary ticket exchange business, StubHub, for $4 billion in cash. More recently, during the third quarter, the company sold its valuable online classifieds unit to Norwegian digital marketplace company Adevinta for $9.2 billion in cash and stock. Those disposals, plus a new CEO shepherding the largest growth in its core marketplace business in over a decade as a key stay-at-home beneficiary, have made eBay one of our biggest winners this year.

Finally, in August, a U.S. appeals court reversed a lower court ruling against Qualcomm in an antitrust lawsuit brought by the Federal Trade Commission, handing the company a decisive victory and, though the government is appealing, it likely marks the end of a years-long overhang around the legality of Qualcomm’s licensing business and essentially validates its business model. The regulatory all-clear and excitement over the coming 5G cycle have driven Qualcomm shares to all-time highs.

As we hit the homestretch on what has certainly been the most memorable year in our company’s 43 year history, we are already looking forward to what’s sure to be a better 2021. We hope you continue to stay safe and healthy as we get through this health crisis, and look forward to seeing you in our office soon. In the meantime, if you have questions or thoughts, please give us a call, schedule a Zoom with us, or come to the office for a socially distant visit.

Penn Davis McFarland, Inc.
October 2020