June 2020 IssueLong scroll reading

What We Do Not Know!

By Edward A. Studzinski

“Pessimist: one who, when he has the choice of two evils, chooses both.”

                    Oscar Wilde

One wonders what fifty years down the road, people will say about this period and how we as a nation dealt with the challenges with which we were presented.

In this country, we have had the conflict between states that never really closed but recommended social distancing and states that fully locked down and shut-in their residents and shut down their economies. In the latter case, the initial goal was to “bend the curve” until the healthcare system could prepare for the onslaught of expected cases by building up supplies and resources. That goal morphed into “staying home to save lives.” That wisdom became suspect when Governor Cuomo of New York was forced to admit that the later batches of hospital admissions in New York City consisted of people who had not been anywhere but in their apartments. It had become apparent that fresh air (opening windows) tended to dissipate the virus whereas modern high rises with sealed HVAC systems and windows that did not open did not dissipate the virus.

Which leads me to say that we now know more about what we do not know. As analysts, it is increasingly apparent that we are dealing with a high-frequency low severity event (in terms of the ultimate mortality rate from the pandemic). Will there be a second surge of the virus later this year? It is not an unreasonable assumption. What I do know is that we have now better prepared the healthcare system for such a surge, in terms of the necessary spaces, equipment and testing capability. And, we have learned from research and practice more about how to mitigate the effects of the virus, except in those whose health is already compromised. The greater issue, unfortunately, is that the other diseases and illnesses that cause death in the U.S. have continued to march forward, now unimpeded. Seven hundred and fifty thousand people a year in the U.S. are diagnosed with cancer in one form or another. Since the beginning of the year, with the issues raised about the dangers of COVID, half of those seven hundred fifty thousand have been missing their appointments for chemotherapy, radiation, or follow-up testing. We will most likely need another category of death related to COVID. That is, deaths caused by not getting proper treatment for diagnosed illnesses due to fear of catching COVID. 


I am going to repeat myself by saying that bonds are not a great place to invest now. With interest rates as low as they are (1% or less on risk-free governments), it would take little movement in those rates upwards to wipe out, on a mark to market basis, a considerable amount of hard-earned permanent capital. Given the number of bankruptcy filings and corporate restructurings (layoffs) that we are starting to see, it is difficult to make an argument that this is an asset class that will serve its traditional role as an anchor to windward in a balanced portfolio. And besides corporate issues, I should note that the same concerns apply to municipal bonds. There will also be a group of corporate restructurings that will occur that had been waiting for the right moment to execute. The virus has provided the justification for moving forward.

I continue to believe that the role traditionally played by the fixed income component should be taken over by cash. And while the cash will earn less than a fixed income bond portfolio, it should hold its value as a preserver of capital (if you stick to Treasury money market funds and insured bank certificates of deposit). The cash provides the opportunity to selectively go forward into equities that become irrationally undervalued at times. Those equities will take the place of providing income, assuming that they are in good, dividend-paying securities. That is, those that have a consistent history of paying dividends that have increased over time. In that sense, you are looking for businesses that generate cash, do not have a lot of debt, and do not require a lot of continued capital investment in plant and equipment to sustain the business.

An example of a business not to invest in would be an aircraft manufacturer. That business has a continued capital investment requirement in plant and equipment, is levered with debt, and is a situation where it takes twenty years to figure out if they actually made a profit on the production of a particular aircraft. A reasonable dividend hurdle to look for is an equity issue priced to provide at least a 3% dividend yield. One should avoid the high dividend yielders (paying above 6% in yields or distributions), as in this environment, those companies are as likely to reduce or eliminate their dividends to preserve corporate working capital. A perfect example of that is the real estate investment trust Weyerhaeuser, which a few weeks ago was attracting attention as an issue yielding close to seven percent, apparently a safe dividend. Shortly thereafter, the board, looking into the future as to the demand for forest products for building materials and paper, along with the debt load of the corporation, decided to eliminate the dividend. That has not been an unusual situation. 

Many companies are going to have no earnings … retail is a disaster area … even cloud-based services have most likely been overbuilt. Which leads me to …

What needs to be thought about in terms of equity investments (and those funds that invest in equities), is that for the second and third quarters of this calendar year, there is a better than average chance that many companies are going to have no earnings. What looked to be equity valuations that were only slightly overvalued in terms of the overall market are going to look extremely overvalued.

This leads us to the asset class of real estate. Retail is a disaster area, and many of both the stores and restaurants in that category will not be able to ever reopen. Even if they were, the amount of traffic they will receive would be questionable. The same is true of hotels. Many of those too will not be able to reopen, let alone pay rent. Those that do will see depressed occupancy for a long period of time.

Apartments will be a question of geography, as there will be locations that will see a faster economic recovery than others. Office buildings, especially in downtown urban locations, will see increased vacancy rates as working from home (and workforce restructurings) becomes more common. Industrial property, especially warehouses, should fare better than other classes, but again the issues of occupancy and rent payment will be determinative. Finally, what people thought would be winners, data processing hubs for servers, may not prove out. A consultant friend in the cybersecurity business explained to me that much of the capacity built in that category had been for smaller companies not good at forecasting their future needs, so they had overestimated. Companies such as Walmart, Amazon, Costco and the like were quite good at forecasting their space and server needs. The small business component of demand will be under pressure. The space has most likely been overbuilt.

Which leads me to the following. Warren Buffett was criticized as a result of his annual meeting comments that he had not repurchased any Berkshire Hathaway stock during the days of market downdrafts. He indicated he intended to hold onto the cash hoard the company had built up, as the range of potential outcomes that he saw was too extreme. We had gone beyond the two standard deviations of normal distribution returns and into the world of outliers (think not just a hundred-year storm but ongoing back-to-back hundred-year storms).

Mr. Buffett intends to hold onto the cash hoard the company has built up … I take that as a fiduciary decision to protect his shareholders.

He is in a better position to see what is going on in the domestic economy than most company chief executives as well as most mutual fund portfolio managers. Think about the group of businesses that Berkshire has in its portfolio, including Burlington Northern, Dairy Queen, Nebraska Furniture Mart, Benjamin Moore, NetJets, Berkshire Hathaway Real Estate and on and on. He will be looking at revenues and cash flows from the customers of that diverse portfolio of companies on a relatively real-time basis – a snapshot of information that we cannot similarly access. I take his decision to hunker down and preserve cash as a fiduciary decision to protect his shareholders. That is very distinct from the mutual fund manager hoping to regain a sufficient dollar amount of assets under management to preserve his firm’s unfunded deferred compensation plan for the highly compensated. 

For those who are interested in a better appreciation of COVID, and some of the numbers involved, I recommend “A fiasco in the making? As the coronavirus pandemic takes hold, we are making decisions without reliable data” Stanford Medical School epidemiologist Dr. John P. A. Ioannidis. It was published in Stat, the health care and medical on-line paper out of Boston, in March of this year.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.