September 2020 IssueLong scroll reading

Feet of Clay

By Edward A. Studzinski

“Advertising is the rattling of a stick inside a swill bucket.”

                    George Orwell, ch. 3, Keep the Aspidistra Flying (1936)

I recently had occasion to speak with a long-term value manager who was lamenting how badly value was out of favor and how much it was hurting his and his firm’s performance and investor returns. The genesis of that sub-par performance, which one finds repeated across many value-oriented firms, is a departure from being attuned to the intrinsic business value of the firms invested in, replaced by a laser-like focus by his firm’s analysts and portfolio managers on what stocks are going up because the market favors them. But to some extent, the lament has been correct – most value investors are having a terrible time.

That said, let us look at some firms that have managed to deliver good performance in a period of financial distress in the markets and the economy. For example, Sequoia Fund has managed to recover from its huge misstep with Valeant. Year-to-date the fund has a total return in excess of 13%. During the first half of this year, they would attribute that success to thinking about investing in businesses rather than thinking about the business of running an investment firm. They recognized how easy it would be to make mistakes that would be justifiable – “no client will blame us for raising cash.” And they correctly view a mistake such as that as making a business decision, not an investment decision. They were able to avoid such mistakes because they knew their clients. They knew their clients wanted them to remain focused on investment decisions, not business decisions. (By way of disclosure, I have been an investor in Sequoia for more than thirty-five years).

A somewhat different focus, but still one worth looking at, is that of Troy Asset Management in London, which has a responsibility now for managing the portfolio of one of the most successful investment trusts (closed-end funds) in the UK – Personal Assets Trust.

In this environment, they believe one should be keyed to capital preservation first. A lot of thought should be dedicated to considering what could go wrong with an investment idea. Environmental, social, and governance issues will increasingly dominate the discussion. A company (and an investment manager) that is attuned to the maximization of shareholder value above all else stands a good chance of having an investment with no value whatsoever. Understanding a company’s philosophy and approach to the so-called ESG issues provides useful intelligence into the quality of management and the quality of management’s execution. Ignoring such issues could result in the loss of a company’s franchise or license to operate in the future. I find it interesting that so often managers and investment analysts are clueless about the fact that such things as franchises or licenses in banking or broadcasting can rather easily be taken away in the right regulatory climate.

Likewise, COVID has also provided Troy with some extraordinarily useful indicators as to the quality of both businesses and managements. One can observe low-debt, highly cash generative businesses that have shown the quality and resilience of their cultures with no COVID related layoffs this year, choosing to protect the jobs and incomes of their employees. One can contrast that with the behavior of those companies that have indicated a willingness to restructure (fire employees) either during COVID or after government support runs out. Those are clearly not businesses to own for the long-term. And at Troy, there is a list of things that they will not do as investment managers: they will not overpay for growth, they will not invest in challenged businesses, they will not launch new investment products (trying to catch a wave or alternatively, staunch the flow of departing assets), and they will not chase distressed turnarounds. They will not be distracted by FOMO – fear of missing out.

Pandemic Economics

Barron’s had an article this past Sunday on the credit ratings of states, giving a snapshot as to the damage that has been done to their balance sheets (Leslie P, Norton, “Is Your State in Financial Trouble? Here’s How All 50 Stack Up,” 8/31/2020; by their reckoning, Illinois is in the worst condition of any state, Idaho the best).

 It increasingly looks like many states (and by extension other subdivisions of local government) will have trouble meeting their financial obligations to bondholders, absent a miracle of some sort that comes to the rescue of empty coffers. The financial difficulties have been exacerbated beyond the pandemic due to the outbreaks of civil unrest in many large cities.

A friend in municipal finance told me that half of Chicago’s tax revenue base comes from the sales tax.

That revenue base was already under pressure by a shut-down that closed restaurants, bars, stores, hotels for several months. And then we had the unrest that targeted the downtown retail businesses, just as things were starting to reopen. Chicago has now taken on aspects of a boarded-up war zone, conventions, and other tourist business is gone, not to return until at the earliest 2021. The estimate is that fully 25% of the bars and restaurants in Illinois will never reopen again. Saddest of all, there is a population exodus from the city of those that it can least afford to lose. Chicago could become Detroit.

New York City is in a similar situation. Another friend made a trip into the city from her weekend house in Connecticut to keep a medical appointment and check on her townhouse. She found no one on the streets and seven large moving vans in the area where she lived on the Upper East Side. Granted, with the perspective of hindsight, one wonders how much that Amazon headquarters might have helped things economically had it not been chased away. Those jobs would have been the kind of jobs needed.

What does this mean for investing in municipal bonds? Well, it is an area now full of minefields.

Muni bond investing is an area now full of minefields. Few funds or firms have analysts who know how to do municipal credit analysis.

Unfortunately, few funds or firms have analysts who know how to do municipal credit analysis. I can point to a very few banks and investment firms still trying to do a good job in those areas, but the nature of the business changed when the amount flowing into those assets grew exponentially. Most municipal bond funds now rely on ratings from the agencies – Moody’s or S&P. I would suggest that you are in unchartered territory, as the ratings are historical. And do not expect that a rating given as a result of an underlying bond insurance guarantee will be adequate to protect you from defaults.

Test Sensitivity

There has been an ongoing stream of media criticism about the failure in this country to test enough people for COVID, and to do it rapidly. An article in the Sunday New York Times of August 30, 2020 on page 6 of the front section raised an interesting point. The article was titled “You’re Positive, but Are You Contagious? Tests May Be Too Sensitive, Experts Say.” The upshot of the article is that the standard tests are diagnosing too many people as positive who are carrying an insignificant virus load and not contagious. The problem is that the most common test used just provides a yes or no answer as to whether a person is infected. The PCR test commonly used amplifies genetic material from the COVID virus in cycles. The fewer cycles required, the greater the virus load is and the more likely the patient is contagious. The number of cycles used to find the virus is not sent to doctors, even though the information is available and could tell doctors how infectious a patient is and what the next treatment steps should be.

The most disturbing part of the article (which makes one wonder why it was buried on page 6)

Up to 90% of people testing positive barely carried any virus.

is in looking at three sets of cycle data from Massachusetts, Nevada, and New York, up to 90% of people testing positive barely carried any virus. Or put differently, if you applied that data and rate of contagiousness across the U.S., the 45,604 people who tested positive in the U.S. on Thursday, August 27th, only about 4500 may have actually needed to isolate and submit to contact tracing. And there is a simple fix to the problem. Just lower the cycle threshold from the number of cycles to find the virus (now usually set at 40) to a number suggested by many experts of 30 to 35.

Think about that as each night you listen to the Voices of Doom on the nightly news telling you that another X thousand people tested positive today. Makes you wonder when we moved beyond the science that so many politicians emphasized, and into the realm of something else. I commend the entire article to you, along with another recent piece in The Wall Street Journal, (Greg Ip, “New Thinking on Covid Lockdowns: They’re Overly Blunt and Costly,” 8/24/2020) about whether there had been a better way to protect the public health than shutting the economy down. The last point I would raise is, given the millions of dollars we have now spent on this disease, it is remarkable as to how little we really know about how it is transmitted.

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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.