Antony Burgess from Veritas Asset Management, sub-investment manager of the Nedgroup Investments Global Equity Fund, discusses their Covid-19 strategy to take advantage of falling markets.
Our inflation targets are not going to be met in a sharply falling market, but the fund held up relatively well in Q1, which helped the numbers for the past 12 months. The portfolio returned -5.5% for the past 12-month period compared to -10.4% for the MSCI World Index. We are highly price disciplined and coming into 2020 the fund had a significant amount of cash, about 14%. This was not an asset allocation decision and we had no foresight on Covid-19 or markets falling but, when we were selling positions last year, it was becoming increasingly difficult to re-deploy that cash. We were concerned about valuations of markets and about a potential recession on the horizon.
What’s interesting to see is which companies did well over the last quarter. The first grouping is those companies that benefit from people being online more, such as Altice USA and Charter Communications, both big US cable companies, and Alphabet who owns YouTube. While they’ve suffered a bit from lower advertising revenue, they’ve experienced substantial demand. The second grouping is companies that provide critical healthcare coverage, such as Baxter International who specialises in end stage renal disease and kidney failure and Cigna, a health insurance company that has not really been impacted. Consumer staples include Reckitt who produces most of the cleaning products that people have been stockpiling. It may be a source of cash as things normalise and the demand for some of their products reduces. The next grouping is the more defensive, industrial area that includes BAE (British Aero Space) Systems with low exposure to commercial aerospace. Another holding is Canadian Pacific Railway, who transport food and healthcare goods and have weathered the storm well and where we expect a lot of upside when things normalise.
By far the biggest negative impact on the portfolio has unsurprisingly been the aerospace sector, such as Aena SME (Spanish airport operator), Airbus (builds A320s, etc.), Raytheon (defence) and Safran (mid-size aeroplane engine providers). The barriers to entry for this sector are huge with these companies in a very strong solvency position with cash flow problems as opposed to solvency issues.
Our Covid-19 response
When we realised that the virus was a global issue, we put together our Covid-19 response. Stage One was to say what the base case and what the bear case was for each of our holdings. If we look at what’s happening in other countries, we expect a slow return to normal with a slow recovery in the second half of 2020 and a more normalised recovery in 2021. The more negative scenario is that things don’t get back to normal, we get second waves and have intermittent lockdowns and don’t get recovery until next year and more significant recovery in 2022. We then worked out the rate of return we would want from any company for both scenarios by trying to value them based on the assumptions for the base and bear case.
Stage Two was to split the universe list of companies that we have into most impacted and least impacted by Covid-19. The most impacted include companies like American Express, Amadeus IT Group, Booking.com, etc. all companies that support the travel industry and have become exceptionally cheap. The least impacted include those that are benefitting, such as online, healthcare, payment companies, etc.
We then had a buy price for both the base and bear case and we initiated a position in the names we wanted to buy of about 1% when it got to the base case IRR and then we increased the weighting when the markets fell further and we got to valuations that were discounting our bear case. Because of the magnitude of the fall in March, we were able to stick to the stocks on the least impacted list, which was our preference as we needed to hedge against the virus getting a lot worse. The companies we therefore bought were Abbott Laboratories, Alibaba Group, Becton Dickinson (plastic medical devices), Cochlear, Mastercard and Raytheon. We sold out of Dentsply Sirona, Microsoft and Rolls-Royce Holdings.
The bear case for Abbott Labs
This was a great opportunity to buy something that we didn’t think we’d be able to buy at the valuations we ended up buying it at. Abbott Labs is a healthcare company that operates in three main areas that could be game changers for the business. The first is diabetes where it produces a gadget called FreeStyle, which continuously monitors the blood sugar level of diabetics as opposed to the finger prick method. The global diabetic market is about 430 million, which is expected to double by 2050 and Abbots is hoping to get to 66% of this market over time. The second area is artificial heart disease products and the third is their diagnostics. They have just announced that they have come up with the quickest Covid-19 test, which is being rolled out in the USA, with the results available within 5 minutes. Despite the products they offer, their stock fell with the panic we saw in Q1.
At the end of March, there were 30 stocks in the portfolio. We’ve increased our holdings in much more predictable businesses while we were able to do so. Cash is very close to zero, which is the first time we’ve been fully invested since 2008. There’s a good chance that we’ve already seen the bottom of this market. We’re close to our sector maximum of 30% with 29% in healthcare, almost 25% in communication services and just over 19% in industrials, with these sectors representing our biggest positions.
One of the things we did going into this crisis, because we were concerned about valuations and a possible recession, was a lot of work on the solvency of every position in the portfolio, i.e. the covenants in place, how much cash they generate, would they survive a recession, etc. While we’re being tested with a very extreme event as far as solvency is concerned, it has left us in a good position and we’re very happy with the stocks in the portfolio today.