2020 has been a very interesting year thus far across many fronts. The investment markets have been volatile as the domestic economy, as well as the global economy, adjusts to a new normal. The markets are doing well, but many investors are concerned it may not last. In a recent web seminar the FLI team reviewed the economic and investment landscape with an eye towards the future.
“People who succeed in the stock market also accept periodic losses, set -backs, and unexpected occurrences. Calamitous drops do not scare them out of the game.”
The second quarter’s strong performance for our strategies reflected massive Fed intervention (three trillion dollar expansion of balance sheet), the benefits of government programs designed to aid those most impacted by the economic shut down from the coronavirus (more than three trillion dollars), and the gradual reopening of the U.S. economy. Almost 0% interest rates, trillion dollar aid packages, and the belief that some normalcy would return in the next twelve months prompted a 20.5% gain in the S&P 500 Index during the second quarter. Meanwhile, those companies with the best prospects for durable earnings, as well as many companies that delivered services necessary for people and businesses to carry on under the restrictions imposed during the pandemic did exceedingly well (e.g., Amazon.com saw a 41.5% increase in share price during the quarter). We have tended to favor growth-oriented companies for quite some time, and those companies whose strategies included cloud computing and digital and electronic payments have long been staples in our portfolios.
Our clients, who through our guidance, maintained substantial equity investments in a diversified asset allocation made significant gains during the quarter. We can also say that virtually none of them left the “game” as referenced in the above quote from legendary investor Peter Lynch. The first quarter, facing a “novel” virus and a virtual shut down of our economy shook most investors to the core. However, we at FLI have experienced “calamitous drops” and “unexpected occurrences” before. We must admit that we have not seen such a pandemic in our lifetimes. Companies with strong balance sheets and excellent management coupled with the rapid and bold actions of both the Fed and bipartisanship in Congress gave us the confidence that better times would return in the not too distant future.
As we ended the quarter, the environment for investing in all asset classes was characterized by the following:
1. A pandemic virus (COVID-19) with no therapeutic cure or vaccine and cases increasing in certain parts of the country.
2. An economy that is gradually reopening with various restrictions limiting commerce and some freedom of movement for many around the country.
3. Certain companies thriving in this environment (Amazon.com, Microsoft, Walmart, Costco Wholesale, PayPal Holdings, etc.) while many industries are still reeling from various restrictions and consumer anxiety (hotels, airlines, casinos, restaurants, etc.).
4. Interest rates are historically low making it difficult for investors to obtain much more than return of principal in fixed income investments, while in Europe and elsewhere negative interest rates remain.
5. Some segments of real estate face the prospect of rents not being paid for now and therefore have issues meeting operating expenses and having to negotiate forbearance agreements with banks holding their mortgages. This impact seems to be affecting the ability for certain types of transactions (e.g., commercial sales and refinancings) to be completed or undertaken.
6. Scientists are working around the clock with government aid to create a vaccine for this dreaded virus which is impacting over 180 countries. Therapeutics are also being searched for to lessen the severity of the disease, especially among the older population and those with co-morbidities.
7. Many private equity valuations have been reduced to reflect these difficult times and the uncertain pace of economic activity while waiting for more visibility of success in the fight against COVID-19.
If the above was not enough, the murder of George Floyd in Minneapolis at the hands of a rogue cop (and three others who failed to act) has led to massive demonstrations about police brutality and racism. These demonstrations in some cities metastasized into looting, arson, and some bloodshed. This also has shook our country as many are calling for the defunding or elimination of the police. At the same time the level of crime has dramatically increased in cities such as New York City and Chicago, and six square blocks were taken over by demonstrators in Seattle ultimately leading to the deaths of two innocent people. After two weeks, the Mayor of Seattle ordered the end of the occupation and police took steps to disperse protestors from the occupied area.
So why is the stock market doing so well? What should we be doing as investors? It has long been thought that the stock market anticipates the future. We agree. Despite the conditions listed above, the economy is rebounding in spite of the uncertainty with the disease and civil unrest. This is seen in the recent nascent recovery in employment (shown below):
This significant jump is only the last two months and we need to be cautious about the trend. Too many Americans are still out of work with approximately 33 million still receiving unemployment assistance (as of June 20, 2020). We expect another round of government stimulus, anticipated to be approximately a trillion dollars, to bolster the economy and buy time as the recovery unfolds.
At the same time, the large money mountain on the sidelines continues to earn next to nothing in cash and treasury bond yields are at or near historical lows. This suggests to us that some of these funds will seek asset classes with better returns in the near future, including equities.
Money market fund yields and the rate on the Ten-year U.S. Treasury still are significantly below the dividend yield on the S&P 500:
It is worth noting that the yield on our Dividend Growth strategy exceeds the yield on the S&P 500 by more eighty basis points and as of June 30, 2020 has produced an average dividend increase of 7% from our portfolio companies. This is particularly noteworthy as we expect the S&P 500 dividend to remain essentially unchanged due to companies impacted by the economic shutdown not raising, cutting, or eliminating their dividends.
How Did We Do?
Our defensive equity and traditional equity strategies all appreciated by at least 17% during the quarter, with many actually increasing by more than 20%! Several of our strategies made up most, if not all, of the losses of the first quarter. Our concentration on growth-oriented companies which are well positioned as we look forward seems to be working. Many of these companies reflect products/services and secular growth trends which accelerated because of the pandemic and the new or revised ways of life for both businesses and consumers. In addition, appreciation in our Dividend Growth strategy reflected most companies expected to raise dividends thus far in 2020 continuing to do so with a few exceptions that held their dividends waiting for more visibility (in our opinion). Including those few that did not yet raise their dividends, the average dividend increase for the portfolio companies has been 7%, which we expect will increase somewhat during the course of the year as we believe most of the companies that have not raised their dividends will do so.
Our private investments (which are presented to qualified clients) continue to show progress but have been somewhat impacted by the economic shutdown. One of our mezzanine real estate investments reflected some slowdown in refinancing activities, but we do not believe that valuations have been impaired. In another, our mezzanine loans for prime industrial properties continue to show significant promise, especially helped, in our opinion, by the continuing growth of internet business and one-day delivery becoming the norm. Separate reports will be forthcoming. Also, a few days after the quarter ended, Perosphere Technologies, a private equity investment, signed an agreement to be acquired. We will be writing a report on this as well once the transaction is completed.
We remain cautiously optimistic while using all of our investment tools to have overcome the first two tumultuous quarters. Those same tools of diversification, asset allocation, and diligent investment management with proven investment strategies will be needed to face the uncertainty that we see going forward. The uncertainty includes:
1. Defeating or at the least living with the COVID-19 virus as we approach the regular flu season (and there is some concern about a new virus emanating from China in the form of a swine flu).
2. A continuation of the reopening of the economy that will probably have some fits and starts along the way, but we do believe it will continue to improve into 2021.
3. A domestic population more divided than we have ever seen, while we approach a major Presidential election in just four months.
4. Longer term, dealing with a blossoming Federal deficit (projected to be $3.7 trillion this year) as well as a swollen Federal Reserve balance sheet which could ultimately lead to higher inflation and/or higher interest rates.
5. Valuations for stocks, bonds, and real estate that will be bloated if the economy does not come back from its shutdown in due course. Strategas Research Partners, one of our economic advisors, projects a price-to-earnings ratio of near 21 for the S&P 500 for 2021 (although we believe it could be somewhat lower).
Of the above, the one which will receive the most attention in the coming months is the Presidential election followed by what happens in the Senate. If the Democrats win back the White House and flip the Senate (assuming the House majority stays Democrat), it will most likely mean significant tax and regulatory changes in the future. Based on what has been suggested by the presumptive Democrat candidate for President, we can expect higher taxes on the wealthy in several areas. It could also mean more regulations for small and large businesses as we emerge from the COVID-19 forced shutdown. We at First Long Island will be watching the outcome of these elections very carefully. We will have a special section in our next quarterly report (late October) trying to forecast what a potential Democrat sweep (all three branches) would possibly mean.
We urge all of our clients to maintain a defensively tilted asset allocation. Given the paltry bond yields (we continue to underweight fixed income and recommend some cash holding), we continue to overweight our defensive basket with inclusion of at least two if not three of those strategies. We also are maintaining a slight underweight to our traditional equity basket while favoring our growth-oriented companies. Growth continues to outpace value stocks by a wide margin. Actually a margin that seems unsustainable, but is based on the durability and duration of earnings growth. The chart at the top of the next page demonstrates that outpacing of growth over value:
Despite a fair number of our strategies having above average allocations to growth or being ordinarily biased to growth, we do have sufficient value exposure and in our opinion asset allocation featuring diversification does pay off over time.
As Peter Lynch states, setbacks and unexpected occurrences are facts of investing life. Between COVID-19 and the potential for sweeping tax law and regulatory changes if Democrats sweep in the upcoming election, we must be vigilant in maintaining a long-term perspective with a prudent asset allocation. Great companies and well located real estate will always have long-term value if purchased at reasonable prices which tend to reflect economic conditions, including both interest rates and inflation. We are maintaining our bias to high-quality companies with strong balance sheets, good management teams, among best-of-breed outside managers, as well as a customized asset allocation for each client based on his or her individual goals and needs. Despite the unusual circumstances that we find ourselves in, none of this has changed. It has worked for our clients in the past and we expect it to work for them in the future.
Stay safe, stay healthy, and do not hesitate to call upon us for any of your wealth management needs.
Robert D. Rosenthal
Chairman, Chief Executive Officer,
and Chief Investment Officer
*The forecast provided above is based on the reasonable beliefs of First Long Island Investors, LLC and is not a guarantee of future performance. Actual results may differ materially. Past performance statistics may not be indicative of future results. Partnership returns are estimated and are subject to change without notice. Performance information for Dividend Growth, FLI Core and AB Concentrated US Growth strategies represent the performance of their respective composites. FLI average performance figures are dollar weighted based on assets.
The views expressed are the views of Robert D. Rosenthal through the period ending July 24, 2020, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such.
References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Content may not be reproduced, distributed, or transmitted, in whole or in portion, by any means, without written permission from First Long Island Investors, LLC.
The COVID-19 pandemic has created many questions in the minds of investors. In a recent web seminar members of the FLI team shared some perspective on the health crisis, economic environment, our current investment approach, and a variety of wealth management considerations.
Karen Weiskopf, Vice President, Marketing at First Long Island Investors and several long-time friends got creative during quarantine and created a virtual BINGO game to support local businesses and Long Island charities engaged in COVID-19 relief efforts. The group has raised over $33,000 so far and even had Academy Award Winner Natalie Portman call some numbers. CBS New York recently featured their efforts.
We as a firm, had an excellent 2019 in absolute returns, making up for a downturn in the fourth quarter of 2018 caused by the premature Fed tightening and an evolving trade war with China. 2020 began with gains in the U.S. markets supported by the expectation of domestic growth fueled by almost record employment and strong consumers buttressed by low interest rates and low inflation. Corporate earnings were projected to increase modestly over 2019. Domestic GDP growth projections for 2020 and 2021 were between 1.8% and 2.2%. Stocks looked reasonably attractive to us especially when compared to low-yielding bonds. However, this level of valuation was attractive only if the projected earnings growth materialized.
Reality interfered with our plans when “out of the blue,” a vicious virus emanated out of Wuhan, China in December 2019. It is believed the Chinese delayed disclosing the true nature of this coronavirus and the critically important fact that the virus was spreading from human to human – community spread. This element gave rise to what would become a global pandemic as Chinese nationals and visitors to and from China became lethal carriers of the virus. Unsuspecting nations including the U.S. and all European countries became victims, both victims of disease and the ensuing economic contraction necessary to stem the tide of the growth of this heinous virus. Social distancing and “shelter in place,” both prescriptions for killing the virus as well as killing the economy, have become part of the norm!
What is now occurring is a two-pronged war. The first is a medical war against the virus. Our soldiers are healthcare forces made up of frontline doctors, nurses, physician assistants, and all others on the front lines in all medical facilities. They are battling day and night with the beginnings of a surge of patients as testing for the virus ramps up. The virus remains highly contagious and some carriers have no symptoms. Unprecedented amounts of testing are now being undertaken, but at a slower pace than required. The best prescription to stem the tide of disease spread is social distancing which has become the cause of our second war, the economic one.
Social distancing has required the shutdown of an unprecedented amount of commerce. Cruise lines, airlines, hotels, casinos, all professional sports, and live events (including concerts) began the economic contraction. Now given the disease spread, government at both the Federal and state levels have created guidelines limiting groups to no more than ten or even worse “sheltering at home.” Businesses have had to adapt to having employees primarily working remotely. Virtually all restaurants, bars, and clubs throughout the country have temporarily closed. Tens of thousands of workers are being let go or furloughed on a daily basis. Most automobile production facilities have closed. Schools, kindergarten through twelfth grade, across the country as well as many universities have sent students home indefinitely.
This unprecedented dislocation of our way of life appears to be necessary to limit the spread of the disease and keep the fatality level down by spacing out hospital admissions in an attempt to deal with the capacity of our hospitals. Additionally, this disease is particularly severe for seniors and people with preexisting health conditions. There is really no way to adequately describe this challenge although it is one we believe that we as a nation will beat in time.
Clearly, this “out of the blue” global pandemic has already brought an end to our 11-year bull market and will cause a recession. A recession that a month ago seemed very unlikely to us. It has also brought incredibly rapid government action along with decisive and bold Fed action lowering interest rates and using the Fed balance sheet in many developing ways. It is expected that well in excess of a trillion dollars will be earmarked for afflicted workers, small businesses, and certain major industries. Hopefully our elected officials can come together in the next few days and leave behind partisan politics.
As we write this, the S&P 500 Index has declined 30.4% year-to-date and declined 33.8% from its high in mid-February. With so many industries and companies, big and small, curtailed or closed for an unknown period of time, corporate earnings and GDP will substantially decline. Thus we are undoubtedly in recession and the stock market is declining. High-quality bonds have performed better than high-yield, low quality bonds. Real estate values will likely decline as commercial tenants defer or renege on rents. Shopping centers are closed as stores have been forced to close, waiting out the hoped-for decline in disease spread.
In addition to this debacle, our economy also is digesting an oil war resulting from the failure of OPEC countries to reach agreement on limiting supply, primarily between the Russians and OPEC countries led by the Saudis. The good news for now (for consumers and businesses) are lower oil and gasoline prices. The bad news is the impact of collapsing prices on America’s oil and oil shale businesses. This could also impact debt arrangements with many domestic banks.
Looking Across the Valley
As long-term investors, we have experienced other periods when unexpected events led to substantial market declines. October 1987, the dotcom crash of 2000-2002, and the financial crisis of 2008-2009 were other periods where we faced dramatic market routs. Our advice then was the same as it is now: stay the course in high-quality companies, bonds, and real estate. Valuations have become quite attractive assuming that the companies we invest in will at some point in the not too distant future return to “normalized earnings.” Some companies that we invest in might even benefit in the short- and long-term from this crisis including Amazon.com, Facebook, and Alphabet (Google’s parent company). Additionally, other companies that we have an interest in will ultimately benefit from new 5G technology like QUALCOMM, or the continued move towards cloud computing such as Adobe and Microsoft. We believe there is a certain inevitability of a return to normal where great companies will prevail. Look to 2021 for more normal earnings and economic conditions.
However, for the time being the equity markets are falling quickly. To make matters worse, high-quality companies are falling along with lower-quality ones. Future earnings and dividends do not seem to matter in the short term but our experience tells us that they will matter in time. Vitally needed pharmaceutical companies are trading at what we believe will be viewed as bargain prices with many paying high dividends based on the reduced share prices of these companies. Banks that are well capitalized are also in free fall despite rock solid balance sheets. Technology companies, as mentioned above, with great prospects also have fallen victim to the panic selling. Every sector of the S&P 500 is down at least 20% with more than half of them down more than 25%. There appears to be a disregard for a future that is brighter than the gloom and uncertainty of today.
As we have often said, we own interests in real companies that have assets and almost always make a profit. In today’s world, that does not seem to matter, but it will. We believe many of these companies are cheap and deserve to be held for the long term.
The consumer, who is the backbone of our domestic economy, has suffered a vicious gut punch. A punch that has temporarily stopped many from working, shopping, eating at restaurants, and participating in activities that were always taken for granted. Unemployment will soar in the weeks to come. Many smaller businesses will close. This is war. We need the Federal government to come to the aid of the consumer, worker, and business. We expect that to happen shortly. This will make a difference and the sooner the better.
How to Invest
Our adherence to a prudent asset allocation has worked for us to a degree. Many of our defensive and traditional equity strategies are outperforming their benchmarks despite being sharply down. Quality will ultimately prevail. Diversification in having some bonds and defensive strategies is keeping our clients in the battle.
We do not know where the bottom is as we have no crystal ball. However, we believe we know good prices for solid companies, and those of today seem like good prices for many. However, they could get even better. That said, if one has additional liquid assets (beyond what is needed to either live on or sleep at night) we would consider deploying in stages to what we believe is an exceptional long-term opportunity for the future.
Hold on and let’s beat this invisible enemy, the coronavirus. Once we as a society and government do that, you can count on America as consumers and businesses to come back. We always do.
Thank you for your confidence in us and the kind words many of you have said to us as we have reached out to you during this surreal period of time. Please do not hesitate to call.
Stay safe and practice social distancing and good hygiene.
In good health,
Robert D. Rosenthal, Chairman, CEO, and Chief Investment Officer
Ralph F. Palleschi, President and Chief Operating Officer
*The forecast provided above is based on the reasonable beliefs
of First Long Island Investors, LLC and is not a guarantee of future
performance. Actual results may differ materially. Past performance statistics
may not be indicative of future results. Partnership returns are estimated and
are subject to change without notice. Performance information for Dividend Growth,
FLI Core and AB Concentrated US Growth strategies represent the performance of
their respective composites. FLI average performance figures are dollar
weighted based on assets.
The views expressed are the views of Robert D. Rosenthal through
the period ending March 23, 2020, and are subject to change at any time based
on market and other conditions. This is not an offer or solicitation for the
purchase or sale of any security and should not be construed as such.