2020: Unprecedented polarisation and rotation

As we move towards the end of 2020, something that cannot come fast enough for many, we thought it might be useful to look back at 2020, what happened, as well as providing our view on the outlook for 2021.

Fund Commentary
18 Dec 2020

As we move towards the end of 2020, something that cannot come fast enough for many, we thought it might be useful to look back at 2020, what happened, as well as providing our view on the outlook for 2021.

Strangely in a year that has been so impacted by macro news, the investment environment for fundamental investors could be considered more benign than the last few years.

There were many times when markets moved on macro news, and sometimes irrationally, but announcements of company results were often the main driver of movement in individual stock prices. Polarisation has been the name of the game, at pretty much every level; by sectors obviously, but also by countries because of the vastly different decisions taken by governments to try and control the virus, with significant discrepancies even in neighbouring countries. This dispersion has been extremely favourable for active investors and in particular fundamental stock pickers, who have been better placed to understand the impacts of the environment on companies’ earnings.

A perhaps underappreciated feature of stock markets, in general, is the uneven distribution of returns, meaning average stock returns strongly differs from the average market return. Recently compiled data for the past five years found that this period has been no different from what has previously been demonstrated in academia and sell-side research.

An interesting study focusing on the returns of the Russell 1000 over the past five years concluded that:

  • <13% of stocks outperformed by 100% or more. However, half of these outperformed by at least 3x pulling the market average up significantly.
  • >Two-thirds of all stocks underperformed the overall market with the median stock returning 58% less than the market average.
  • >30% of stocks delivered negative absolute returns despite the market returning 94%.

Proponents of passive investing will argue that this phenomenon underpins the need to own all stocks rather than an actively selected group. We would dare to disagree.

As of 15th December, the Strategic European Silver Stars Fund reported a +27.0% YTD performance, which compares to -3.8% return for its benchmark. The 30%+ outperformance this year is a perfect illustration of the benefits of fundamental and concentrated portfolio management philosophies in our view.

The scale of Covid coming to light

What started in January as news of another virus outbreak from a Chinese wet market turned into something more sinister as the human-to-human transmission was found, and the virulence of the virus became more evident. Markets sold off, particularly in the last week of January, leaving the EuroStoxx 600 down 1.2% for the month, but this was nothing compared to what was to come.

February saw the EuroStoxx 600 fall a further 8.3% after the virus found footholds outside of China and it was clear that transmission was not under any control despite efforts at test and tracing. Markets resorted to being driven by panic and fear as the flow of rumour and misinformation ran wild. March saw global lockdowns and liquidity crunches in almost every asset class. Large-cap indices in Europe finished the month down 14.5%, the sharpest plunge in history. As the search for liquidity became obvious, small & mid-caps indices dropped by an additional 7% during that month.

The market sell-off in Q1 was not completely indiscriminate to start with, but by March it frankly did not matter if a company was going to be impacted or not, its share price was down heavily. Fundamental investors were hit with the markdowns alongside every other investor.

Share price falls like this provided a massive opportunity. Knowing companies inside out helped in not losing sight of fundamentals, although not possessing a crystal ball either. One CEO asked on an investor call during the crisis what the impact of Covid was going to be on the companies’ returns for 2020, answered: “I can’t tell you how many of my staff are going to be in the office next week, how am I meant to be able to tell you what the earnings are going to be for this quarter never mind the rest of 2020.”

Very similar to 2009, the key question in March 2020 was not about guessing 2020 EPS or the pace of the recovery. All that mattered was figuring out whether companies had enough cash and undrawn credit lines to cover their debt instalments due in the coming three years.

Governments learnt lessons from 2008, but sell-side research was behind the curve

The aftermath of the financial crisis of 2008 saw many countries impose austerity measures to try and curb public spending and bring GDP / debt ratios back under control after the bailouts to the banking sector. This period saw many firms struggle, redundancies increase, and inflation stay resolutely low despite interest rates often at zero, and negative in places, combined with massive quantitative easing.

In comparison governments worldwide realised that to avoid the complete collapse of their economies from Covid, and more importantly the ability to restart their economies after this massive external shock, they needed to support companies. This came in many forms around the world from furlough schemes, to company loans and grants, and whilst it was not coordinated it was generally of a similar nature and certainly unprecedented.

Sell-side research analysts, which have lost a lot of experience and calibre since MiFID was implemented, were slow to react. Brokers decided to wait for Q1 numbers to adjust and incorporate the pandemic impact in their estimates, often assuming an Armageddon type scenario, that fortunately and thanks to government actions never materialized.

On the back of the central banks’ actions and government measures, the stock market bounced in April. The rebound was often labelled as “the most hated rally in history”. Many investors remained stuck on the side-lines, watching stocks shoot higher without them. The truth was that although markets, in general, were rising from their lows, there was massive dispersion between stocks.

Lessons learnt from the first lockdown

Many countries learnt lessons from the first lockdown by seeing what worked in both their own countries and in others. One fantastic example we regularly used this year as an illustration of the above is Rexel. This company manages a global distribution network servicing professional customers in the industrial, residential, and commercial sectors, operates in 32 countries, with 2,000 branches.

When unveiling its Q1 2020 sales on 23rd April, it provided investors with a useful additional data point: its 1st April to 15th April YoY change for the group and per country. During those two weeks, the French business declined by 59.8%, while at the same time their German activity improved by 2.6%. The dichotomy of returns was entirely caused by the variations of lockdowns that were imposed across different countries. As one can see, polarization this year went way beyond a pure sector dichotomy, separating winners from losers only by industry.

It also helped answer some important questions: will the French government reinstate the same restricting conditions in the case of a second lockdown? Guess what? It did not. Lockdowns measures for France this fall have been far less restrictive than for Switzerland in springtime, where officially, there was no lockdown.

As further lockdowns came into effect as we entered Autumn in Europe far fewer businesses were required to close, aid was more focused, and the impacts of the lockdown were reduced. Investors that had carried out the work on the first lockdowns were much better placed to predict the impacts of the second ones, but in general, we are still seeing sell-side research and many investors missing this nuance. The immediate return to panic and fear led to a sharp selloff in markets with the EuroStoxx declining 5.5% in the last week of October.

Vaccines and the US election

A more stable investing environment after Biden won the US election and more importantly, the announcement of several viable vaccines drove markets to rally in November. The EuroStoxx gained 13.84% in its second-highest monthly return ever with massive sector rotation. The value and cyclical sectors that saw some of the highest losses in Q1 have produced some of the largest gains, whilst many of the stocks that have benefitted from the lockdowns, and produced brilliant results for the last six months, have been under pressure last month.

Some market pundits are talking about all the good news being priced in and all the risk is to the downside. We do not feel this is the case at all. Some stocks have done outstandingly since March, reducing the upside potential, and deteriorating the risk profile of those potential investments. However, many other companies remain well below their Q1 2020 highs, even post the November rebound.

We started repositioning our portfolio over the late summer, taking profits in companies with less upside potential and reinvesting in others with sizeable opportunity. Sticking to our long-established investment process of putting money to work where our fundamental valuation is significantly different to the market price has worked well through 2020 and has positioned the Fund for what we would hope will be another outstanding year in 2021.

The long term passive allocators who held their exposures have managed to recoup some of their losses since the March lows: The EuroStoxx 600 net return remains down nearly 4% year to date as of 15th December. We come back to the point raised in the introduction: the average stocks return strongly differs from average market return.

What may happen in 2021

2021 will hopefully be less eventful than 2020, but just because the vaccine is now being rolled out it does not mean that it will be plain sailing. It will take time for the vaccine rollout to reach the levels needed for life to go back to normal. Lockdowns and restrictions are likely to still be a tool that governments utilise to control the spread of Covid. Markets are likely to be jumpy especially given the large moves that we have seen, but more positively they are already starting to focus back on other issues such as ESG rather than just Covid.

In normal circumstances, as a manager, we should not feel so at ease after such a strong year, posting a 30%+ outperformance. This time around, the situation is radically different as the recent portfolio rotation has totally reshuffled the cards.

We believe 2021 should remain an investment environment favourable for active management. We are seeing opportunities in Europe today that we have not seen for many years, combining low valuations with sharp earnings growth prospects for the next two years at least, benefitting from:

  • Worldwide economic recovery with consensus views at +5.2% for 2021.
  • A continued low-interest-rate environment.
  • A renewed interest in Europe.
  • YoY results comparisons for 2021 that will be much easier given most businesses were closed for at least two months of 2020.
  • Adjusted cost basis for most corporates as 2020 was a great opportunity to adapt.

As of today, the Fund’s largest positions all trade with a PE below 10x for next year, with free cash flow yields of at least 10%, a powerful cocktail for future performance in the months / years to come.

If you have any questions on the updates to the prospectus, positioning of the Fund or would like to further detail on our views please do not hesitate to contact us. Visit the Fund Page >

Adam TurbervilleAdam Turberville
Head of Marketing & Client Relations
+44 1481 742380

The views and statements contained herein, including those pertaining to contribution analysis, are those of Pascal Investment Advisers SA in their capacity as Investment Adviser to the Fund as of 15/12/2020 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.