In the depths of the pandemic and market volatility in April 2020, we released a report for clients recommending screens of stocks that we thought would outperform even if the market had not continued rallying off the March lows.  One year on, we review our recommendations, which have outperformed global indices.

Buying dips can be very uncomfortable

Steep declines in markets lead to the best buying opportunities, but bear markets are torturous to navigate and often contain several false dawns.  We only know when the market bottomed in hindsight and so it is usually better to buy a day late than a day early.  With this in mind, back in the depths of the pandemic, we tried to find companies that would offer the best chance of survival and could navigate through all of the pandemic-induced uncertainty.

The main takeaways from our report back in April 2020:

  • Many stocks and sectors exit bear markets at different times.  Knowing when the broad market has hit its ultimate bottom is helpful, but mainly as a sign to increase portfolio risk to maximum
  • The out-performance of defensive vs cyclical companies in bear markets is usually greater than the subsequent under-performance after the market bottoms
  • How to screen for global quality companies and how to find companies that can offer the best upside coming out of a market bottom

Averages and bottoms

Bear markets are difficult for both bulls and bears.  Market indices become much more volatile as bear market rallies can be just as powerful as sell-offs.  Life becomes easier when you shift away from index averages and identify sectors or factors that bottom early and will ultimately outperform.

Chart source: Bloomberg, Macrobond, Variant Perception

Bear markets have historically lasted 18 months on average, enduring an average 42% peak-to-trough decline.  The 2020 bear market lasted 33 days with a max drawdown of 34%.  The extraordinary action of central banks across the world made this the shortest bear market ever and helped all stocks rally off the bottom.

Finding “LUV” in a pandemic

In our report we said: “We expect the recovery pattern across industries to be 3-speed, and come in 3 different shapes, L, U and V.  The L’s are those firms who most likely are or will become insolvent; the U’s are firms that once demand gradually begins to pick up should eventually recover; and the V’s are firms that are best placed to benefit from huge fiscal and monetary stimulus waiting in the wings as demand returns.

Combining this with our leading indicators, we expected the sharpest recoveries to be found in areas that were most sensitive to easier financial conditions like autos and housing.  Autos were the worst performing industry in the US up to April.

Chart source: Bloomberg, Macrobond, Variant Perception

The auto sector has been the best performer since then, helped on by surging liquidity and a shift in consumer demand towards cars and away from public transport.

Never waste a good crisis

We did not know when the bear market would eventually end, but we recognised that prices were suddenly a lot more attractive for quality companies.  Even if the bear market ran on for longer, buying into quality businesses at attractive valuations is a time-tested strategy for long-term success.  These companies often fly under the radar and are perennially undervalued – some liken this style of investing as “eating like a pigeon while crapping like an elephant”.

It is precisely because of this low upside/high downside risk proposition that many of these quality companies were undervalued.  To find these quality companies, we avoided earnings-based metrics that can often shroud the underlying cash-return potential of a business, and instead focused on cash-based return measures such as CROCI (free cash flow return on capital invested).

Chart source: Bloomberg, Variant Perception

These companies have stood the test of time and have shown the highest out-performance in crisis periods.

Chart source: Bloomberg, Macrobond, Variant Perception

While the bear market ended up being incredibly short as a result of unprecedented policy stimulus, the out-performance of quality did not last long.  But the screen did its job and protected capital very well and allowed us to invest in quality companies at attractive valuations.

Sharpening the “V”

We also prepared for a market that could rally and not look back in light of the unprecedented policy response.  We tried to eliminate the companies that were most at risk of bankruptcy and tried to find the biggest winners.  In the US, we noted small cap value stocks were on a major downward trend and suggested that many could offer asymmetric upside.  Globally, we noticed that LatAm markets were disproportionately punished and many companies were trading on single digit P/Es in spite of strong operating performance.

We screened for companies with trailing P/Es less than 5 and applied quality filters to avoid bankruptcy candidates and find good operators.  This screen of “V”s has outperformed the MSCI All Country World since we released our report.

Chart source: Bloomberg, Macrobond, Variant Perception

The bulk of this outperformance occurred after the Pfizer vaccine announcement on November 9th.  As we noted in the report:  “While these companies currently offer attractive risk premia, there is the possibility that it will take time for the premium to narrow”.  The imminence of vaccines allowed markets to reprice risk – pushing up the valuations of companies that could benefit the most from demand coming back.  What is most impressive about our selection of “V” companies was that it did not lag the index prior to the announcement.  By applying a quality filter, we avoided the “L” companies that languished after the market bottomed.

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