- Integer Investments
Letter to investors
Updated: Apr 2, 2020
- The coronavirus is worrying investors
- Markets have declined 15% from their peaks
- We were cautious before the pandemic, and we continue to be
- Here we discuss our portfolio and how we will position for the future
Dear friends and investors,
This week has been a particularly challenging week for stocks and global markets. Therefore, I would like to share my thoughts and plans.
First of all, be assured that we are monitoring the markets and the virus situation very closely. We will do all we can to ensure that your investments are safe and well balanced to face the situation ahead. As you know, my own wealth is invested in exactly the same way, so your losses will be my own losses.
Second, let me explain how I see the situation and how we are positioned. As we know, the Coronavirus is claiming lives all around the world. At the time of writing more than 86,000 cases exist, with 3,000 mortalities. The vast majority of cases are in China but, after an apparently limited outbreak, the virus is now spreading quickly all over the world. This is what is worrying the markets.
The virus is spreading
In the first few weeks, almost all cases were around the epicentre of Wuhan, but now many cases are reported in South Korea, Italy, and Iran. Infection growth rates in these countries are 20/30% a day. Iran is also problematic, because the health system is weak and the country exists in a neighbourhood of poverty and low quality healthcare (Middle East, Africa). The mortality rate in Iran also suggests that numbers are higher than declared (even the deputy health minister is infected).
Figure 1. Virus infections as of 1st of March.
Considering how widely spread the virus is, it will be challenging to control it. Some countries have started limiting flights and travel (banning flights from China or Iran), but the virus has nevertheless spread to dozens of countries. As it is impossible to ban all international travel, Coronavirus will continue to spread. Some commentators argue that within the coming year, some 40 to 70 percent of people around the world will be infected with the virus. This sounds steep but, even if it is 10%, we are looking at 770 million people, with a mortality rate of 2%, meaning 15 million deaths. Hence, the situation could get serious unless the virus weakens or we find a cure. I have no expertise to evaluate the likelihood of these eventualities, so mass infection is a possibility we need to contemplate.
A number of companies and governments around the world are working around the clock to develop a vaccine. However, estimates about how long it will take range from 3 months to 18 months. Obviously this difference could have huge implications. A 3 months vaccine would reduce deaths and the spread by a large magnitude. It is almost impossible to predict what will happen along this front. In general, the situation looks serious.
The impact on the economy
Additionally to the humanitarian costs, this obviously impacts the economy and, consequently, our investments. Here, there are two scenarios; short-term and a long-term. If the situation somehow gets handled in the short-term, either because the medical situation improves, or because government measures (see China) work, the effect on the economy and the markets will be limited. The current estimates suggest an economic weakening, but the range is broad. For example, IMF estimates shave China’s growth by 1% (to 5.6%) and global growth by 0.1%. These estimates were made a few weeks ago, so they might worsen soon. All in all, it is very hard to predict how economic growth will be affected in the short term, but if the health situation improves within 1 to 3 months, more or less everything will be fine and the portfolios will regain ground as quickly as they have lost it.
The situation would be very different if the health situation worsens and there is no end in sight for a few months. This is negative for both the economy as well as for portfolios. If economic activity slows down for a prolonged period, many companies around the world are at risk of closure, and many will start to lay off employees. For example, Bloombergreported that 33% of SMEs in China would run out of cash in a month, and 32% in two months, if the situation did not improve quickly. The Chinese government is addressing these problems, but they won’t be able to hold up decline forever. Another sector that is being impacted is Oil and Gas. Oil prices are already down and a lot of companies are overleveraged. Hence, a long period of subdued demand might be dangerous. For example, two days ago Barrons reported that the iShares iBoxx $ High Yield Bond ETF (HYG) had its biggest single day of withdrawals on record on Wednesday, losing $1.6 billion. That was about 9% of the $16.8 billion in assets under management. 10% of the assets of this ETF are in Energy.
Most of these situations, by themselves, are not terribly dangerous. However, markets are driven by emotions. If some banks start to reduce exposure to certain industries, others will follow. In turn, these companies will struggle to refinance with normal interest rates, they will face bankruptcy, exposing other players in the industry and supply chains. Workers will be laid off, the economy will be affected and so on. Remember what happened during the last crisis, which started with mortgages in the U.S. and then affected the entire world. Viruses and health problems spread as fast. I believe that this more severe scenario will materialize if the health situation (and expectations) doesn’t improve within 3 months, leading to a recession.
The market and the economy regardless of the virus
Unfortunately, before the outbreak, the economy was already struggling and the markets were corrupted. Over the years, central bank interventions affected market behaviour in a way that will emphasize any potential effect. Loose monetary policy has pushed investors to risk levels they are not ready to sustain. Think, for example, about pension funds (and pensioners). These are generally low risk and invest mostly in government bonds. The problem is that governments bond are yielding very small, even negative interest rates in Europe. Therefore, they had to invest in other assets such as real estate or lower rated bonds. Some others have invested in relatively safe companies such as Coca Cola to obtain a dividend yield of 3%, way above the current 10-year yield in the US (now 1.5%; hovered around 2% for a while) and the 0% you can get in Europe. The problem is that Coca Cola shares are not bonds, and they behave differently. Below you can see that Coca Cola has lost 10% of its value in 5 days. These types of stocks might face lower volatility compared to high flying tech stocks, but they will go down in price if a recession arrives. And actually, this might not even be the case considering the market distortions I mentioned above. Hence, if we face a prolonged recession and a consequent stock market decline, the market will need to rebalance and price risk accordingly. This will be very painful. It is no surprise that this is the fastest market correction in history. We believe that if markets and central banks don’t normalize, something else will pop up in the future, the virus is just an excuse for markets to reassess the situation (quickly).
Figure 2. Coca Cola stock price
Source: Google Finance
The rapid and unprecedented decline is not surprising because we have made history in a number of ways. This is the longest and strongest bull run ever. The table below, reported by CNN, shows some numbers. Note that this table was updated in April 2019. Hence, the run is even longer and more profitable than reported below. From April 2019 to the peak in February 2020 markets gained an additional 15%. So from the low of 666 in 2009 the SP500 has gained 408% (not including dividends) to reach 3386 in the peak of February 2020.
Figure 3. Historical bull runs in the S&P 500.
This growth has been fuelled by profit expansion but also through multiple expansion. In this case, looking at the Shiller PE ratio (10 years of profits) for the last 140 years, we are in the third highest multiple. The only higher multiples were Black Tuesday and the internet bubble. Hence, we arrive to this moment with pretty stretched valuations.
Figure 4. Historical Shiller PE ratio
Unfortunately, almost all asset prices are inflated. For example, the chats below show real estate prices around the world. As the Economist reports, most real estate numbers have experienced strong growth over the last 1 and 5 years. For example, Dublin, Auckland, Berlin, Vancouver, Amsterdam, Shanghai, Sydney, have seen growth of over 50% in 5 years. This means that most real estate assets are expensive according to historical trends. For example, Hong Kong is 93% above long term affordability averages. Many other cities are in the same situation.
Figure 5. Historical real estate asset affordability and growth
Not only are companies pricey, they are also indebted. The graph below shows that companies’ debt is at the highest point in over 70 years.
Figure 6. Historical U.S. corporate debt to GDP
Another factor is government debt. To face the financial crisis, governments have saved banks and raised funding themselves. This means that debt to GDP is quite high. For example, from 1995 to today, the US debt increased from 93% in to 136% of GDP. Japan from 94% to 234%. Italy from 120 to 147%. France from 67% to 122%. UK from 53% to 116%. Only Canada and Germany are relatively stable. Therefore, should a recession arrive, governments not only will have a hard time investing for growth, but may face market turbulence (see the European debt crisis a few years ago). Clearly, central banks would need to step in.
Figure 7. Historical government debt to GDP
The reason that asset prices (not only equities) are inflated and companies and governments are indebted is because interest rates have never been so low (the graph below is the longest I could find but it only covers data up to 2015). The current 10-year yield of 1.3% is the lowest of the last 200 years. European interest rates are negative, and as far as I know, this was a taboo until a few years ago. As this paper from the ECB says, “a tenet of modern macroeconomics is that monetary policy cannot achieve much once interest rates have already reached their zero lower bound (ZLB)”. Of course now policy makers start to find reasons to justify this perverted mechanism – the so called “this time is different” defence. But think about it: why would I lend money to someone, and pay this person to take my money? I understand that inflation, future expectations and so on could explain this fact, but I struggle to find any sense in this. I think that in a few years we will look back and wonder what we were thinking.
Figure 8. Historical 10-year U.S. Treasure yield
Central banks have not only lowered interest rates, but also printed money like never before. This is the longest-term graph I could find, though it only shows data to 2012. The FED current estimates show that in 2015 central bank assets represented 23.2% of GDP, and the latest estimate of 2017 prints 21.7%. So, higher than the great depression and World War II.
Figure 9. Historical U.S. FED balance sheet
The U.S. looks conservative compared to its Japanese counterpart. The BOJ has now reached 73.4% of GDP! This compares to 6% before 2000 and 17% during the financial crisis. The ECB is also around 20%. This means that investors are competing against their central banks for assets. Estimates are that $16 trillion of debt around the world offer negative yields and that this is approximately 30% of outstanding debt. This changes market behaviour since central banks are not driven by profits. The graph below shows that half of the world’s governments have a 10-year bond with negative yields.
Figure 10. Percentage of countries with negatively yielding debt
I believe that central banks, once the gold standard was removed, inflated one crisis after the other. The idea of sustaining economic growth means that central banks tried to avoid a recession, therefore delaying the inevitable and dropping interest rates lower and lower over time. This created bubbles such as the real estate boom of the early 2000s. I believe that central banks should remove growth support as one of their two mandates. All in all, we are in a historically unprecedented distorted market. This means that the future might look very different from the past.
One thing that has behaved differently is inflation. Economic theory suggests that when monetary supply and velocity increase, inflation goes up. However, despite all the monetary stimuli, inflation has not changed much. There is a number of potential explanations such as technology, globalization, and the ageing population, yet central banks do not really know what is going on. The previous US central bank Governor Janet Yellen called inflation a “puzzle”. Facing uncertainty, central banks have done more of the usual (see above), expecting different results that, so far, did not materialize. I have my theories, but they would be a topic for another day. What is important to remember is that inflation could go in any direction. It would be okay if it stays where it is now (1-2%), but dramatic if it goes much higher, above 4%. This is because markets and economies could be washed with cash and low interest rates that would cushion the impact of a recession and the virus. However, if inflation picks up, central banks would need to be cautious to avoid even higher inflation. Creditors such as pension funds that moved down the duration curve, or holders of those negatively yielding $16 trillions, would struggle, with unknown consequences for the broader market. A rapid sell-off in long duration bonds would be consequential for everyone.
What to expect
The key message I want to channel is that there is a pandemic that could disrupt the economy and supply chains in the short term (beyond humanitarian issues). The short-term impact might be limited and nothing to be concerned about. If the virus effect persists long-term we will face an economic recession. Unfortunately, we would arrive to this recession with a corrupted market where its participants are stretched and mispositioned. If we didn’t have these market imbalances I would not worry about the virus. But in these circumstances an adjustment would be severe with hard-to-predict consequences. It is possible that central banks would pump a huge amount of cash into the system while governments would be powerless due to their high debts and political issues. Additional monetary stimuli might help in the short-term but, if inflation picks up, the situation would collapse very quickly. Central banks would have to choose between reinstating growth and weakening inflation. There would be market panic because investors would need to rein in positions, but many investors have moved down the risk and duration curve and would not manage to reposition. Think about the mismatch between asset and liability duration of the global financial crisis. Hence, my expectation is twofold:
1) If only short term, the market doesn’t move much from current levels, then recovers fast. This is probably what is going to happen over the next week/s.
2) Long-term, we enter a recession. Markets will face significant declines in the range of 30-50% from the peak (so additional 20-40%). This is due to both the recession and the fact that we would enter it with inflated asset prices. If inflation picks up, the risk is that central banks would struggle to balance their dual objective. At that point we might see a 70% market collapse from the February peak.
How we position our portfolio
So here what we are doing to ensure a viable portfolio long-term. In the short-term we have given up some gains (our average portfolio was up 14% in 2019), but we are weathering the current market downturn quite well (our average portfolio is down 1.17% YTD, compared to declines of 8.56% for the SP500, and 11.1% for the Eurostoxx 50. How are we achieving this?
First of all, we are positioned for the next 30 years. But we also try to be positioned for the next months, a sort of all-weather portfolio. We are doing the following (please note that some accounts might differ due to regulatory or size reasons):
1) We have sizable positions in gold (8.2% of portfolio) that is considered a hedge against market turbulence and inflation (although this week some volatility meant that gold sold out on Friday, overall it has performed very well).
2) Before all the turbulence, we bought index options. These have performed very well. Should the market calm down we will buy more. We are especially interested in far out-of-the-money options that will cover us in the event of a significant market decline. We had bought SP500 mini PUT options with strike price of 250. This level seemed outrageous a month ago but not anymore. We have the December 2020 250 PUT at an average price of $5.51. It is currently trading at $12.96 with a significant gain. We also had options with similar duration and strike price of 325 and 290. Now options are expensive due to significant volatility. If volatility declines we would add out-of-the-money options with a yearly duration. At the moment we have sold the 325 and moved down to 250 even more, solidifying some gains. In some cases, due to the small portfolio size, we have bought DOG as an hedge (a negative bet on the Dow Jones).
3) Our portfolios have generally included a large portion of short-term, high-quality bonds or cash. 22% of the average portfolio is invested in SHV ETF (short term US government bonds); 10% is invested in ERNA ETF (ultra-short corporate holdings, mostly in A-rated companies); 9% invested in ERNS ETF (ultra-short corporate holdings, mostly in A-rated companies or institutions); 10% direct exposure to US treasury bills with expiry on June 2020. We also own AAA ETF (cash in Australian banks; 1% of portfolio). The ETF pays approximately a 2% yield and gives exposure to the AUD which has declined a lot and should recover if the situation improves. In total 52% of our portfolio is in short-term high-quality bonds and cash that pay approximately 1.8% in yield at current prices, and 5% in cash, mostly in EUR.
4) The remaining portfolio is invested between REITs and stocks.
a. REITs are generally safe as they are backed by real assets and rented long term. These will provide income even if a recession hits (to a certain extent). Two of our REITs are in the medical sector which, in theory, should perform well in case of virus issues. We have HTA and VTR (1.5% of portfolio each). These two pay an average dividend yield of 5%. We then own BIP (3.2% of portfolio), a strong player in the infrastructure space with a dividend yield of 4.25%. Even in a recession infrastructures are needed and so should perform decently. Governments might also step up investments in infrastructure to help the economy, so supporting BIP. Two slightly more speculative investments are SKT (outlets, 1.2% of portfolio) and WPC (operationally critical commercial real estate, 0.8% of portfolio). The former is performing poorly but currently offers a dividend yield of 12%. And, as the founder says, “in good times, people love a bargain and in tough times, people need a bargain”. In a recession the company would definitely struggle, but it is well managed, with limited leverage, and it offers interesting risk-rewards. Similar story is WPC which offers a dividend yield of more than 5% and invests in operationally critical commercial real estate around the world.
b. In terms of stocks we are slowly adding to our positions. We are looking for companies with (a) long term sustainable businesses, meaning with long term trends supporting their industry and with solid competitive advantage; (b) with low leverage; (c) well managed and (d) with positive free cash flow. Of course we also want to pay a fair price. This has been difficult but with prices coming down more opportunities are becoming available. Currently our largest position is Berkshire (BRK.B). The company has three advantages. First of all, some of its subsidiaries are defensive (e.g. utilities). The company also has exposure to airlines and consumer cyclicals such as Apple; but overall this is reasonable due to its diversification and large cash holdings. Third, obviously, it is managed by a great investor that can benefit from market opportunities like no other. We have recently invested in tech companies in China. The rationale was that the trade war impact was exaggerated and that these companies would thrive anyway. We had bought a sizable position in CQQQ (Internet/technology China ETF 3.3% of portfolio) and individually in Tencent (700; 2.4% of portfolio). These investments had performed wonderfully but of course now they are retracting. We still believe in the long-term potential of these companies and we will add more if prices decline (at $44.5 for CQQQ and HK$335 for Tencent). We like Skechers due to its loyal customer base, strong cash position, and good management. We have added on Friday closing and it now represents 1.9% of our portfolio. We also recently started a position in Visa (2.1% of our portfolio). The company will grow for many years due to the transition from cash to cards. It is also investing in technology through acquisition or in-house initiatives. It furthermore pays a dividend and has virtually no debt. In addition, it is not exposed to counterparty credit risk (as is American Express for example). We also own Google/Alphabet (GOOGL; 1.7% of portfolio). We all know the market leading position in internet searches, but also interesting bets in cloud, AI (I believe strongly in this industry and Google is a leader) and self-driving technology (another market leading position in an industry of the future). The company has $140B in cash and a reasonable multiple. We recently added to Danone (BN; 1.5% of portfolio). The company makes water, dairy and plant-based products. As people say, you always need to eat. The company strategy is also sensible, a 16 P/E is very prudent when you factor in that revenues are growing at 2-3% annually. Danone offers a 3.4% dividend yield, and exposure to the EUR. The company has $9B in net debt, but a 2X EBITDA and $2.5B a year in FCF should make it manageable. We have some small positions in Nasdaq ETFs, BOTZ (ETF on robotics and artificial intelligence), MILN (ETF on millennial trends). Should stock prices continue to decline, we will convert bonds and cash into stocks, gradually. Entry prices will depend on the situation of course, but some estimates are provided. Following the principles outlined above, we will add to our positions and we aim to start positions in solid companies such as NVIDIA (around $200), Amazon (AMZN, $1700), Salesforce (CRM, $120), Deere (DE, $120), Disney (DIS, $100), Nike (NKE, $75), Netflix (NFLX, $250), Tesla (TSLA, $300), Apple (AAPL, $200), LVMH (MC, €260), Intuitive Surgical (ISRG, $360), Autodesk (ADSK, $140), SAP (SAP, €100 and then $85), Paypal (PYPL, $70), Nestle (NESN, CHF 85), American Water Works (AWK, $75), Waste Management (WM, $90 and the $75), Microsoft (MSFT, $125). We are conducting more research into companies such as Baidu, Alibaba, Tripadvisor, Hilton and Marriot. We will avoid Oil and Gas because of a negative long-term trend and high investments and debt required for operations. We will also avoid banks (apart in extreme cases and for very strong companies) because of inflation and recession risks. We will also avoid airlines and cruises due to high investments in fixed costs and the difficulty of differentiating product offerings. We also like companies in the HACK ETF, as cybersecurity will be more and more relevant in the future. We realize that we might not be able to buy the above companies at these prices but we can do two things: (a) Wait longer, opportunities will eventually materialise; (b) Sell PUT options. This will provide income if not exercised, and will give us a lower entry point with a discount if exercised. So far, we have sold BRK.B with strike price 200 in January 2021. We sold it for 1.13 (now it sells for 1.4) so this gives us approximately 5.6% income. We also sold Visa PUT Dec 2020 strike 160 at $8.47 (now selling for $10.55). This gives a 5.3% income. This strategy will also help to finance additional cover on the index.
First, as we started, we want to ensure that we are doing all we can to preserve your capital but also to put it to work to gain long term. We are reasonably worried, but if the health crisis gets resolved in the short term, there should be limited damage and our portfolio will continue to perform positively. If it takes longer, all the economic issues and market imbalances created by years of loose monetary policy will need to be faced. If inflation picks up, the damage would be significant. Clearly, if the market falls, also our portfolios will suffer. However, we have been waiting for a market clean-up for a while, and this could provide the long-term opportunities that we have been waiting for.