July 2020 Letter
As we formally kick off summer and the second half of 2020, we hope this letter finds you well! We are also hopeful that America’s reawakening can continue in the months ahead as we await a vaccine for Covid-19. However, we also know that as we reopen, things will look different. In the near term, until we have effective treatments, everyday life will look starkly different. But, we also know that some of these changes will endure long after a cure moves us past the current pandemic. This quarter, we want to briefly touch on the recovery in stocks since the lows of late March, what the recovery tells us about a better future that feels distant today, and the importance of sticking to a plan. Next, we want to look at the varying shapes of near- term recovery that many have described with certain letters of the alphabet. Finally, we will cover what we believe to be some of the more enduring long-term behavioral changes and their investment implications.
On March 23, 2020, after a mere 22 trading days, the S&P 500 found itself 34% below its February all- time high. The pandemic was spreading, credit markets were dysfunctional, and stay-at-home orders were closing the economy. It’s often said, “stock markets hate uncertainty.” Uncertainty in the markets usually gives way to fear or optimism as the key determinants to short-term direction. Longer term, fundamentals are more accurately priced into markets. By mid-March, fear was palpable and no one seemed to have any control over the situation. Finally, by the end of the month after extraordinary actions by both the Federal government and the Federal Reserve, emotions began to calm, but few, if any, were ready to predict better days ahead for the stock market. On March 23, there was little reason to be optimistic.
Thanks to government action, credit markets began operating more smoothly and hundreds of billions of dollars entered the economy. True, we witnessed historic job losses, but government intervention and increased optimism about healthcare solutions started to paint a picture of a bridge to the other side. By early June, the S&P 500 was within 5% of its February high. For many investors, optimism had replaced fear. In less than three months, the S&P dropped by 34% and was up over 40% off the bottom.
What’s an investor to do (or not do)? Stick to a plan and resist emotion. We establish long-term goals for our portfolios, accounting for acceptable risk and volatility. Then, we develop an asset allocation target that prepares our portfolios to weather eventual market downturns and perform in line with our accepted level of volatility. We know there will be downturns and being properly prepared can make us less susceptible to knee-jerk reactions. The trick, however, is having the fortitude to re- balance when needed. Asset classes that become overweighted are probably relatively expensive and should be trimmed and asset classes that become underweighted are probably relatively cheap and should be bought. Executing a disciplined plan is the key to taking emotions out of investing.
By most accounts, the economic freefall that started in late March was largely over by the end of May. What came into question next was the eventual slope of the recovery, with options ranging from a hopeful “V,” to a less optimistic “U,” to a dreaded “L.” We, however, think it’s more nuanced than that. Different parts of the economy will have different rates of recovery, impacting companies in varying ways. Those most likely to experience a “V” are businesses whose products and services were deferrable during the shutdown, but ultimately have to be made up. For example, hospitals were essentially shut down, with the exception of Covid-19 related services. This meant that most, if not all, elective medical procedures were cancelled. Everything from heart valve repair to knee replacement was put on hold. Obviously, these procedures are not deferrable indefinitely and new cases continue to grow. Hospitals and surgery centers have discussed operating longer hours and weekends over the next several months to clear the backlog. Medical device makers should see sales volumes recover soon. Dental and veterinary procedures should snap back quickly, as well.
Other potential “V” shaped industries include home and auto maintenance. Home improvement stores were allowed to remain open during the shutdown and sales actually rose. Stuck at home, many homeowners spent money on everything from painting to gardening. This trend should continue as more activities take place from home. Driving is another trend that should recover pretty fast. Whether it’s driving to avoid mass transit or a summer road trip to avoid flying, miles driven should increase, adding to vehicle wear and tear and fuel consumption.
The road ahead is less certain for businesses facing a “U” shaped recovery. A “U” shaped recovery implies a slower rebound, and for a lot of businesses, that slope will be dependent on capacity. As we reopen retail, theme parks, hotels, restaurants, airplanes, and theaters, we will do so at a diminished operating capacity. Last year, according to JPMorgan, these categories made up 19% of U.S. GDP, employing over thirty million people, or about 20% of the labor force. Importantly, however, these businesses only accounted for 7% of S&P 500 earnings last year, giving at least a partial explanation why people feel as if the stock market is somehow disconnected from the economy. Some businesses are already thinking of creative ways to expand capacity. Restaurants, for example, are converting parking space into outdoor dining areas. Many businesses require operating at greater than 50% of capacity and some as much as 80% - 90% of capacity to breakeven. The shape of these “U’s” will depend on bringing capacity back on line.
As for the dreaded “L’s,” recovery, if any, will be dependent on confidence and for most people that means a vaccine. International travel will be slow to come back without a vaccine for fear of getting quarantined far from home during an outbreak. The cruise ship industry continues to push back the target date of new sailings, now sometime in late September, but a second wave could upend that timeline. Business travel may never be the same following the success of remote meetings and increasing electronic documentation. Brick and mortar retail, already hard hit pre-Covid-19, will continue to consolidate, particularly those stores that can’t execute a digital omni-channel experience for their shoppers. Lastly, sports will continue to struggle to put a product on the field, court, or ice and it will likely take a vaccine to see sold out stadiums again.
Trends that endure
If one word can sum up the post-pandemic world, that word would be, digitization. So much of our daily lives went digital during the shutdown and many of those trends not only worked better than expected, but people preferred them. For the consumer, two key themes emerged that will be enduring for years, contactless payments and telehealth. Already, the rest of the world is way ahead of the United States in conducting contactless transactions. Outside of the U.S., over 60% of card- present transactions are conducted without physical contact. In the U.S., that figure is still below 10%. In the U.S. there are over 100 million digital wallets, nearly 200 million tap-to-pay credit/debit cards in circulation, and nine of the top ten card issuers now issue tap-to-pay cards, but there are still more cash transactions than contactless. Usage has been slowed by a lack of educating both consumers and merchants, as well as the slow uptake of advanced point-of-sale (POS) systems. Post pandemic, consumers will continue to migrate away from exchanging cash and demand contactless options that will speed up adoption rates. Online sales will also continue to grow, but so far in 2020, online sales are still only about 15% of total retail sales.
The pandemic fast tracked a trend that many thought might still be several years away, telehealth. One of the biggest impediments to broader adoption of telehealth solutions had been bureaucratic red tape. At the onset of the pandemic, the Centers for Medicare and Medicaid Services (CMS) made a series of changes that broadened the range of covered services utilizing telehealth tools, including payment for telehealth services equal to in-office visits. Although some of these changes were authorized with an emergency order and are temporary, it seems that services that prove useful will be here to stay. Telehealth services extend beyond virtual office visits. Wearable devices and smartphones allow for remote monitoring of patients with diabetes, hypertension, and mental health issues. Scientists are also testing fitness wearables to detect early signs of Covid-19 symptoms and pinpointing geographical areas that may be flaring up. All of these capabilities will be further enhanced by the build out of 5G communications in the next few years.
For businesses, digitization means scaling up and securing mission critical architecture that now extends to employees’ homes. Routine workflows and client communications have changed and many functions are transitioning to third party cloud platforms. This all requires more networking gear, software, and consulting services. Supply chains may migrate back to the United States and factory automation tools and more sophisticated logistics software will ensure improved profitability. Again, 5G will also play a transformational role.
One area of business sure to keep changing is the digitization of forms and documents. Electronic signature services are expanding and notary services look to be next. Online document and contract management services will also continue to grow. For example, efforts are underway to digitize the mortgage process. A national mortgage electronic registry system continues to grow and companies are now digitally connecting county assessors with mortgage providers and servicers. Many of these new services will be software as a service (SaaS) subscriptions leading to recurring revenue streams for many technology companies.
Many of the stocks in our portfolios are well positioned for these trends and we continue to look for more. The world may have changed, but old fashioned research and ignoring emotional impulses remain the backbone of successful investing.
COVINGTON CAPITAL MANAGEMENT
601 South Figueroa Street, Suite 2000
Los Angeles, CA 90017 | 213.629.7500