Putnam’s equity investment professionals recently discussed market conditions, Putnam strategies, and their outlooks.
- In terms of market volatility, we may not be out of the woods yet.
- Our performance continues to be driven by stock selection and minimal exposure to factors.
- Strong revenues and sales resulting from the pandemic may not necessarily translate into profits.
After the close of the market on March 26, the glass was starting to look half full. Three consecutive positive days lifted the S&P 500 to 20% above the intraday low set on Monday, March 23. Also, we have completed a full week without a limit-down trading halt.
A look at positioning and flows
Looking at flows in the different pools of equity capital, we may have seen capitulation last week.
- For traditional long/short hedge funds, last week saw the largest unwind in history.
- Quantitative funds and risk parity accounts, like the traditional hedge funds, were forced to take down risk, which meant liquidating long equity books.
We’ve looked at corporate buyers and what they mean for the supply/demand dynamics of the market. Over the past few years, share buybacks have been a huge source of demand. The buyers were aggressive on sell-offs, which helped to mute the downturns. Now, however, we see two problems. First, as we approach the end of the quarter, many of these corporate buybacks go into a blackout period, which usually lasts about two weeks. This is not great timing considering the market could really use that demand. Second, many companies are now suspending or cancelling their buyback programs.
The good news is that pensions may make up for the lack of corporate bids, at least for this quarter-end. We believe the estimated rebalance into equities is approximately $200 billion, the largest rebalance we’ve ever seen. That’s after a record underperformance of equity to fixed income in the past 90 days.
Liquidity versus volatility
It’s important to remember that volume is not liquidity. Equity volumes are running at record levels now. On any given day, we’re looking at two times normal levels. While we see high volumes and heavy trading, the actual liquidity metrics were severely challenged. Bid/ask spreads in the month of March are two times wider than normal.
Volatility: We are not out of the woods yet
Last week, the VIX [CBOE Volatility Index] reached 80 and closed above 70 for four straight days. That took us to levels more extreme than we saw in the 2008/2009 time period. I would say we are not out of the woods yet.
Kathryn B. Lakin, Director of Equity Research, Portfolio Manager
There are many layers of uncertainty in the marketplace. The coronavirus is one, but there are also oil prices, and — something that now seems forgotten — it is a presidential election year for the United States.
Observations on COVID-19
The impact of the virus is not yet available in macro data, but we did see a huge spike in jobless claims on March 26. It was the worst weekly employment data we’ve ever seen, and yet the market was up for the day, suggesting that the virus has become less of an “unknown” for investors.
What we know is that the virus is highly contagious. It is more serious than the flu, and we have testing and capacity issues. Key hotspots such as New York City will be out of hospital beds in short order. On the positive side, we have seen countries such as China getting some control of the virus after putting strict quarantine measures in place. Also, a vaccine could provide a permanent solution, but we believe that is probably 18 months out.
In terms of the economic impact, the majority of Americans are living paycheck to paycheck, and 30% of private employment is in small businesses — those with fewer than 50 employees. On average, we believe those small businesses have less than a month of cash on hand. This is something our team has been discussing for a few weeks now, and it is incorporated into our analysis.
On the positive side, the stimulus is massive and it’s focused on getting small businesses and challenged sectors back on their feet. Anti-viral measures could mitigate symptoms and come into play sooner rather than later. Combine this with low interest rates and low oil prices, and we have some potentially positive trends for consumers.
Our team's focus
We are looking at the balance of short term versus long term, and we are stressing all of our theses. By this, I mean we’re looking at recession-type scenarios for businesses. We’re looking at their balance sheets to determine their liquidity.
We are having some interesting conversations regarding the virus impact, based on detailed analysis by our quant team. We are asking, “What if social distancing, to some extent, becomes the norm over the next one or two years? If so, what companies do we want to own in that environment?"
We look for businesses with durable growth that may be more immune to downturns, such as tower companies and large technology companies. Our team of analysts takes an opportunistic approach, but the challenge is how quickly things are moving and changing. For example, we are looking at companies that benefit from quarantines and stay-at-home orders, such as retailers whose sales are surging as consumers stock up on supplies. However, a long-term view is critical. We need to identify the secular winners — those businesses that we want to own for the next few years.
What if social distancing, to some extent, becomes the norm over the next one or two years? If so, what companies do we want to own in that environment?Managing factor exposure
I am the manager of the Putnam U.S. Research strategy, which includes the top ideas of our research analyst team. One of my goals is to make sure that stock-specific risk is the primary driver of returns. That is, we focus on the underlying fundamentals of the business rather than factors — sectors, styles, or company size, for example.
Going into this drawdown, the stock-specific risk of the portfolio as a percentage of total risk was approximately 73%–75%. This indicated that returns would be largely driven by our stock recommendations and the performance of those companies, rather than by factor exposures.
We have a risk management sleeve that makes up approximately 10% of the portfolio. What happens with risk models in periods of extreme volatility is that the risk associated with these factors increases, so it’s normal to see stock-specific risk come down as a percentage of total risk.
Our performance continues to be largely driven by stock selection and minimal exposure to factors, and this remains our goal. Ideally, it will enable us to pursue outperformance during the pullback as well as when the market moves higher.
Lauren B. DeMore, CFA, Portfolio Manager, Analyst
Our U.S. Large Cap Value Equity strategy has held up relatively well during the recent downturn. We attribute this to our strong emphasis on portfolio construction and managing risk and factor exposures.
Assessing risk scenarios
On a regular basis, we review risk scenarios. For example, how would the portfolio perform if oil prices fell 20%? For example, how would it hold up if growth outperformed value by 10%, or if interest rates rose or fell? We aim to ensure that the portfolio will not underperform or outperform in a meaningful way in any of these stress scenarios. Our research team has done a great job, and we want our analysts’ ideas to shine. We seek to construct the portfolio in a way that enables stock selection to drive performance.
Staples: A combination of attractive valuations and better sales
In the consumer staples sector, we entered this period of weakness owning companies that we believed had strong fundamentals and relatively cheap valuations. These companies have recently benefited from strong in-store sales — but the key is the combination of the cheap valuation and the sales boost.
Also in consumer staples, we’re learning that the strong revenues and sales resulting from the pandemic may not necessarily translate into profits. Many businesses are not getting the incremental margins that they usually do because logistics are more expensive. For example, many are airlifting products in the rush to get them to stores, which is more expensive than shipping by truck.
We’re learning that the strong revenues and sales resulting from the pandemic may not necessarily translate into profits.Other sector opportunities
We also are finding attractive opportunities in health care, including companies developing products to treat COVID-19. In communications services, we believe our holdings will potentially benefit as people spend a lot more time with their broadband and are hesitant to cut any corners there.
Energy has shrunk to just 4% of the strategy's benchmark [Russell 1000 Value Index]. It is always challenging to predict the direction of oil prices, and I don’t believe anyone expected the Saudis to flood the market with oil, driving prices into the low $20 range. Prior to the downturn, we had been focused on energy companies that can live within their means and aren’t dependent on high oil prices, and this approach has been particularly helpful. Also, we believe lower oil prices could pave the way for consolidation, which should make for a healthier industry going forward.
Financials, which represent a larger slice of the value pie, entered this downturn much better capitalized than at the time of the global financial crisis. Banks will see pressure on their net interest margins from lower rates, but we don’t expect this to be a terminal situation.
Gregory D. McCullough, CFA, Portfolio Manager
Two aspects of our investment process that have served us well recently are portfolio construction and risk management. We seek to allocate our risk budget to specific stocks, rather than to sectors or industries. We seek to keep our sector weights in a 3% band relative to the strategy's benchmark [Russell 1000 Growth Index], and we want individual stock selection to drive performance of the portfolio.
Seeking secular winners with durable growth
We seek to avoid companies with levered balance sheets, overly cyclical businesses, or commodity-driven businesses. We look for secular winners in growing industries with pricing power, which enables them to pass on costs in periods of stress. Many of the businesses we own have subscription bases, long-term contracts, price escalators, and a general lack of customer concentration. We believe these characteristics related to business quality are more present in our portfolio than they are in our index or in the portfolios of our peers.
For risk management, we look at prior downside capture when evaluating a new name for the portfolio and we gravitate toward companies that have a narrow range of outcomes. We analyze both the opportunities and the vulnerabilities of the business. We are fixated on the duration and durability of growth as much as we are on the absolute level of growth for a given business. We believe this also differentiates us from our peers. This does not make the portfolio immune to a shock like the current downturn, but I believe the portfolio was better positioned given our fundamental stock selection.
Growth themes for a challenging environment
A thematic approach is a distinctive feature of our strategy. We currently have about a dozen themes in the portfolio, and we typically add one or two new themes each year. In our view, the themes are multi-year growth drivers, with secular tailwinds that allow growth potential even in a stressed macro environment like we have today.
One example is controlled distribution. This is based on the idea that companies with a direct channel to their end customers will potentially outperform their peers over time. This theme encompasses a diverse set of companies, and the benefits include the opportunity to manage inventory, to sense real-time changes in demand, to alter promotional activity, and to manage costs in a difficult environment.
Another theme that has clearly shined over the past few weeks is cloud computing. This is the infrastructure that enables distance learning, business communication and productivity tools, social media, and gaming. We have seen a huge rise in the adoption of public cloud systems over the past few weeks. We believe these demand drivers are likely to persist through the downturn and into the recovery and normalization phases.
We believe many of the companies in our portfolio may come through this crisis even stronger. These are businesses with market share leadership positions, solid balance sheets, strong brands, and strong margin profiles, which allows them to spend additionally during periods of stress when competitors may be forced to cut expenses.
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