A swoosh-shaped recovery seems likely
With volatility comes dislocation – and recent stock market falls appear to suggest an outcome somewhere between scenario two and three. This would indicate a Nike-shaped swoosh recovery rather than a V-shaped recovery (scenario one) or L-shaped stagnation (scenario three). Of course, even ‘scenario two’ investors differ in their assessment of whether the ‘swoosh’ will be closer to a ‘V’ or ’L’.
We expect a Nike-shaped swoosh of uncertain gradient, but one that implies an ultimate recovery. Of course, we do not know for sure what the outcome will be.
Adapting to the new normal
The relative positioning of our Asia ex-Japan portfolio remains similar to how it has been for several years. Our stocks, on average, are cheaper, lower quality and smaller than the average benchmark stock, with less debt.
Last year – predating the coronavirus – we substantially reduced our underweight in mega caps by adding to our holdings in Samsung, TSMC and Alibaba. This move was partly informed by our expectation that the low interest rate environment would persist. Since the beginning of 2020 and the economic disruption resulting from the coronavirus pandemic, the relative performance advantage of mega caps has sharply accelerated given the safety provided by size, dominance and liquidity in the context of elevated uncertainty and a still lower, still longer interest rate environment.
Overall, we do not believe that our holdings are at significant risk of financial distress because they generally have strong balance sheets, strong business models, strong industry positioning and/or are Chinese state-owned, implying a very high likelihood of non-dilutive financial support if required.
There is however one plausible exception: we have an approximate 0.5% interest in a Korean steel maker. Although we do not expect it to fail, it might. Nevertheless, we have retained our exposure to the company because we do not expect it to fail, our position is small, and most importantly, trading at 0.1x tangible book value, we believe the payoff structure is highly asymmetric at around 5:1 in terms of the potential gain if things work out ok (as it re-rates towards around half book) or if it falls to zero in the less likely, but plausible, event of it failing.
We will also continue to seek new opportunities where stocks have adjusted inappropriately in response to the changing economic landscape (because they have fallen too much relative to their changed bottom-up prospects).
For now, we remain focused both on the long term and on the possibility of interim financial distress. But when the economy recovers, we believe our portfolio is well positioned to outperform. That’s because although our stocks, on average, are more economically sensitive than the benchmark, they have less debt. As such, we expect the companies in which we are invested to survive the coronavirus pandemic (undiluted) and reach the other side, whenever – and whatever shape – that recovery might be.