01 May HCF Newsletter- April 2020 Updates: Markets and Portfolio Overview
Dear Valued Clients and Partners,
Fund Performance Chart as of 27 April 2020
Our HCF Class 1 portfolio (as of 27 April 2020) has rebounded significantly about 21% between 27 March 2020 to 27 April 2020. We have also allocated 4% of our cash holdings to companies (2 China A-Shares, 1 ASX listed, 1 HKSE listed) which we have been eyeing for some time. Due to our core holdings’ good fundamentals and positive price performance, we have clawed back the previous subpar performance in 2019 (due to us being too conservative having more than 30% cash holdings) and are currently outperforming the MSCI APAC by about 15% (since October 2018).
The challenge of being an investor is to be able to hold onto and even add on to those positions that have been properly researched and yet mispriced for a long time. This is a true test of the emotional stability in an investor.
However, we are of the view that this COVID-19 pandemic will likely be a prolonged one (as compared to SARS) and are mentally prepared if the market were to take a downturn. Coupled with the pandemic is the unusual phenomenon of negative oil contract prices (for WTI) where the demand for oil has dropped dramatically due to many countries having their various versions of “lockdown” and the impact it has on travel (particularly international travel and energy consumption) in general.
With that in mind, we are open to accepting fresh funds to grab the opportunities made available in these volatile times. If you are keen to take advantage of this market situation by investing or adding more funds in our fund, do drop us an email at email@example.com indicating your interest so that we can follow up with you.
Lessons from Life Experiences
Things can flip on their heads within moments! Just 2 months ago, Singapore seemed fully prepared (with reference from the experience we had with SARS) for this COVID-19 pandemic, and had seemingly ticked all the boxes in her preparations for the general population. At this current juncture though, we are facing a massive increase in the numbers coming from an unexpected quarter (the migrant workers’ community). I think it is unfortunate that a blind spot/ overlooked area resulted in the big increase of COVID-19 cases, despite the efforts and good work by the Singapore Government. While many (online and offline) comments were made concerning the living conditions of the migrant workers, the underlying issue (which applies similarly to nursing homes and army camps) is communal living.
Just as disasters can always strike where least expected, the same applies to businesses in general. Like it or not, the best laid plans and processes can always go awry for a variety of reasons. But does that mean that we do not plan or put in place processes that will support us in achieving the results that we desire? Plans and processes are in place to increase the probability of the results materializing. Without good planning and proper processes, the chances of achieving any desired results becomes minuscule.
This applies to investing too. While we all desire to achieve good investment returns, without a good strategy, plan and processes, to do that on a long-term sustainable basis is close to impossible. Throw into the mix a big dose of human emotions and we can see why it is so hard for most investors to do well in the market sustainably.
On top of the pandemic, we also have the curious case of oil contracts (WTI) going negative on 20 April (people get paid to purchase oil!). While many are expecting oil prices to be weak (including me), for the price to go negative is extremely unusual. The main issue was that physical oil contracts require delivery of physical goods, at a time when oil storage options were running out and the oil wells production and supply were not stopping.
It is amazing to think something invisible to the naked eye could have such a drastic impact on society and the economy today. Strangely enough, we find this is also applicable to businesses and investments where more often than not, the intangibles in business may contribute more to the success of the business. This includes the leadership’s vision, management skills, values, and character. Many successful businesses are successful not because they have the best buildings, the best equipment, or plenty of human resources, but because they have the intangible ability to put the resources and capital that they have to work in the manner desired.
Most of the time, people tend to look at the materialistic and tangible stuff, but what life has taught me is that the intangibles, the Invisibles, or also known as the qualitatives, are usually the deciding factor in whether a person, business or investment is going to be successful.
Prologue to next segment of Newsletter:
During these few months, the impact of this COVID-19 issue is unprecedented in its health and financial impact. For this particular issue, instead of sharing on a specific company visit that we did previously, Richard will be sharing his perspective from his observations on the two largest economies of the World, China and the US.
Clive Tan | CEO
Hidden Champions Capital Management
In the wake of the COVID-19 pandemic, the market has been going through a roller coaster ride for the past few months. At the point of writing, this deadly virus has already infected nearly three million people worldwide and cost the lives of two hundred thousand people. We have witnessed possibly the most volatile period in the past decade; the fastest slide in the history of S&P 500 followed by a seemingly “V” shaped recovery. The market is juggling two conflicting situations facing investors – on one hand, are the fears of an impending global recession, yet on the other the massive fiscal stimulus alongside the expansion of Central banks’ balance sheet and the hope of a possible vaccine to treat COVID-19.
Days after that, we witnessed the occurrence of another market abnormality when oil prices became negative for the first time in history. How is this possible and how do we reconcile it with the onset of the global pandemic crisis? From the appearance of how well the market rebounded, it also raises the question of whether everything will soon return to normalcy levels pre-COVID-19 days? While it might be still early days to address all of these, the team shall attempt to share some insights and takeaways from our findings to date with a focus on the world’s two greatest economies, the United States and China.
When Will It End
Until the day that the vaccine is developed, it is difficult to keep the disease at bay. Even when the lockdown and social distancing measures start easing out, the spread of disease cannot be prevented and contained as long as people continue to travel and co-mingle. If we were to jump at the opportunity to resume economic activity just because of a decline in the number of new cases, we may be putting ourselves at risk of subsequent waves, possibly spreading even more rapidly and widely.
Amongst several companies in a global race to develop a vaccine for the virus, there were key developments on the 29th April for Gilead Sciences Inc.’s experimental drug Remdesivir in a closely watched government-funded clinical trial treating hospitalized COVID-19 patients. Patients put on Remdesivir recovered 31% faster than those given a placebo and this led officials to support the use of drugs as a standard of care. However, a separate study also found that the therapy did not lead to any clinical improvement for the patients in China. It will be interesting to find out if Remdesivir is eventually the answer the world is looking for in combating against COVID-19.
Severe Economic Impact Of Coronavirus
The U.S. Labor Department released its weekly jobless claims data on 30th April, announcing an additional 3.84 million Americans filing for unemployment benefits during the week ending April 25. This brings the total number of first-time claims to 30.3 million over the past six weeks — representing roughly 18.6% of the US labor force after businesses laid off and furloughed workers during stay-at-home orders across the country.
While we understand that jobless claims could be temporary for some as the companies choose to hold their position and “reinstate” them when business resumes, we cannot help but be alarmed by the figures which underscored the widespread collapse in the economy as a result of the COVID-19 containment measures. Can you imagine 1 out of every 5 people without a job?
Rising unemployment will severely impact consumers’ incomes, taking a toll on their ability and willingness to spend, which should lead to a major contraction in the economy. As expected, the Commerce Department reported that personal incomes fell by 2%, and personal consumption expenditures dropped by 7.5% in the month of March.
In response to the grim economic outlook, the Federal Government has boosted aid and loosened eligibility standards to help more Americans whose finances have been crushed by widespread business closures and stay-at-home orders. The extra money will help the economy from collapsing entirely, but the U.S. could be well headed for a deep recession. The economy could start to recover in several months, but the speed it snaps back will depend on the government’s success in squelching the spread of the coronavirus.
Meanwhile, China’s economy recorded the first contraction in decades in the first quarter of 2020 as the coronavirus outbreak shut down large parts of the world’s second-largest economy from the rest of the world. Gross Domestic Product shrank 6.8% in the first quarter compared to a year ago, the worst performance since at least 1992 when official releases of quarterly GDP started, worse than the consensus forecast of a 6% drop. Factory output fell 1.1% in March, retail sales slid 15.8%, while investments decreased 16.1% in the first three months of the year.
A special survey by China Beige Book, a unique data-gathering firm that relies on bottom-up reporting from firms and banks inside China to provide a more transparent look at business conditions, revealed that China is getting back to work — but not back to normal. The good news is that almost all — 91% — of the more than 500 Chinese companies surveyed had re-opened by late April, and about three-quarters were working on-site again, but just 42% were able to operate at more than half their capacity. Worse, demand for goods and services from Chinese companies has plummeted. Foreign orders have fallen more than twice as fast as domestic ones, with orders from the U.S. contracting the most among major trading partners.
Concurrently, we cross-checked with one of our recently added Hidden Champions company, Shanghai International Airport (SHSE:600009), which reported a staggering drop of 60% and 85% respectively for flights and passengers in the month of March.
If you look at it simply, how can the economy recover when there is minimal tourism or business activities when most countries put on travel restrictions or no travel at all? Even if the global quarantine is lifted, when will you take your next flight?
When The Stock Market Doesn’t Make Sense
During this Circuit Breaker period, I started watching an American drama series ‘Designated Survivor’ with my wife. It all began with a catastrophic attack on the night of the State of the Union address which claimed the lives of the president and most of his Cabinet. As those above him in the line of succession was killed, Tom Kirkman, the Housing and Urban Development secretary, a lower-level cabinet member was naturally promoted to the President of the United States and emerged the designated survivor from the crisis. Thrust into his new position of power, Kirkman struggled to keep his country from dissolving into a state of chaos and to restore order and peace. One of the key takeaways was the importance of “Project Confidence” in times of turmoil. It seems that this is exactly what we see in global markets today, especially the US.
In March 2020, The Fed announced its unprecedented expenditures with unlimited QE and support, showing their commitment to do whatever it takes to prevent a global credit crunch and help the economy till it returned in line with its mandates. We saw actions that took months of deliberation during the last Global Financial Crisis in 2008 being rolled out in a matter of weeks. It even pledged to buy risky corporate debt (i.e Junk Bonds) as part of its emergency financing package for the economy, something it has never done before.
The move was seen to be so aggressive that it sparked a stock market rally. It also shows the extent to which the financial system will sustain the economy to avoid a collapse in the global economy. The effects of the Fed’s plans projected much confidence to shift consumer’s sentiments entirely. Many used to think bad news leads to a drop in prices. However, we think there is an additional element in this formula: bad news + investors view of a bleak outlook → price declines. Kudos to the Fed, who tackled the psychology aspect by projecting confidence to the point that even with the facts: all of its virus numbers, unemployment claims, defaults, bankruptcies, business closures, contraction in the economy, and bad news which follows do not matter anymore.
While these actions can bring hope to the economy in the short run, what are the consequences for the US, their economy, and the global stock market down the road?
Oil Price Crash
Even as the world becomes increasingly more used to the convulsions of the coronavirus pandemic, the breakdown in oil trading leading to a crash in oil prices is shocking and incomprehensible to many.
West Texas Intermediate, a reference benchmark for U.S. oil trading, plummeted to a barely comprehensible -$37 per barrel on 20th April. At any price below zero, sellers of oil are actually paying buyers to get rid of it.
We saw an analogy online which jokes but adeptly describes the situation:
“Imagine the following…you paid $500 today and committed to receiving an escort at your house in 15 days, because your wife will be traveling. This is called a futures contract.
Unfortunately, the lockdown came and your wife will be home for the next 60 days.
Now, you do not want this woman to show up at your house at all, and thus you will try to pass this “futures contract” to someone else.
Only you cannot sell this commitment now, because nobody can receive the escort at home anymore. Everyone is in full storage (their balls) with their wives.
To make matters worse, not even the pimp (Chicago Mercantile Exchange) has more room to receive girls because his house is crowded with girls.
So you will pay anyone just to take the girl off your hands.
Do you now understand why oil has a negative price when the contract is delivered?”
If you are an investor, it is quite likely you start thinking of investing in oil because of its depressed prices. A quick search online on oil ETFs will lead you easily to United States Oil fund (USO), the largest oil ETF. The week before the negative prices saw fund inflows of about US$1.5bn as US crude prices hit their lowest point since the early 2000s due to plunging demand. It was reported that retail investors, in particular, were trying to speculate that market will recover once social distancing measures from COVID-19 eased and they can ride the high in the recovery of oil prices.
This move by investors into USO is reminiscent of 2009, when many investors bought the ETF as crude prices slipped to near $30 a barrel, before almost tripling over the next 12 months as the world economy emerged from the depths of the financial crisis. However, investors found their ETF returns only rising ~60% and was not in tandem with the gain in oil prices. They ended up losing significantly each month just by the process of rolling contracts.
One thing to note is that oil contracts do not trade like equities. Instead, they expire monthly when the underlying crude oil is delivered to buyers. Over the long term, the negative roll yields accumulated, causing United States Oil Fund investors to bear painful losses. And this is our greatest fear – how it works is poorly understood by greenhorn investors. By investing in such ETFs, there is this additional risk on top of the risk of placing a bet which might go the other way.
In short, from a retail investor perspective, the popular USO does not track the oil prices and we strongly advise against investing in it.
Updates On Our Portfolio
The team has reviewed the portfolio to assess the impact on the companies in light of deteriorating market conditions from COVID-19. We are glad to say that majority our companies are affected to a limited degree. An example is the Hong Kong company in our portfolio that produces cow and goat Infant Milk Formulas. Their sales continues to remain resilient during down times, and in fact benefitted from the stock-piling with the social distancing measures and increased home consumption this period. Additionally, demand for its products during the coronavirus pandemic was also further driven by mothers are unwilling to risk spreading the virus to their babies through breast feeding.
The team would like to assure our investors that extensive research has been done for the companies invested including assessing the quality of their revenue during times of crisis. We believe this will allow the portfolio to come out stronger in the long run, as evident by how the portfolio is up when the market is down.
We are still perplexed by how the market is going so strongly when the virus remains rampant, flights are barely resuming, non-essential businesses stopped their operations, unemployment rates are still rising, and supply chains are disrupted. Some say the market is forward-looking and the worst is over, but we hold the view that the market has yet to account for its actions today and has not considered the risks ahead. Despite having deployed a small percentage of our funds during the dip, we are continuing to monitor and be ready to respond and seize the opportunity when that day arrives.
Richard Sim Zhipeng | CFA, CA
Hidden Champions Capital Management