Actively Positioning Capital in an Uncertain World

We’ve just experienced a period of unprecedented volatility and its underlying cause is still with us. Now, we find ourselves in a situation where there’s no way to be certain whether a stretch of relative calm is a return to “normal” or a second chance to batten down the hatches.

Time for Active Decision-Making

Money is in motion amid this uncertainty as portfolio managers and plan sponsors alike position their portfolios to take advantage of opportunities while accounting for the many risks that remain. We believe active decision-making should guide this activity. Though indiscriminate panic selling took us from all-time highs to bear market territory in record time, we don’t think indiscriminate buying will lift us to the next bull market.

Consumer behavior, corporate supply chains and government policy are changing rapidly, putting the world’s capital markets through a stress test that is exposing many weaknesses. With this in mind, we believe active security selection and portfolio management are particularly important for three reasons.

Quality Comes to the Fore When Times Are Tough

In the months ahead, we expect some company management teams to use COVID-19 as an opportunity to explain away deeper issues. Therefore, a key challenge will be to differentiate between high-quality companies experiencing transitory headwinds from companies that are severely impaired. We’ll be looking for financial stability and the ability to grow through economic booms and busts.

• We’re looking for high-quality balance sheets with low levels of debt and assets that generate high, sustainable returns on capital and attractive free cash flow.
• In fixed income, we’re positioning our portfolios to weather a U-shaped recovery with an emphasis on securities the Federal Reserve is buying—high-quality corporate, mortgage and municipal securities and TIPS.

Sustainable Results Are More Valuable

The ability to generate sustainable results is highly coveted as many corners of the economy shut down. During this time of uncertainty, it’s crucial to thoroughly assess the viability of the business model behind every security and its ability to bounce back from disruption. This is also a time to look for companies with self-help characteristics such as strong competitive advantages and business models that can sustain their results without the benefit of a sharply rising economic backdrop.

• We believe companies whose revenues are driven by long-duration contracts with built-in annual price escalators present attractive opportunities. Since these businesses have minimal variable costs, we can model a range of financial outcomes likely to be unaffected by the virus.
• Directives to shelter in place and work from home have helped strengthen ongoing trends in information technology, including digitalization, cloud computing, the 5G network rollout and data center expansion.

Risk Management Will Be Key

Actively managing risk through portfolio construction and security selection are important in this uncertain environment. Though the downturn has reduced valuations broadly, an attractive price alone isn’t a good enough reason to buy. The question is whether low-priced securities are true opportunities or mistakes waiting to happen.

• We believe balance sheet leverage, liquidity and the cash burn rate will help determine whether businesses fail or succeed.
• The wide range of potential earnings impacts underscores the importance of differentiating between businesses that face cancellations versus those experiencing only delays in revenues.

Be Selective as We Find a Way Forward

Though a passive approach may make strategic sense for certain aspects of our clients’ portfolios, we don’t think this is the right time to own the entire market. From here, we believe investors will differentiate on a security-by-security basis with a preference for higher quality, sustainable results and more attractive risk profiles. Therefore, we believe this is the time for active security selection and portfolio construction decisions.