Investing in Uncertain Times:
A Conversation with US Equity Portfolio Manager Chris Sierakowski
Four months into 2020 and things are clearly not progressing as we had envisioned. It is always difficult during a crisis to see what will become obvious in hindsight, but we believe we have the advantage of an investment approach that is built to look through market turmoil toward long-term fundamentals. At the same time, the current COVID-19 related disruption is creating risks and opportunities for our portfolio holdings, which our research analysts are evaluating. Against the backdrop of this dynamic environment, Tom Kronzer spoke to US Equity Portfolio Manager Chris Sierakowski about his views on the market and how he’s thinking about his US Equity Select portfolio.
The global spread of the coronavirus has caused considerable economic and market disruption. As concerns about the virus’s impact increased, have you taken any portfolio action?
The speed at which markets fell and then rebounded has been remarkable. The S&P 500 Index peaked at an all-time high on February 19 and proceeded to fall 34% in the next 24 trading days, marking one of the sharpest drops in the history of the market. The broad index has since recovered more than half of the points drop. This month through April 30th, the U.S. market is up more than 15% and up nearly 30% from the trough in mid-March.
In terms of portfolio activity, as we came into 2020 we sold a few of the stronger performers from last year. Some of these names had gained over 75% in the trailing twelve months and had moved to valuation levels that looked relatively less attractive to us. One impact of the sales was to reduce our sizeable information technology sector overweight at the start of 2020 to an underweight position by the end of February.
Against the backdrop of a significant market decline in March, we opportunistically added to many of our highest conviction names. We also initiated a few new positions ; one is a semiconductor manufacturer and the other a regulated utility in Michigan. While these are two very different companies, both are high-quality franchises with durable earnings streams. Moreover, their valuations had moved lower while their high dividend yields should help provide some ballast in a volatile market. These two stocks also highlight our portfolio construction strategy to balance high quality cyclical exposure with attractively valued defensive names. When combined with our core holding of long-term compounders, this positions the portfolio to benefit from an eventual recovery while also acknowledging we have limited visibility around the duration of the current economic pull back.
More generally, how do you think about risk management and downside protection in your portfolio?
Our best risk management tool in a concentrated portfolio is by looking at security-level risk using our Confidence Quotient (CQ) framework, with a particular focus on financial condition, fundamental momentum, and market position. We leverage the deep domain knowledge of our equity research team to stress test the business models and balance sheets of our holdings.
Early in the COVID-19 crisis, we analyzed exposures to China and the broader Asian supply chain impacts across our covered companies. As the coronavirus spread more widely, we considered the implications of a broader global economic slowdown. We looked at financial leverage, interest coverage ratios and debt maturity schedules. We questioned the impact of a sharp economic recession on the revenue models and the implications for margins and free cash flow. And beyond 2020, we considered whether the current environment would have lasting consequences for the secular growth drivers and relative market positions of our companies. Overall, we remain confident in our portfolio positioning along with the quality and durability of our individual holdings.
The portfolio performed relatively strongly in 2019 and continued to do so through the recent turbulence. What have been some of the drivers of that? Any lessons learned?
We continue to focus on our core investment philosophy around quality, sustainable growth and reasonable valuation. The bulk of our relative performance in 2019 was driven by stock selection. The top stock drivers were broadly based across technology, industrials, real estate, healthcare, communication services, financials and consumer staples. The common thread was a high level of conviction by our analyst team around the idiosyncratic aspects of the investment thesis for each name.
With the market up over 30% last year, we utilized our valuation discipline to trim the positions of many names that had performed well. We believe that positioned us well coming into 2020. We used the market sell-off to re-allocate to some of our highest conviction names at what we consider to be attractive valuations. Our goal is not to optimize short-term performance, but to focus on positioning the portfolio for the long term. We believe this will allow us to continue to compound at a rate in excess of the market, while doing so with lower risk given our focus on quality and durability.
Even before COVID-19, concerns were expressed about the length of this economic cycle and the ability of equities to continue higher. Has your outlook for equities fundamentally changed?
As COVID-19 has become a global pandemic, the macro implications have expanded. What began as a regional crisis has progressed to a point where entire countries are on lockdown, with businesses not considered “essential” shut down by state governments. With many citizens in self-isolation, consumer spending on retail, travel, dining and entertainment has plummeted. While Fed rate cuts in response to the crisis are supportive of the economy, they have materially hit financial stocks as net interest income is negatively impacted.
The macro slowdown has also intensified the disruption in the crude oil market and the energy sector has been devastated. Overall, companies across the board have less visibility on revenue and, in many cases, have cut capital spending and removed financial guidance. We have lowered our own earnings estimates for individual companies and for the market overall. We began the year looking for mid-single digit earnings growth for the S&P 500 but have cut our outlook to a material decline for 2020, while also taking down expectations for 2021. It’s hard to say how much lower earnings will decline, but we are considering 2020 to be a lost year for earnings. We are focused on establishing where earnings can get back to in 2021 and 2022 as we hopefully move past this situation and return to a more normalized environment.
You invest in a select group of 30-40 US stocks. What do you look for in those companies? Are there any recent examples you can share with us?
Our investment philosophy is based on investing in high-quality, reasonably-valued companies that we think can generate sustainable growth over the long term. How we define quality differs from many in the industry. We use a framework called Confidence Quotient (CQ) to assess companies in five broad areas, including things like market position and management talent. The goal is to identify companies with a durable competitive advantage which will lead to lasting sustainable growth.
Two recent additions include a large home improvement retailer and a leading waste management company. Beyond 2020, with only modest revenue growth assumptions, we believe the home improvement company can improve sales productivity and operating margins under a refreshed leadership team. With operating leverage and a disciplined capital deployment plan, we believe that the company should be able to drive double-digit earnings growth over the medium term. Earnings will clearly take a hit in 2020 given the ongoing pandemic, but the balance sheet is strong, and the stores have thus far remained open as an essential service.
The waste management company is a leading provider of waste collection and disposal services in North America. It has a healthy balance sheet and a resilient revenue model and we view it as a stable compounder with a strong market position and associated pricing power. The company is diversified geographically across the US and across the various client segments of commercial, residential and industrial. With mid-single digit revenue growth and stable-to-improving margins, we believe that the company can drive durable earnings growth at an above-market rate with lower-than-average earnings volatility. The current market environment has provided an opportunity to build this core position at what we believe is an attractive valuation.
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