In our most recent commentary on crisis negotiation and its application within financial consulting, we explored the parallels between these two domains. In this first of four subsequent series we demonstrate how these principles are applied in practice.
CRISIS ACTORS: Crewcial Investment Team; Approved Value-Biased Managers
ISSUE: Extended unfavorable market (COVID-19)
GOAL: Renew conviction in long-term expectations
ASSESSMENT
Before COVID, the growth/value spread was near record levels. Most public equity markets outside the US, as well as companies involved in anything other than technology, underperformed on a relative basis. Experienced and talented value-biased investment managers, when judged against their respective broader market indices, were starkly underperforming, with their once enviable long-term track records appearing mediocre to downright poor depending on the index of comparison. Significant limited partner fund redemptions ensued—assets under management declined precipitously, more than 80% in some cases.
Then COVID exacerbated the situation. Investor uncertainty rose to a fever pitch, further punishing these managers and leading to LPs questioning their insight—the prevailing narrative being the world had gone digital and remote, so anything industrial, capital intensive, or hospitality and travel related was not going to survive in a post-COVID world, emphasized by soaring technology and ecommerce stock valuations once the initial shock of the pandemic subsided.
COMMUNICATION & ACTIVE LISTENING
Discussing portfolio company developments with value-biased managers on behalf of our clients provided some needed insight. Although they were unhappy about their portfolios’ share price returns, most underlying companies were executing well on their business models—increasingrevenue, operating margins, and profits. However, the markets didn’t care, and share prices either stagnated or derated. Growth and momentuminvesting dominated stock markets around the world, while the significance of value and valuations seemed a distant memory in the minds of investors. If one believes that sustainable earnings growth is the primary contributor to share-price appreciation and that price matters, then many companies of interest were simply being ignored.
Our approved managers mentioned examples across a variety of industrial- focused sectors, such as energy, materials, and industrials, where revenues and profits were increasing yet share prices were decreasing or stagnating. In many of our discussions, the managers referenced data from Bloomberg and other market sources, plotting the positive key financial metrics against the overlay of a stock’s price, which did not follow the same upward sloping trend line. Therefore, earnings multiples continued to contract, limiting downside risk due to exceptionally low expectations and inexpensive multiples for mature, well-managed, and profitable businesses.
BUILDING TRUST
In times of distress, an investment manager’s fortitude or lack thereof is on display. Numerous discussions emphasized that this was actually a very favorable opportunity to invest, not raise cash. Our managers demonstrated conviction in their portfolios and processes by re-underwriting and adding to beaten-down positions, as expected. In some cases, depending on the industry (travel and hospitality), revenues deteriorated significantly, so capable management teams, robust balance sheets, and competitive moats were key determinants of a company’s future health. Investment managers that deeply researched their holdings were better able to analyze the potential range of such outcomes and probabilistically weigh them in an advantaged manner, while effectively communicating this approach to clients and other investing relationships through transparent, responsive, and open dialogue.
Our information and intel gained from constant manager touch points reinforced our views that this underperformance was temporary—a market anomaly. The conclusion also hinged on common sense; while no one is perfect at manager selection, could we be wrong on every value-biased manager that we have known and respected, for over a decade in many cases? While the performance pressure was still painful, the managers were investing like our due diligence determined they would, so terminating them and shifting to what had “worked” in an interim period would not be a prudent decision. Discipline and patience are key in such situations.
INFLUENCING AND PERSUASION
While our discussions and analyses were performed in earnest, clients were still experiencing weak returns and losing patience. Synthesizing our due diligence across multiple managers, analyzing portfolio holdings, and reviewing processes, we concluded that the managers processes were not impaired and that the laws of finance and physics (i.e., what goes up...) were still relevant. Forward returns had meaningful upside and limited downside, the asymmetric outcome that most investors work so hard to achieve. With that said, we did not know when such conditions would change, but we knew that abandoning these strategies in favor of those that worked would be a mistake and result in capital impairment.
These challenges were communicated to clients, detailing valuation multiples comparing growth and value stocks around the world. Our communication focused on the degree to which value stocks were currently inexpensive coupled with low investor expectations—any additional unwelcome news would have minimal negative impact. However, maintaining capital with some managers proved difficult. For example, one of our managers, a long-biased, leveraged, Japan-focused deep-value activist, experienced unprecedented underperformance during 2020, down almost 50% at one point during the year. Clients were rightly upset, and some wanted to redeem immediately. We maintained our conviction in the manager, although they had also moved up the capitalization spectrum in their activism on a couple of portfolio companies, deviating from the more mid-capitalization companies in which they’d invested in the past. The manager acknowledged this “mistake” but believed that it could still achieve a positive outcome because of the margin of safety and embedded unrealized value in the portfolio, especially among the larger-capitalization holdings.
RESOLUTION
As a firm, we preached patience, and suggested clients maintain exposure to the out-of-favor strategies. We provided qualitative and quantitative information to our clients evidencing the cyclicality of the managers and markets, the inexpensive valuations, and the potential capital impairment of abandoning these strategies during such a period of extreme under performance. While we were mostly successful in maintaining exposure across most clients, this was not universally the case. Investment committees have varying degrees of experience and risk appetites; additionally, each institution has unique circumstances that may require a different approach due to liquidity or other constraints. Part of our job is to recognize this and adjust accordingly Therefore, a one-size-fits-all approach is not realistic; one with flexibility and the objective of maximizing long-term returns is best. As one would expect, some clients redeemed, some maintained, and some invested more capital. Those that maintained or invested more capital were well compensated for their patience.
DEBRIEFING AND EVALUATION
Success was defined by diligent monitoring, staying grounded in rationality, the unsustainability of the growth/value spread, the ultimate spring-loaded future performance projections of these incredibly inexpensive stocks, and our awareness of cognitive biases that could sabotage a performance recovery. Most people are pleasure seeking and pain avoidant; therefore, removing the pain point seems natural and feels good in the moment. Depending on the source of the pain and the end goal, this is sometimes exactly the wrong thing to do. Conviction and discipline are most needed when confronted with the uncomfortable. It is also critical to look for dissenting evidence instead of solely drawing from a familiar and inherently supportive echo chamber. All evidence, positive and negative, should be considered and weighed appropriately to produce robust investment outcomes. This is what we expect of our managers and of ourselves. Ultimately, sustainable long-term performance will speak for itself.