Quarterly Letter, August 2020

By Ron Muhlenkamp, Founder and Jeff Muhlenkamp, Portfolio Manager

Economic activity in the U.S. and around the world continues to be driven by the spread of the COVID-19 virus and reactions to it. We said that in July and it remains true, if perhaps a little too obvious to be worth stating. What is not obvious to us is what factors account for the differences in the severity of the virus in different places, which mitigation measures are effective in coping with the pandemic, and what actions have mattered little to the progression of the disease. No matter how much time we spend researching the subject we remain uncertain that we really understand why the virus is behaving the way it is. Our current assessment is that the virus has largely burned itself out in the U.S. and Europe, is well controlled in Asia, and that extreme lockdown measures did more economic harm than virus-control good. We hold these conclusions lightly and are ready to change them if new evidence or analysis suggest we should.

Early in the year the range of responses by governments to the virus was extremely wide: everything from do nothing to restrict everyone to their homes. It is our observation that the range of responses has narrowed a little bit since then, with the most restrictive measures falling out of favor and more moderate or targeted measures being employed in the late summer, early fall.
Thus, we believe things are getting better from: the virus is receding and the reactions to the virus are less economically damaging. From an investment point of view there remain two important and interrelated questions that we don’t have answers for yet:

1. How much economic damage was done that we don’t know about yet?
2. Which changes in how we work, play, vacation, educate, eat, etc. will be temporary, and which will prove longer lasting?

With regard to the first question, we still don’t really know how many businesses will never reopen. Government restrictions are quite impactful to many businesses and we don’t know when they’ll end. How long consumer aversion will last is probably unknowable. So whether we look at restaurants, airlines, hairdressers, or other businesses we don’t know how long their revenues will remain depressed. Many businesses are surviving on government loans or grants. While we know the extent of the existing assistance, we don’t know if more will become available in the future. So we really don’t have any idea how many businesses will ultimately fail. Business failures have a direct impact on unemployment, commercial loans, and commercial real estate values to name just a few things that are top of mind. Loans and real estate are assets, so we don’t know the magnitude of the losses that are coming, or who, exactly, will bear them. It’s our observation that the share prices of bank stocks have gone up very little from their March lows—we’re not surprised. Listening to the big banks during their earnings calls and speaking to smaller bank CEOs on several occasions, it is clear the banks have little idea which of the loans on their books are still good, and which will end up defaulting.

Regarding the second question, there have been some huge changes in the workplace, education, recreation, etc. How many of these changes are permanent? How much business travel never comes back, impacting airlines, hotels, taxis, etc. on a permanent basis? How many workers continue working from home, reducing the demand for office space and putting downward pressure on real estate values? There appears to be a significant movement of people out of cities and into the suburbs, how long does that continue and what does the total impact look like? How many workers decide to stay home to help the kids with school and how does that affect the work force? We don’t know the answers to any of these questions yet and it will take time to start to understand what the long-term effects are. This results in more uncertainty regarding the future of many businesses and industries than we had at the beginning of the year.

So, a lot of uncertainty still around the short-term and long-term impact of the virus, some of which we think is priced into the market, some of which is not.

Also of interest this quarter was the announcement by the Federal Reserve that they would begin targeting average inflation, not “spot” inflation. What does this mean? It means that if inflation has been below their target of 2% for a period of time, which it has, the Federal Reserve will now allow inflation to run above 2% for a period of time before they take action to reduce it. It remains to be seen whether this change in attitude by the Federal Reserve actually matters or not since the Fed has been unable to generate the inflation they sought the last ten years or so. Inflation as measured by the U.S. Consumer Price Index (urban) in August was 1.31%. Interestingly, that rate is almost twice the current yield on the 10-Year U.S. Treasury, which was .66% on 9/29/2020. So the holder of a 10-Year Treasury is losing purchasing power due to inflation at twice the rate he is growing his wealth via receipt of interest. The longer that situation persists, the more the bondholder loses ground, which is why we remain uninterested in being long-term bondholders and are skeptical of owning companies that have large holdings of long-duration bonds (examples are banks and insurance companies).

The portfolio is tilted towards economic recovery consistent with our view that the economy is improving. Some of our long-term holdings are trading at a premium to our assessment of their value and so we have reduced our position size in those companies. We’ve put some cash to work and are happy to hold on to the rest until we find attractive opportunities to employ it; we’re not in a hurry. We also continue to hold a position in gold, which we view as a hedge.

With our best wishes for your continued success and good health!

P.S. Jeff here. I just finished reading “Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts” by Annie Duke. Making decisions without all the facts is essentially my job description and I am always looking for ways to improve. Mrs. Duke does a great job laying out the problem, what she learned as she tried to improve her decision-making process as a professional poker player, and how the rest of us can improve our thinking as well. I highly recommend the book if you have an interest in decision making and will add this one to my recommended reading list.

The comments made in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.