Keeping You Informed: Cambridge

Speakers:
Geoff Scott, MBA, CFA, Institutional Portfolio Manager
Brandon Snow, Principal and Chief Investment Officer
Stephen Groff, CFA, Principal and Portfolio Manager
Greg Dean, CFA, Principal and Portfolio Manager
Dan Rohinton, Portfolio Manager
Paul Marcogliese, CFA, Fixed Income Portfolio Manager
Bob Swanson, MBA, CFA, Principal and Portfolio Manager

Overview

Since the markets became affected by COVID-19, the most expensive stocks in the S&P/TSX Composite Index have fared the best. The top quintile of the most expensive stocks has outperformed – companies trading at 40-plus times earnings. Interestingly, this is a continuation of similar trends over the last few years that saw mega-cap companies lead the market.

Large-cap growth has been the one area that has outperformed and held up the market. However, this is territory in which we do not often operate because our overall approach is to focus more on valuation.

We expect to see more opportunities to invest as we gain an understanding of what the outlook is, how long the pandemic shutdowns will last and the nature and pace of the recovery. The liquidity levels in our portfolios are good, and we have the flexibility to react to information changes and to meet client demands. It is important to follow our process and continue to freshen our view of our portfolios weekly if not daily to help us determine where the risks lie going forward.

Canadian equity

As the year began, we expected some level of economic growth and saw the best opportunities in cyclical companies, including some energy companies. But as the virus accelerated, we reassessed and diversified our exposure. We were able to add some attractive and stable high-quality companies, in terms of both business model and balance sheet, which had the benefit of being highly liquid.

Following the historic sell-off and despite the subsequent rally, based on the fundamentals we do not believe the downturn is over. While the markets will offer great opportunities going forward, the key right now is balanced positioning with a lot of flexibility – and patience.

Canadian dividend equities

When the pandemic impacted Western markets, some of the more cyclical positions of the Cambridge Canadian Dividend Fund were hard hit, notably energy. Overall, we believed equities were highly discounted after years of relative underperformance and poor returns. But now that we are in the “basin” you are seeing a lot more discipline, with valuations that had reached multi-year and even multi-decade lows.

We have reduced the portfolio’s energy weighting – although we have increased some positions within less risky areas of this sector. We pivoted away from the more exposed exploration and production companies into lower risk areas that we still think present good risk/reward, such as pipelines.

Other areas like consumer staples have offered opportunity. This has always represented a substantial weight in the fund, and currently is our largest sector. We continue to see good opportunities here.

Another attractive sector is financials, where a number of entities offer outstanding risk-reward opportunities when you take a multi-year view. While we’re all operating in a highly uncertain environment, when you look longer term, especially given the attractive prices we have been paying for some of these businesses, there is no apparent material downside, given the nature of their operations and how they are capitalized.

Small/mid-cap equities

The strong large-cap outperformance is due largely to a few mega-cap companies. Without their contributions to performance, the large-cap experience has been far less profitable, with many valuations descending to mid- and small-cap levels. This has significantly improved the quality of our smaller-cap universe, which has grown to 1030 names from 940 names. We have identified opportunities among these former large-cap companies and have calls arranged with many of them.

We have avoided highly levered companies and the leverage in Cambridge Growth Companies Corporate Class is approximately one times debt-to-EBITA, compared with more than three times for the Russell 2000 Index. Our returns on invested capital are significantly higher than the benchmark. We also look for companies that are consolidators of their industry.

Global equities

We have taken advantage of recent market opportunities to own stronger businesses and to sell some of the companies that are more directly exposed to COVID-19 – for example, aerospace-related entities. We have been putting some of our cash to work more recently as we gain a better sense of what the fundamentals could look like going forward.

With some of the most expensive companies leading the market across Europe, Japan and in parts of China, we believe this will lead to some companies trading at 100 times earnings or higher, yet that are considered to be recession-proof. Nonetheless, these companies do present some risk and have the potential to become more attractively valued, which eventually could translate into investment opportunities. In the meantime, we are doing our due diligence on such companies.

First-quarter earnings projections are confirming the quick pace of global economic deterioration, particularly in the United States. While it is too soon to say how effective government rescue programs will be, these have at least provided some hope. This has reinforced our view we have an attractive long-term entry point for a select group of high-quality businesses.

Fixed income

We have held a long duration in Cambridge Bond Fund for more than two years, which has given us a huge advantage as rates have fallen. In addition, we have held long bonds in countries that most investors were avoiding, such as the German and British markets that have done extraordinarily well. While our positions in preferred reset issues have done poorly lately, the portfolio’s long duration has provided an offset. This showed that the risk in the portfolio was quite balanced going into this downturn.

After reducing our corporate-bond exposure during 2019, we have not reversed our position here, even though many issues now are trading at more attractive levels. Our belief is that just because corporates are cheaper today does not necessarily mean they might not be cheaper tomorrow.

We are also not convinced the economic stimulus tools being employed by governments in response to COVID-19 – such as purchasing BB-rated bonds – are right for the circumstances. Governments are not lending to companies that just have a shortage of capital flow; in fact, they have a shortage of revenue. Because that revenue will not necessarily come back, we worry that this strategy is simply pushing the problem farther down the road.

Asset allocation

Despite the natural tendency to buy during market dips, we decided to maintain our defensive stance in Cambridge Asset Allocation Fund and let equity valuations come down a bit more. As a result, we are 15% underweight equities, with the majority of that being reallocated to the bond portfolio.

There is no clarity in this marketplace. As such, we believe it would be short-sighted to identify a decrease in daily COVID-19 infection rates as the point at which economic prospects begin to improve. The sea of superlatives in current use to describe the plunge in economic growth, oil prices and other key numbers shows the extent to which we have moved into uncharted waters. This suggests economic recovery will take longer than what many currently anticipate.

Our mindset is to do all we can to preserve capital for the time being. Our equity and bond portfolios already have reduced risk, and our defensive asset allocation serves as a backstop. When we begin to see things open, people getting back to work and disposable income increasing again, we can then feel more comfortable increasing the equity weighting. However, should the economy continue to deteriorate beyond expectations, we could further reduce our equity allocation.

Source: Cambridge Global Asset Management

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Published April 23, 2020.