Searching For A Bargain - Volume III: Where Contrarians Look Amid The COVID-19 Coronavirus Crisis

Summary

• The COVID-19 Coronavirus has dramatically altered the investment landscape and indexes have fallen into bear market territory.
• This article will review international market valuations versus North American indexes, beaten-up American sectors, and contrary Canadian opportunities.
• It will also discuss Contra the Heard’s strategy during the current market environment.

Introduction

Twice a year I conduct a screen of North American indexes, international benchmarks, and a top-to-bottom assessment of the existing watchlist here at Contra the Heard Investment Newsletter. The COVID-19 Coronavirus has altered the investment landscape significantly with major global benchmarks falling into bear market territory.

As a result, the Contra watchlist has expanded significantly. Today the list includes 701 US names, 152 Canadian names, and 42 ETFs. By contrast, the fall 2019 review yielded 556 US names, 127 Canadian names, and 52 ETFs. Those interested in the fall 2019 review can read about it here.

The goal of this process is to identify opportunities worthy of further review, or companies which may make good portfolio additions in the coming months and years. 19 of the 701 US names fit into this category. In Canada, the short list is 10, and there are four ETFs high on the radar.

Before reading further, keep in mind that I will not be discussing the individual names found during the process. Instead, this article will provide an overview of the countries and industries we are looking at closely.

International Versus North American Valuations – The US Remains Expensive

America is cheaper than it was last year, but remains high compared to historic norms and other regions. One way to compare different countries is to use the so-called “Buffett Indicator,” which compares a nation’s current market cap to gross domestic product versus historic norms. Guru Focus provides this information here:

Source: Guru Focus’s April 2, 2020 Global Market Cap to Gross Domestic Product Table

Based on this metric, the United States remains expensive despite the awful year-to-date performance. Canada, meanwhile, is edging toward the cheaper side of its historic range. Though the Buffett Indicator is useful, considering an array of metrics produces more reliable signals. StarCapital does this by tracking a variety of inputs:

Source: StarCapital’s March 31, 2020 Global Stock Market Valuation Table

Here too, the United States looks lofty. According to StarCapital, it is one of the more expensive nations, along with India, Indonesia, New Zealand, and Australia. Canada is in the second quartile of the most expensive countries. Turkey, Russia, Singapore, South Korea, and Austria are the most undervalued, while Spain, Italy, China, Portugal, and the Czech Republic are close behind.

Understandably, many of these undervalued nations carry more risk than either the US or Canada. From corruption and limited rule of law in places like China, Russia, and Turkey, to poor demographics and massive debts in Italy, Spain, and Portugal, none of these geographies are for the faint of heart; what’s more, these risks don’t even start to account for the country-by-country impacts of COVID-19.

Though there are many index funds which follow these geographies, a handful of ETFs which track these countries specifically are:

• iShares MSCI Austria ETF (EWO)
• Deutsche X Trackers Harvest CSI 300 China A-Shares ETF (ASHR)
• iShares China Large-Cap ETF (FXI)
• iShares MSCI China ETF (MCHI)
• SPDR S&P China ETF (GXC)
• iShares MSCI Italy ETF (EWI)
• Global X MSCI Portugal ETF (PGAL)
• iShares MSCI Russia Capped ETF (ERUS)
• VanEck Vectors Russia ETF (RSX)
• VanEck Vectors Russia Small-Cap ETF (RSXJ)
• iShares MSCI Singapore Capped ETF (EWS)
• iShares MSCI South Korea Capped ETF (EWY)
• iShares MSCI Spain Capped ETF (EWP)
• iShares MSCI Turkey ETF (TUR)

Going long on cheaper markets is one strategy, but shorting the expensive ones is another. We do not short here at Contra the Heard Investment Letter, but those who do may want to consider these ETFs, which track the world’s relatively overvalued markets:

• iShares MSCI-Australia ETF (EWA)
• iShares MSCI India Index ETF (INDA)
• WisdomTree India Earnings ETF (EPI)
• iShares S&P India Nifty Fifty Index ETF (INDY)
• iShares MSCI India Small Cap Index ETF (SMIN)
• Invesco India ETF (PIN)
• VanEck Vectors India Small-Cap Index ETF (SCIF)
• iShares MSCI Indonesia ETF (EIDO)
• iShares MSCI New Zealand ETF (ENZL)
• Invesco QQQ ETF (QQQ)
• iShares Core S&P 500 ETF (IVV)
• SPDR S&P 500 Trust ETF (SPY)
• Vanguard S&P 500 ETF (VOO)
• Vanguard Total Stock Market ETF (VTI)

Though we own ETFs and I recently took a position personally in the iShares MSCI Turkey ETF, our preference is to generate foreign exposure through American Depositary Receipts or to invest in international organizations listed in North America. American Depositary Receipts are a mixed blessing, however, as while they do give investors exposure to enterprises abroad, they generally also come with high fees.

Beaten-Up American Sectors – Contrary Candidates Abound

As the COVID-19 crisis continues to unfold, valuations across all sectors in the S&P 500 are coming down. By way of contrast, here are sectoral valuations from September 2019 versus April 2020:

Source: Guru Focus’s S&P 500 sectoral breakdown – Sept 2019 versus April 2020.

The selloff and drop in valuations mean that we’re finding more opportunities in many corners of the market, though some sectors are taking a harder hit than others. Oil and gas, for example, is facing dual threats – first, from declining global demand as the economy grinds to a halt, and second, from the price war between Saudi Arabia and Russia. Skilled investors should be able to find value in this space, but be warned – it’s full of landmines given that shareholder dilution is common, many balance sheets are debt-heavy, and overall cash flows have evaporated. Other debt-heavy industries which showed up in droves included REITs, steel companies, specialty chemical makers, miners, and sea-borne shippers.

Retail is another space that has featured regularly on our lists over the last two years, and this review was no exception – but this time everything is in free fall. Dozens of entities are on the list, from watchmakers and women’s apparel to discount stores and home furnishings. Compared to oil and gas, it’s easier to find retailers with clean financials, but with many stores closed as a result of COVID-19, even the cleanest balance sheets will tarnish. Contra has not been spared in this regard – a retailer we own is Hibbett (HIBB); those who are interested can read about our position in it here.

Financials are beaten up too, in everything from asset managers and regional institutions to international banks and insurance companies. This is not (yet) a housing crisis, and banks are in much better shape than they were in 2008, but the second or third order impacts of COVID-19 may include defaults among individuals, households, and companies. If, or perhaps when, defaults occur, it will impact the banks. In the aftermath of 2008, Contra the Heard took several positions in American banks, and if things get bad, we look forward to owning more of them again. While we still own a few these days, the vast majority have long been sold. Read about Contra’s bank holdings in the prior cycle here.

Other sectors that have been smashed include airlines, cruise ships, casinos, movie theaters, restaurants, and transportation/logistics companies. As with the other industries out there, finding companies with clean balance sheets and strong enough cash flows to weather the storm is key. Sometimes when reviewing candidates in these fields, it feels like I find only one strong candidate for every five I discard.

Contrary Canadian Sectors – Oil Gets Smashed (Again)

As of April 2, the Canadian benchmark was down slightly more than American counterparts; this is largely because oil makes up such a significant component of the Toronto Stock Exchange.

Source: TMX Group - April 2, 2020.

Even if the Saudi-Russian rift is mended, demand has evaporated at an unprecedented rate. Canadian oil outfits, like their US counterparts, are in a tough spot. This is made even more challenging by the cost of extracting from oilsands, pipeline problems, and the discount Canadian oil gets versus West Texas Intermediate. Balance sheets among Canadian oil companies are often stretched as well, with a lot of debt compounded by significant shareholder dilution over time. Add on falling revenues and net losses, and investing in this industry requires a great deal of skill and courage.

Corporations in the retail, REIT, airline, construction, and transportation/logistics space found their way on to the watchlist as well. Some of these names were familiar from prior screens, but many of them are new. Canadian pot stocks also popped up during my screening process, but none of them ended up on the list; the basic filters for debt, dilution, profitability, cashflows, etc. excluded all of them from consideration. This will likely change at some point in the future, but for now these former darling pot-stocks will remain far from Contra the Heard’s investment radar.

Income-oriented Canadian investors may be interested in preferred shares. The segment has had a rough year, especially on the rate reset side. Three ETFs that follow the Canadian preferred universe are:

• BMO Laddered Preferred Share Index ETF: ZPR on the TSX
• Horizons Active Preferred Share ETF: HPR on the TSX
• iShares S&P/TSX Canadian Preferred Share ETF: CPD on the TSX (CYSXF Analysis & News - iShares S&P/TSX Canadian Preferred Share ETF)

Contra’s principals and I sometimes purchase preferreds personally, and discuss them with subscribers. We have not, however, bought a preferred share ETF or invested in preferred shares for either portfolio at Contra the Heard. This is because volumes are low, the field is volatile, and assessing them adds complexity. They offer income and seem cheap, but these securities are not a free lunch.

Contra’s Strategy and COVID-19

In any given year, stock exchanges can rally 50% or fall by half. Either extreme is unlikely, but of course both are possible. 2020 may demonstrate this to investors and prove unlike anything we have ever seen. Since the start of the year, all major North American indexes have crashed into bear market territory at a rapid pace. The COVID-19 Coronavirus is highly infectious, has a high mortality rate, and is a new and previously unknown virus, which means there is no vaccine and no immunity within the global population. In response, governments, health care systems, companies, and other organizations have taken unprecedented measures to slow COVID-19’s spread.

It’s too soon to say how deep the second and third order economic, social, and political impacts will be, but we are starting to get a taste of that with borders shut, record unemployment claims, and widespread lockdowns. Even with unprecedented central bank intervention and massive government stimulus, we expect huge job losses, bankruptcies, and financial pain. Moreover, these government actions are not a free lunch with no future consequences.

For some, a global recession has gone from being completely dismissed to now considered a “base case.” Others are even throwing the word Depression around, and the high-yield index is spiking, suggesting rising credit concerns. Regardless of where things go from here, it’s spooky to see March 2020 sharing the record books with October 1929.

Source: Dow Jones Industrial Average largest daily change records.

In 2019 and early 2020, Benj talked openly about the potential for a recession before the end of 2021 – most recently at the Vancouver Resource Investment Conference, with yours truly. (The presentation can be found here). This is of course not because he foresaw COVID-19, but because the economic expansion was the longest on record, valuations were high, and global debt to GDP had hit a record 322%. Virus concerns aside, this economic cocktail was concerning because long bull markets breed complacency, high valuations are the enemy of positive future returns, and debt is the enemy of stability. It looks like COVID-19 was the straw that broke the camel’s back.

Contra entered this situation in a good position. Last year only saw one purchase in the Vice President’s Portfolio, and none in the President’s Portfolio. The Vice President’s Portfolio is sitting on record-high cash. Better yet, at the start of the COVID-19 crisis, the President’s Portfolio sold its stake in Alpha Pro Tech (APT) for a significant gain (purchased at $1.17 and sold at $7.65; you can read more about Contra the Heard’s history with Alpha Pro Tech here). This win bolstered our ammo going into the situation but the joke was on us, APT rallied over $30 shortly after it was sold.

In the Vice-President’s Portfolio and personally, my goal is to buy into names slowly, and methodically convert cash into equity. I don’t know where the bottom is (assuming it has not already happened), so I’m not going to rush into positions or run through cash reserves. So far, I’ve bought during periods of heavy selling, when buyers are few and far between. I also sold weaker positions in the late March rally. The motto “buy the dips” in bull markets and “sell the rallies” in bear markets also influenced the timing of these sales.

When choosing what to purchase, I focus on balance sheet strength, cash flow robustness, and valuation. Though no security analysis will be perfect, it’s important to assess companies and their prospects as well as possible before committing capital. Bear markets teach investors that they should hold more cash. They also teach those only ever looking at discounted cash flow models that balance sheets don’t matter until they’re the only thing that matters. Long story short, balance sheet quality will become increasingly important if the continuing COVID health crisis turns us from recession into financial crisis.

Finally, a note on psychology – investing in a bear market can be emotionally challenging, so much so that many don’t try it. Buying into intense selling pressure devoid of buyers takes cash and gumption. This COVID-19 crisis is a truly awful situation, but the worse it gets, the more likely it is to reward astute, plucky, and patient investors who can endure the pain and stick around for the eventual bull market gain. While bull markets build wealth, bear markets build character.

Conclusion

COVID-19 has dramatically altered the investment landscape, and indexes have fallen into bear market territory. As a result, Contra the Heard Investment Newsletter’s semi-annual screen of international benchmarks and North American exchanges has uncovered more candidates than in prior years. On a global basis, America continues to look expensive, while Canada ranks in the second quartile. Within North America, dozens of sectors are beaten up, from oil and airlines to retail and finance.

Contra the Heard entered this situation in a good position. Net selling in both portfolios has occurred over the last few years, and the cash reserve has reached a record high. Our strategy amid these unprecedented markets is to ease into positions with strong balance sheets, and chip away at names instead of going all-in – because we don’t know where the bottom is or if it has already happened. If this keeps up and economic damage continues, shrewd investors will eventually have the pick of the litter, as few will have the heart or capital with which to act.

Analyst’s Disclosure: I am/we are long HIBB, TUR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. Contra the Heard Investment Newsletter provides research, it does not advise. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.