International Equities

Pyrford International discusses COVID-19's impact on its portfolio positioning

Recent volatility has provided the opportunity to make two changes to the portfolio allocation.
March 2020

Pyrford International

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The initial outbreak of pneumonia cases was reported to the WHO on December 31, 2019 with the WHO declaring a global health emergency on January 30, 2020. The initial market reaction was predominantly focused on the tourism industry in Asia with airlines, restaurants and hotels selling off as well as luxury goods companies. We don’t have exposure to these industries but we are looking at those stocks where the valuation has become more attractive since they sold off.

The acceleration in cases of the coronavirus outside of China heightened uncertainty and caused the market to selloff on February 24, 2020. Up until this point the global market reaction had been relatively muted meaning valuations had not moved to a point that, in our opinion, justified a change to our positioning. However, following Saudi Arabia’s announcement that they will increase supply by 2.5 million barrels a day markets plummeted due to concerns on the finances of oil-producing countries and on the potential for corporate debt defaults in the energy sector. The energy sector was already facing headwinds of weak global growth before Saudi Arabia’s announced that they will increase supply by 2.5 million barrels a day. Note that the oil stocks we own are integrated oil majors and operate at the lower end of the production cost curve, meaning they remain profitable at lower oil prices, so they are somewhat shielded. In addition they are integrated oil companies, meaning they have both upstream (exploration & production) and downstream (refining) operations which provides a hedge compared to outright upstream oil companies. In a low oil price environment the volume pickup in the downstream business offsets a reduction in activity in the upstream. We do expect the oil price to recover and take some comfort in the oil futures curve that is pricing in a gradual price recovery.

Outside of domestic Chinese production and demand concerns, there is the broader global economic impact to consider. During previous health emergencies emanating from Asia, China represented only 4% of the global economy. China now represents 16% meaning an economic slowdown in China will weigh heavier on global demand and trade. There is scope for China to implement stimulus measures such as cutting reserve requirements at banks or fiscal stimulus but these needs to be balanced with the fact that the Chinese economy does carry more debt than it did in the past. As of today it looks like China is coming out from the outbreak from a health point of view, so we would expect the Chinese economy to return to relatively normal shortly.

As the epicenter has now moved to Europe and the US we are seeing very strong responses from governments – the first consequence of this has been massive demand destruction. People are being told to stay at home and not travel or even full lockdowns – predictably any sector exposed to this has collapsed. This is being offset by central banks throwing their last remaining instruments at this. We have already seen the Fed cut rates to zero though the market reaction was not a positive one. Yesterday Bank of England reduced rates to 0.1% which is the lowest ever. It seems unlikely that this will stem the tide. This will be swiftly followed by huge fiscal spending. It’s probably too early to say when and at what level this might stabilize markets. But a bottom will be found and we think there is the potential for equities to enter the end of 2020 on a more positive footing. Key to this will be earnings guidance from company management teams who are still digesting recent events.

Pyrford International Stock Fund update

We had for a while believed that the strong performance in 2019 meant that increased uncertainty could lead to weakness in equity markets. Markets are most vulnerable when valuations are expensive and markets have been in expensive territory for several years. Whilst the coronavirus may have been the catalyst that has caused markets to correct, our positioning reflected the value opportunities available coming into this were scarce. Recent volatility has provided the opportunity to make two changes to the portfolio allocation.

Country allocation

We added 2.5% to our UK allocation and reduced our allocation to Switzerland by 2.5%. The change in allocation was applied proportionately across existing holdings.  The UK market had moved to a yield of 4.7% as oil and commodity names in the UK equity market declined on concerns over slowing global trade.

Stock level change

We added Nabtesco to the portfolio, reducing several Japanese holdings to accommodate. Nabtesco is an industrial conglomerate specialising in precision gears, motors and, braking systems amongst others. The company generates healthy, stable margins, in part due to product diversification but also growing maintenance related sales. At present MRO (maintenance, repair & overhaul) represent 20-30% of overall sales.

Should the recent selloff in global equities persist, we will continue to review our positioning based upon our 5 year total return forecast of dividend yield and 5 year real earnings to identity opportunities. A market dislocation as large as this will inevitably throw up new stock opportunities and we are actively looking at our reserve list. We are also reviewing our holdings; in particular the Energy names that have been hit very hard by the price war. The situation is clearly developing rapidly as cases are identified and as health bodies decide upon how they want to deal with outbreaks. Some pharmaceutical companies are already trialing drugs that claim to treat symptoms of coronavirus.

During such an uncertain backdrop it is paramount we focus on our investment process of value and quality to help dampen any volatility that may lie ahead.

We are long-term, patient investors at Pyrford. Between now and the end of 2020 there is the potential for unrealized losses to accrue in the fund due to the turbulent macro backdrop and uncertainty over company level earnings but given our genuine focus on long-term investing (our average holding period is 8 years, meaning we do not churn the portfolio) the impact on realized losses should be relatively subdued. Clearly, if markets do stabilize and recover as demand returns those losses will be significantly reduced. In terms of trading, we regularly stress test the fund and do not consider there to be any liquidity issues in the event we were to receive material redemptions as yet but will continue to monitor liquidity.

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Disclosures

The information, estimates or forecasts provided were obtained from sources reasonably deemed to be reliable but are subject to change at any time. This publication is prepared for general information only; it should not be construed as investment advice or relied upon in making an investment decision. There can be no guarantee that any strategy (risk management or otherwise) will be successful. All investments involve risk, including the loss of principal. For a complete listing of our fund holdings please click here. Past performance is not a guarantee of future results.

You should consider the Fund’s investment objectives, risks, charges and expenses carefully before investing. For a prospectus, which contains this and other information about the BMO Funds, call 1-800-236-3863. Please read it carefully before investing.

Pyrford International Ltd is authorized and regulated by the Financial Conduct Authority, entered on the Financial Services Register under number 122137. In the USA Pyrford is registered as an investment adviser with the Securities and Exchange Commission. In Australia Pyrford is exempt from the requirement to hold a financial services license under the Corporations Act in respect of financial services it provides to wholesale investors in Australia. In Canada Pyrford is registered as a Portfolio Manager in Alberta, British Columbia, Manitoba, Ontario and Quebec. Pyrford is a wholly-owned subsidiary of BMO Financial Group, a company listed on the Toronto Stock Exchange (ticker BMO).

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