As the coronavirus pandemic curtails economic activity around the world and financial markets teeter, investors have been scrambling for cash. That includes gravitating toward companies with strong balance sheets—a cohort that has shrunk over the past decade as debt held by nonfinancial corporations ballooned 76%, to $6.6 trillion.
Companies with strong balance sheets have outperformed the broader market since the S&P 500 (.SPX) peaked in mid-February, according to Goldman Sachs chief U.S. equity strategist David Kostin. Widespread economic distress is likely to prompt even more companies to re-evaluate their dependence on debt financing in coming months—low interest rates notwithstanding—and look to shockproof their finances by piling up more cash.
Ironically, many mutual funds that favor companies with fortress-like balance sheets lagged behind their peers during much of the late, great bull market, which finally met its demise in March. Yet, these fund managers’ focus on companies with the financial wherewithal to survive and thrive postcrisis is likely to serve investors well both now and in the future.
Barron’s has identified five veteran fund managers who are sticklers for strong balance sheets, and whose funds have lost less than peers during the market’s recent rout. Some even favor net-cash companies, or companies with more cash than debt on their balance sheets—an enviable position to be in as the economy heads south. Here’s how the five are approaching the downturn—and a look at the stocks they find appealing now.
Laura Geritz, who runs Rondure New World fund (RNWOX), has always been a balance-sheet investor. She has also been worried for some time about rising debt levels around the world. Now the market shares her concerns. As Geritz notes, many investors began differentiating between companies with weak and strong balance sheets only in the past couple of weeks.
Rondure New World, which will hit its three-year anniversary in May, is down 23% this year, but beating 85% of peers. “We want to hide in cash in balance sheets,” says Geritz, who built a strong track record at Wasatch Advisors before founding parent Rondure Global Advisors. “The consumer was holding the U.S. economy up like Atlas. I don’t even know if we are in the second inning” of the current coronavirus-induced selloff.
Geritz recently added to a fund position in Japanese leisure and theme-park operator Oriental Land (OLCLF), which has a net 319 billion yen ($2.9 billion) in cash and long-term investments, equal to about 7% of its market capitalization. That’s enough to go without customers for two or three years without having to cut capital spending, she says. Oriental Land’s U.S.-traded shares are down 9% year to date, to a recent $126.
Dan Davidowitz, manager of the Polen Growth fund (POLRX), says that before the coronavirus outbreak, people might not have appreciated the risks embedded in businesses with aggressive balance sheets, including companies that bought back stock but failed to build up a cash cushion. Davidowitz, who runs a concentrated fund, has no tolerance for leverage, and has always favored companies flush with cash that can fund themselves and invest in or even buy other companies. That has helped performance this year, with the fund down 17%, beating 73% of its large-cap growth peers.
Davidowitz has been adding to top-five holding Facebook (FB), which will see a near-term slowdown in its advertising business but is likely to be resilient longer term. Facebook, he says, could even see an uptick in user engagement, and possibly less competition from other social-media platforms. Another plus: $50 billion of cash on its balance sheet, and an estimated $20 billion in annual free cash flow.
At 18 times earnings, Davidowitz says the stock price isn’t in line with the company’s reality. In other words, Facebook is much too cheap.
Charlie Dreifus, manager of the Royce Special Equity fund (RYSEX), focuses on smaller companies. Dreifus has been investing for more than five decades, and built a record outperforming during market downturns. His risk-averse approach puts a heavy focus on clean balance sheets, metrics such as cash conversion rates, and free cash flow—traits even more important now, he says, since earnings are becoming less important, given the unknowns.
Royce Special Equity is down 28% this year, outpacing 96% of its small-cap value peers. Value investors have struggled through much of the bull market, but the fund’s average annual 5.1% return over the past 15 years has beaten 92% of its peers, according to Morningstar. Fund holdings include stocks such as Ennis (EBF), which makes printed business materials, and industrial manufacturer Gencor Industries (GENC).
Dreifus is taking a “be greedy when others are fearful” approach, focusing mostly on cyclical companies where capacity is disappearing and inventory levels are shrinking. He believes these companies could be poised to rebound when the global economy begins to recover. But the value manager is buying slowly, dollar-cost averaging in, and not depleting cash reserves too quickly. “In order to assess the outlook for the economy and companies’ revenues and earnings, we must first pass the peak of infections with conviction,” he says.
Charles de Vaulx, a veteran go-anywhere value investor focused on preserving capital, has been bemoaning nosebleed valuations for years, and warning of an array of risks building in the global economy. The IVA International fund (IVIOX) that de Vaulx co-manages has fallen 25% this year, beating 68% of peers.
Holdings in BMW (BMWYY) and Richemont (CFRUY) have taken a big beating, but the fund has been helped by holding some gold and cash, and stakes in net-cash companies that de Vaulx says could generate free cash flow even if revenue falls up to 80%. The fund holds shares of several Asian companies with net cash, including Korean drugmaker DongKook Pharmaceutical, and Japanese health-care companies such as Techno Medica and Rohto Pharmaceutical (RPHCF). “We have been moaning about how lazy the balance sheets of Korean and Japanese companies were, and now, assuming that cash is in the bank and they aren’t going belly up, that’s a wonderful virtue,” says de Vaulx. The fund hedges 75% of its Korean won risk.
This crisis, de Vaulx says, is 10 times worse than 2008, and requires a much more thorough examination of balance sheets, with “violent” assumptions to assess the composition of inventories and other factors. Among them, he is pondering what happens to cash if working capital is released, and studying where companies’ cash is deposited, and in what currency. “We are talking about a 30% to 40% interruption of everything,” he says. “It is so drastic and we have no idea if or when the virus will be contained.”
That said, de Vaulx is adding to auto, aerospace, and beer company stocks, and education and software-related companies with large recurring revenue across the world. All have strong balance sheets.
“Why not more?” he asks. “Because I’m struck by high-quality stocks—like Amazon.com (AMZN), Costco Wholesale (COST), and Expeditors International of Washington (EXPD)—that aren’t as cheap as they had been during previous crises. Sell-side analysts have lowered earnings-per-share estimates a mere 3%, on average, since Feb. 19, which is farcical.”
The conservative $7.1 billion Jensen Quality Growth fund (JENSX) has a history of doing better than peers in downturns. That has been evident over the past month, as the fund’s 13% decline has beaten 91% of peers, according to Morningstar.
The concentrated fund looks for companies generating at least 15% return on equity and strong balance sheets, but manager Eric Schoenstein says screening only for debt levels could lead investors astray. For example, anyone screening only a company’s most recent regulatory filings might miss a subsequent issuance of debt.
The market also might be punishing relatively strong companies that opened up cheap credit revolvers pre-pandemic and now are drawing on them opportunistically. “The market will look at that as a negative signal for the health of the organization, but it isn’t because they are in a cash crunch, but rather making sure they have dry powder,” Schoenstein says.
That’s one reason Schoenstein pays close attention to metrics like cash coverage and debt structure—and who is buying a company’s products. The manager favors companies whose products enjoy inelastic demand, regardless of the broader global economic outlook. Top holdings include Becton Dickinson (BD), Johnson & Johnson (JNJ), General Mills (GIS), and Microsoft (MSFT). “A lot of these businesses can get through this, even if things ground to a halt,” Schoenstein says.
Schoenstein figures that companies with a 40% to 50% return on equity can make it to the other side of the current crisis, even if revenue growth evaporates for a quarter or two. At this point, he, too, is in the nibbling camp. “How do you catch a falling knife?” he says.
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