Sound Shore Portfolio Commentaries
March 31, 2020
We want to begin this update by wishing all of you well and hoping that you and your families are safe and healthy. In addition, we are grateful for the heroism of the healthcare community, first responders and essential workers during the COVID-19 outbreak.
Sound Shore has been operating fully staffed and without disruption from remote locations since March 13th. We remain vigilant and are continually tracking developments with respect to the coronavirus.
The Fund recently experienced significant negative short-term performance due to market volatility associated with the COVID-19 pandemic.
Stocks sold off sharply and broadly due to COVID-19 concerns during the first quarter of 2020, leaving the major indices with their worst quarterly return since the fourth quarter of 1987. All 11 S&P sectors finished lower, with the information technology sector performing best and the cyclical energy sector declining the most. Equity investors had plenty of company. Among the major asset classes, only treasury bills, the US dollar and gold finished up.
As 2020 began, persistently low interest rates and moderate global growth continued to drive investors into bond proxies (utilities, consumer staples and REITS) and high-growth stocks, leading to their outperformance and rich valuations. In fact, from June 2018 until the end of March 2020, the broader market began to underperform the cap-weighted S&P 500 as shown in the graph below. This chart, from Wolfe Research, utilizes the Value Line Index as a surrogate for the average stock. We added the table with other common indices (including equally weighted) to illustrate the breadth of the performance divergence. The conclusion is clear. The move in the S&P 500 since mid-2018 was led by liquidity crowding into a very narrow part of the market and advancing the largest growth names and bond proxy stocks.
Mid-February came and the economic shock of the coronavirus began to rear its ugly head. The market then experienced a climactic decline with the equally weighted indexes leading the way.
By mid-March, with the virus spreading in the US, the Federal Reserve announced it would cut its baseline interest rate range to 0 to 0.25 percent, increase purchases of Treasury bonds and mortgage backed securities. These and several other steps are designed to allow banks, businesses and households to weather an anticipated sharp economic downturn. US interest rates converged with their international peers, dropping well below 1%. With this last move, the bond proxies may have had their final momentum surge. Only time will tell.
Similarly, Sound Shore’s results through March reflected the undiscerning nature of the market’s sharp decline. One example was financial holding Morgan Stanley, an investment we initiated in 2019 when the stock was trading attractively at 9 times earnings. The company is being run by a capable management team that has repositioned the business away from its traditional investment banking roots and towards a very profitable, capital-light, wealth management franchise. Morgan Stanley’s recently announced acquisition of E*Trade bolsters their retail deposit base and enhances an already competitive fintech platform. We believe Morgan Stanley’s consistent performance in wealth management will drive a re-rating of the stock higher.
While we are mindful of the health of those impacted by the virus, we remain focused on:
Every cycle and crisis has differences, but using history as a guide, we believe Sound Shore is well positioned for performance in the years ahead. What is different with the COVID-19 crisis? Without question, the speed of change and recent sharp market declines are unprecedented. It took just 24 trading days between the S&P 500 peak and the low to date. To put that in perspective, the peak to trough decline during the crash of 1987 took more than three times as long (74 days). The negative demand shock has been especially dire and recovery is certain to be uneven. Strong balance sheets, credit quality and liquidity are paramount in the current environment. While our process has been extremely sensitive to these metrics, as well as to a company’s exposure to industry disruption, we certainly didn’t predict a pandemic that would shut down parts of the economy.
How have we adjusted the portfolio? First, we reacted to the short term changes that have resulted from the virus. We trimmed exposure to holdings in the industrial (travel) and discretionary (automotive) sectors we felt had uncertain outcomes in a stalled economy. Additionally, we eliminated an insurer that was levered to rates in favor of financials we believe are more attractively positioned. Meanwhile, we took advantage of indiscriminate selling to add to existing holdings and initiate new positions in sectors such as technology and healthcare.
The goal in making these changes, as in any crisis, is to quickly eliminate potential acute problems, while at the same time taking advantage of mispricings that market fear presents. We believe Sound Shore’s thorough and time-tested investment process remains nimble and allows us to be opportunistic to best position the portfolio for the coming years. We are not expecting a quick resolution to the current crisis and anticipate that stocks will remain volatile for months. Patience will be tested and we must rely on our process, our resolve and our conviction.
When the market senses uncertainty, equities fall sharply and in unison, without regard to fundamentals or an eye to the future. As confidence returns, quality at an attractive price will likely outperform. At Sound Shore, we are long-term, value investors and believe our portfolio is well positioned for trends that are likely to emerge, post-crisis. The chart below illustrates some of the industry leading companies we own at reasonable valuations that we believe will create long-term value for our investors.
A recent addition to the portfolio is Lam Research, a supplier of wafer fabrication equipment and services to the semiconductor industry. Lam is a dominant player with over 60% share in many of its markets. We were able to purchase the stock at a below normal 10 times earnings with net cash on its balance sheet. The company has traditionally been focused on memory, which is the keystone of the digital economy. Given the increased demand for computing power, migration to the cloud, artificial intelligence, mobile devices and the “internet of things,” we believe Lam’s memory business will continue to accelerate. As well, Lam is poised to take share in foundry and logic, where they are currently underrepresented. As a technological leader and with a strong management team in place, Lam’s stock represents a great risk reward opportunity.
While we have high conviction in our portfolio, we also remain disciplined and continually focused on the fundamental drivers of each holding. Since 1978, Sound Shore’s research process is keeping a close eye on valuation, competitive strengths and business sustainability…all critical components in a company’s ability to build long-term value.
The impact of COVID-19 will be with us for some time, with repercussions likely lasting into 2021. We truly are all in this together. Our portfolio company management teams are working at home too. Like us, they are wanting to communicate, interact and discuss how they are adapting their businesses to navigate through this crisis. For our investment team, the cadence of calls and meetings is high. It’s business as usual…just virtual.
Sound Shore Management was built to withstand stresses to the equity market. In times like these, it helps being a private company owned and operated by its employees. Our business model is focused on our clients as we have been here before.
During Sound Shore’s 42 year history there have been …
While never easy to go through, these periods of market correction have consistently presented opportunities for Sound Shore to achieve attractive returns in the years to follow.
Thank you for your investment alongside ours in Sound Shore. Stay healthy.
The views in this letter were those of the Fund managers as of 3/31/20 and may not necessarily reflect their views on the date this letter is first published or anytime thereafter.
You should consider the Fund’s investment objective, risks, charges and expenses carefully before investing. The summary prospectus and/or the prospectus contain this and other information about the Fund and are available from your financial intermediary or www.soundshorefund.com. The summary prospectus and/or prospectus should be read carefully before investing.
Distributed by Foreside Fund Services, LLC.