We are in the midst of a global pandemic. It is essential to appreciate that it is primarily a human crisis. The virus has infected more than 3 million people worldwide, and nearly 250,000 have died so far. It is the first deadly pandemic since the 1918 Spanish Flu, which lasted for almost 36 months and infected 500 million people – approximately a third of the global population at the time. Just like many of the pandemics before, it will challenge, redefine, and change societies.
We are still learning about the SARS-CoV-2 virus and the COVID-19 disease it causes. The first cases were only identified a few months ago, but there are already more than 70 potential treatments in different phases of clinical trials, and more than 200 additional compounds are investigated as possible treatments. Of course, the one real way out of the COVID-19 crisis is to develop an effective and safe vaccine. As of the end of April, there are more than 100 vaccines in development. Eight of them have already entered early human clinical trials. I believe that with the incredible pace of global research efforts, we are likely to have effective therapies within months and a vaccine within the next 12 months. Even with my hope for effective treatments and vaccines, I also believe that the world on the other side of the pandemic will be different.
When I wrote the last communication to Merlin's clients on March 19th, the equity markets were in a seemingly bottomless freefall from their mid-February highs. Of course, I wish I could always predict the future, but it helps to be lucky in addition to having correct expectations. As much as I expected the markets to rebound, I did not expect them to move so far so quickly. The equity markets bottomed out on March 23rd, two business days after my email, and continued to rise in April. As a result, we have come a long way – more than 20% higher since my March 19th note and erasing most (and for the majority of Merlin's clients all) of the entire frightening March decline.
In addition to the search for a vaccine and treatment, the monetary and fiscal response to the economic threat posed by COVID-19 had been rapid and unprecedented. The Federal Reserve aggressively addressed market dislocations and provided virtually bottomless monetary support for the economy. Even politicians, typically very slow to respond, promptly passed a fiscal stimulus package with a promise of further fiscal interventions designed to limit the risk of a prolonged recession. There is a general belief that the risks of doing too little outweigh the risks of doing too much.
Investment wise, as things evolved, I've moved out of all companies I considered to be at most risk, i.e., those directly related to travel and live events (movie theatres, airlines, cruise lines, travel agencies, theme parks, etc.). I haven't owned any oil & gas companies because they have not been attractive for some time, and I've moved out of banks when interest rates stopped rising, so there were already no real banks in the portfolios. After selling some of the most at-risk companies, I waited until March 27th (when the slope of new infections started flattening out) before reinvesting the proceeds into several companies I believed could benefit from rising demand for semiconductors and cloud services.
The crisis will likely accelerate many trends we have already seen. The adoption of remote and flexible working, increasing digitization, rising semiconductor content, cloud, and SAAS were all there before the crisis. The portfolios are increasingly positioned to benefit from those long term accelerating megatrends. As an example, a recent Gartner survey showed that 71% of the companies now believe that they will expand remote work post-crisis.
As I mentioned many times before, it always helps to keep emotions in check and to stay true to the well-defined investment strategy, especially when investing in some of the best companies and management teams in the market. The painful price declines go across the board and do not spare the high-quality fast-growing companies I typically invest it. At the same time, I believed that the companies in the portfolios had the best chance for a strong rebound once the environment started turning around. Historically, prices begin to rebound about 200 days before the bottom of earnings declines. Despite the expected cuts to revenues and earnings, the valuations were already extremely attractive. Several of the industries we were exposed to could benefit from an overall move towards online, remote work, and building out the infrastructure to support it. Even for companies like Apple (which still depends on the sale of actual devices in real stores) will likely experience only a temporary slowdown for one or two quarters. The industry's move towards 5G and shift towards services will drive their growth forward. It remains to be seen whether there will also be "revenge buying" when the stores reopen, which apparently happened in China so that we could have some unexpected positive surprises. Several of the companies reporting their earnings earlier this week have indicated that early April was likely the trough of the economic slowdown. We will have a lot more information shortly – 173 of the S&P 500 companies are reporting this week, and 151 more are scheduled for next week. Many comments suggest that China (which was the first country affected by SARS-CoV2) is on a fast track towards economic recovery. The vast majority of companies in China are already operating, and the supply chains are reported to be functioning normally. While consumers are still lagging, a recent report showed that car sales in China were already at the same level they were a year ago. There are also some signs of a bottom in the US. After the stay at home orders shut down most of the air travel, TSA reported the lowest number of people going through the checkpoints (Total Traveler Throughput) on April 14th at 87,534 (compared to 2,208,688 a year earlier). On 4/30, the number of travelers increased to 154,695 (compared to 2,499,461 a year earlier). Despite the market volatility and shelter at home orders, Merlin continues to function normally without any interruptions. All companies which provide us with a variety of operational support (custody, trading, accounting, compliance, etc.) have also been functioning normally. Of course, many of the people I've communicated with have been working from their homes. It remains to be seen whether all of them will be brought back into the corporate offices when the epidemic subsides. We are going through unprecedented times, and it is a very challenging time to be an active manager. At the same time, this is also an exciting time when active managers should be able to put their skills and knowledge to work and deliver solid returns. I expect the market volatility to continue, but the overall direction to be moving higher with increased knowledge of the virus and the ability to overcome the pandemic and bring the economy back towards growth in the second half of the year.
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