April 15, 2020

“Courage is the key to investing.”

-John Maynard Keynes


Dear Fellow Investor,

During the Great Depression of the 1930’s, John Maynard Keynes, widely considered the father of macroeconomics, strongly advocated for the use of fiscal and monetary policies to mitigate the adverse effects of economic recessions and depressions.  By the mid 1930’s, nearly every Western capitalist economy adopted his recommendations to help stimulate a recovery from the economic collapse of the Great Depression. 

As the world fights the coronavirus pandemic, the global economy faces an unprecedented shut down unlike any since the Great Depression, if ever.  Unemployment claims have skyrocketed in the past two weeks with more to come.  Nearly every major global economy is certain to already be in a recession, the only question is how far GDP plummets in the weeks and months ahead. 

The answer to that question lies in large part on when the virus is contained.  Other key questions include:

·         How effective will the first round of stimulus be? Was it too late? What does the second round look like?

·         How well will the virus be contained when we re-open?  What measures will remain in place and for how long?  Is there a second wave?

·         How will consumer behavior look in a post shutdown world?

The answers to the above questions will largely determine how quickly the economy recovers.  There seems to be three broad opinions on what the economic recovery will look like: a V-shaped recovery, a U-shaped recovery and an L-shaped recovery.  A V-shaped recovery implies the economy will bounce back quickly to previous levels.  A U-shaped recovery implies the economy will ultimately recover, but it will take awhile to hit bottom and recover.  Lastly, an L-shaped recovery implies there has been permanent impairment to the economy that will likely take a number of years to recover. 

It seems unlikely given the severity of the economic shock, particularly as it relates to the service sector, that a V-shaped recovery is in store.  It will take some time for people to regain confidence.  Animal spirits apply on the downside just as much as they do on the upside so, it seems unlikely the economy can just snap back. 

It also seems unlikely that we will experience an L-shaped recovery such as that experienced in the 1930’s.  The fiscal and monetary stimulus to date, with more to come, are likely enough to prevent a complete collapse of the economy for years as seen during the Great Depression.  As Fed Chairman Jay Powell stated during an interview in late March, “we will keep doing that aggressively and forthrightly, as we have been.  When it comes to this lending we’re not going to run out of ammunition.  That doesn’t happen.”  Spoken like a true Keynesian. 

That leaves what we believe to be the most probable outcome and that is a U-shaped recovery.  We don’t have Q1 GDP numbers yet, but it is likely we experienced a drop in Q1 with a massive hit coming in Q2.  The recovery in Q3 and Q4 will in large part depend on how the coronavirus plays out this summer and the testing and treatment advances made prior to the fall.       

With such a range of outcomes, what’s an investor to do?  No two periods are identical, but we believe Keynes’s writings of the Great Depression provide a valuable framework for thinking about the environment we are dealing with today.  Known more for his economic theories, Keynes was also an accomplished investor, managing the endowment of King’s College at the University of Cambridge in his spare time.  From 1930 through 1945, Keynes’s portfolio returned 13.6% annually over a period that included the worst peak to trough market crash in modern history as well as the worst economic depression and a World War. 

A key to his success, according to memos and letters from Keynes, was not getting scared out of his stocks during volatile market periods.  In Keynes’s own words from Keynes and the Market:

“It seems to me to be most important not to be upset out of one’s permanent holdings by being too attentive to market movement…Of course, it would be silly to ignore such things, but one’s whole tendency is to be too much influenced by them.”

As Jason Zweig noted in a blog about Keynes, he understood that bear markets, especially like the one we are currently in, are so unpredictable that reliably sidestepping them is virtually impossible.  Rather than trying to sidestep bear markets, Keynes prevailed over the long run by having the conviction to stay the course through drawdowns and the courage to put cash to work amid scary headlines. 

Just as during the Great Depression, current economic headlines are scary and likely to get worse before they get better.  Everyone knows this and so does the market.  A key to avoiding major financial mistakes in the weeks and months ahead is to not get scared out of stocks.  Markets are a “discounting mechanism,” pricing in today what it believes about tomorrow. When you get the type of correction we have seen in the past month (fewest number of days), history suggests markets generally moved higher in the quarters ahead.   



Portfolio Update

In the weeks ahead, we plan on doing all we can to provide information and views throughout this crisis, especially as it relates to portfolio positioning and company updates.  During the past month, we have used the market volatility to buy names that have been on our wish list but were too expensive (e.g. MasterCard in the Dividend strategy) and in some instances upgraded the quality (e.g. Genuine Parts to buy Starbucks).  We have a list of businesses we would love to own long-term at the right price (e.g. Alphabet) and will look to add using current cash balances should markets pullback from current levels. 

Portfolios remain anchored by positions in the preferred stocks of Fannie Mae and Freddie Mac, arguably two of the most important companies on the planet.  The linchpin of our investment thesis has always been that there is no alternative to Fannie and Freddie when it comes to providing affordable, long-term fixed mortgages and the eventual recapitalization of Fannie and Freddie will require a resolution with the junior preferred shareholders such as FNMAS and FMCKJ which carry a par value of $25 versus current prices in the mid $5 range.  Like nearly every business today, the cloud of the coronavirus hovers over the mortgage finance industry, and in the case of Fannie and Freddie, calls into question what impact there will be on their capital levels from delinquencies and defaults and ultimately what the current pause does to the recapitalization plans and exit from conservatorship. 

With respect to the planned exit from conservatorship, FHFA Director Mark Calabria was quoted in a Politico interview on March 18th as saying, “I don’t see the virus crisis as greatly delaying what we’re trying to do with fixing Fannie and Freddie.  If anything, the stressed environment underscores the need for getting them to a safe and sound position.” 

He reiterated that stance during a CNBC interview on April 1st saying:  “It’s always been my opinion that exit from conservatorship will require a large capital raise from Fannie and Freddie and I’ve always believed that this was a 2021,2022 event….This maybe puts off exit from conservatorship by a couple of months.  The delay is really quite modest in my opinion.  If we are through this in a couple of months, then I still expect initial equity raises by Fannie and Freddie in 2021.”  Note: the repricing of our preferred shares is likely to happen well before an equity raise takes place as the capital structure must be settled before raising capital.

The most important determinant of this timeline in the months ahead will ultimately be how stressed the mortgage system gets as a result of the current forbearance program made available through the Coronavirus Aid, Relief and Economic Security (CARES) Act and how quickly borrowers are able to return to paying status.  The mortgages that are backed by Fannie and Freddie as well as those backed by Ginnie Mae are packaged and sold into separate mortgage trusts.  The mortgage servicers (mostly non-banks) handle the flow of payments for a fee and under these agreements they are obligated to advance the monthly payments on the loans with the understanding that they will be reimbursed by the guarantor (i.e. Fannie, Freddie, or Ginnie) once the loan either returns to its paying status, is bought out of the mortgage pool (i.e. refinanced) or is foreclosed upon.  The arrangements were never designed for the servicers to be on the hook for months and months of nonpayment by millions of borrowers.  Consequently, there is a liquidity mismatch at the mortgage servicer level that will likely need to be addressed should the crisis last too long.  In his CNBC interview on April 1st, Director Calabria addressed the forbearances as being manageable for the industry if this lasts 2-3 months.  However, if it went on for six months, he stressed, there would likely need to be a bigger solution that involved the Fed and/or Congress. 

Given the importance of the real estate industry to the economy (roughly 20% of GDP), we expect the Fed and/or Congress to address this cash flow mismatch in the weeks ahead by providing a lending facility for the mortgage servicers to manage through the liquidity crunch caused by the government mandated forbearance.  Allowing the industry to borrow against the mortgage until the forbearance period is over (forbearance is not forgiveness it should be noted) would be the best solution to ensure mortgage liquidity doesn’t suffer during the crisis, as doing so would ultimately affect the ability of the servicers to originate new mortgages.    

Eventually, the delinquency rates at Fannie and Freddie are expected to increase but we expect it to be manageable given the current capital levels along with their earnings power and available credit facilities through Treasury.  Combined pre-tax earnings for Fannie and Freddie last year were $26.6 billion and with the Net worth sweep no longer siphoning off their capital (as a result of the Sept 2019 PSPA amendment), Fannie and Freddie ended 2019 with $14.6 billion and $9.1 billion of capital respectively.  In addition to their existing capital and ongoing earnings capacity (which will be less than 2019 for sure), the entities had over $250 billion available to them from Treasury under the existing PSPA agreement.  Considering Fannie’s average FICO score at year end 2019 was 750, and the average origination loan to value was 76%, we expect defaults to rise later in the year but expect both entities to be able to handle it.     

While a distant memory right now, the 5th circuit ruling last September that deemed the net worth sweep to be illegal means that Fannie and Freddie should also have an additional $125 billion in capital to manage through the existing crisis had the government not implemented the net worth sweep.  The administration and the FHFA no doubt must be mindful of this ruling as they manage through this crisis.  To that end, on April 2nd the FHFA announced it hired Milbank LLP to provide legal counsel on matters relating to the recapitalization of Fannie and Freddie.  Along with the hiring of restructuring firm Houlihan Lokey in February, the FHFA has slowly put the pieces in place to eventually settle with shareholders and clear the way for a capital raise.    

The endgame in getting Fannie and Freddie out of conservatorship has always been about getting private capital in front of a defined government backstop.  As reiterated in recent interviews by Director Calabria, that plan hasn’t changed as a result of the coronavirus.  How much capital they will need and ultimately how fast they can get there will depend in large part on how quickly the virus is contained in the weeks and months ahead.  Current share prices present hundreds of percent potential upside to $25 par value and realistic future outcomes and we expect shares to recover in the months ahead as the spread of the virus is contained and GSE administrative actions are advanced.    

Next to Fannie and Freddie, our second largest position remains Berkshire Hathaway (equity strategy only).  At a time when balance sheet strength is more important than ever, few are stronger than Berkshire Hathaway.  Adjusting for a 25% markdown in Berkshire’s marketable securities portfolio and a reduction in normalized P/E, we estimate shares of Berkshire Hathaway are hovering around book value.  Should the market trade lower, Buffett’s opportunity set is likely to expand.  If not, financials are likely to lead the recovery given they have been among the hardest hit and Berkshire can be expected to benefit.  We will have more on Berkshire in early May following the Berkshire annual meeting. 

During the 2008 downturn, gold sold off with the broad market as margin calls forced selling.  Once the dust settled, gold was up over 160% the next three years with many miners up considerably more as quantitative easing brought rates lower.   Our gold positions comprise around 8% of portfolio values today and as highlighted in recent trade notes, we remain bullish on gold and gold miners given the Keynesian bazookas being used around the world and likely to be needed in the weeks and months ahead. 

Energy prices have moved up in the past week, though as we write this, it appears for now that the rumored OPEC and Russia truce may not be imminent.  Whether it happens in the next week or not, a supply deal is inevitable in the not so distant future as the entire industry (including OPEC and Russia) cannot afford a year of current commodity prices.  Most companies, including our energy position Birchcliff Energy, are priced as call options and as such have been extremely volatile and likely to remain so until either credit conditions improve and/or commodity prices rebound.  Looking out over the next few months, natural gas producers such as Birchcliff, are likely to be among the biggest winners in the energy space as the amount of associated gas that is being produced (the main driver of North American production growth the past five years), is plummeting.  With spot prices hovering around $1.60 right now, Bank of America recently boosted its 2021 outlook to $2.45, up from $2.30, and Goldman Sachs was even more bullish, boosting their 2021 estimate to $3.50 from $3.00.  According to the Goldman note, “the combination of lower U.S. gas production with a global recession this summer has set the stage for a ‘whiplash’ in U.S. natural gas markets.”  For every $0.10 move in natural gas prices, Birchliff’s cash flow increases by about $8 million.  Given a current market capitalization of under $250 million, a move toward $3.00 natural gas could light a fire under the share price.

Lastly, as noted above, portfolio liquidity remains high to buffer volatility and provide the dry powder to capitalize on further market turmoil.        


The late Shelby Davis, founder of the Davis mutual funds, used to say that “you make most of your money in a bear market; you just don’t realize it at the time.”  Nobody can say for certain when the cloud of the virus will lift, but it will, and when it does, stock prices should move higher.  Staying the course through difficult market periods is not easy or fun, but history has shown it generally pays the best. 

Please do not hesitate to call if you have any questions or wish to discuss your account in greater detail. 

Stay Safe!

Brian F. Boyle, CFA