February 21, 2020
Founded in 2002, Polygon celebrated its 18th anniversary this year. Since inception, our primary strategy, Global Growth, has outperformed its benchmark which consists of 70% global equities (the MSCI All Country index) and 30% US bonds (the Barclay Aggregate bond index) by an average of over 2.5% per year. In 2019, Global Growth gained over 19.4%, net of all fees.
On a risk adjusted basis, our diversified approach, combined with a number of defensive and non-correlated positions, resulted in a standard deviation in the 8% range, giving the portfolio a Sharpe ratio of over two (Sharpe Ratios measure the risk adjusted return by taking the total return of the portfolio, subtracting the treasury bill rate and then dividing the sum by the standard deviation – anything over one is considered good).
At the end of January 2020, 68% of our model portfolio was invested in equities, with 15% in cash and bonds, and 17% in alternative strategies. Geographically, the largest weighting was in North America, which accounted for 42% of the assets. Not surprisingly, almost all the US positions were up, with the core, low volatility index, up 28%. In terms of individual stocks, financials led the way. Carlyle gained 112%, while KKR was up 51%. Tech stocks were also helpful with Google up 30%, Apple up by 88% and Salesforce up 20%. Big Pharma did somewhat less well, with Bristol Myers gaining 27%, Johnson and Johnson up 16% and Abbvie clawing out a 1% return. Going forward, baring political mishaps, the health care sector which lagged the S&P by a substantial 15%, may represent a buying opportunity given its stable growth characteristics and the favorable demographics of an aging population.
Approximately 10 % of the portfolio was invested in Europe. The stocks we held there achieved solid results, with Philips up 42%, while Roche rose 34% and Total gained 10%. Japanese stocks accounted for 7% of holdings, with Sony leading the way up 42%, Fanuc, the world’s largest maker of robotics rose by 26% and Softbank gained 33%. Despite the negative publicity regarding its venture capital troubles, we continue to like Softbank, which owns 28% of Alibaba, 83% of Sprint and 75% of ARM.
Emerging markets totaled 9% of assets. Our position in India gained 10%, Vietnam was up 8% and frontier markets increased by 20%. The investment in the low volatility emerging markets fund gained 8%, while Naspers, our sole African holding, was up 24%. Baidu, the Chinese internet giant, was the worst performing holding in our portfolio, dragged down by a combination of increased competition and trade wars. For the year the stock was down by 20%, nonetheless we continue to believe it is undervalued.
On the fixed income side, we kept to our knitting, using the asset class primarily as a defensive bulwark and focusing on short duration positions. While these investments served their purpose with gains in the 5%-7% range, in retrospect we would have been better served with some longer-term bond exposure, as interest rates declined for much of the year. Non-traditional fixed income positions like high yield (up 18%) and preferred stocks (up 28%) were more remunerative.
Alternative strategies, which comprised over 17% of assets, were additive. Gold gained 18%, MLPs were up 6% as energy related stocks lagged, while the covered call strategy added 23%. Other real oriented assets, like inflation protected bonds were up 8%, while the REIT strategy increased 26%. These defensive positions are designed to provide some degree of protection against inflation and to be less correlated with global equities when the long bull market comes to its inevitable end.
Going forward, I think that both the real economy and equity markets, particularly in the US,will continue to be caught in a tug of war between central bank laxity and fiscal stimulus on the one hand, and political uncertainty and trade wars on the other. Having risen to record highs on the back of our long expansion, corporate earnings are unlikely to grow dramatically in 2020, but should show modest gains. Equity market valuations, though by no means highly stretched, will not provide much support for stock prices.
Two highly unpredictable issues will have a significant impact on both US and global markets: the upcoming elections and the spread of the Coronavirus. While the latter is completely unpredictable, history shows that in general these episodes tend to be over hyped and exaggerated by both the press and the markets, and that, over time, solutions are likely to come forward. Nonetheless, the global impact of a slowdown in China should not be underestimated. China now accounts for fully one third of global growth and, if the outbreak is prolonged, the effect on supply chains and consumers in both China and the rest of the world will be significant, with estimates of its impact on already slowing global growth ranging from between .2% and .5%.
The outcome of the US elections is also hard to predict (remember 2016), but there can be little doubt that Trump will want to continue to provide as much economic stimulus as possible to enhance his chances of being re-elected. He is currently talking about a middle-class tax cut, which would further increase our ballooning deficit, and might also increase inflationary expectations for the frothy economy. However, there is a self-limiting factor here since the Fed may well increase rates if US growth picks up too rapidly. Interestingly, stock markets are now starting to predict that to counteract the impact of the Coronavirus the Fed might now move in the opposite direction. On balance, however, our forecast is for the US to muddle through in 2020 with subdued economic growth, coupled with sluggish returns in equity markets.
Consequently, we intend to maintain our conservative bias in stock selection, focusing primarily on value-oriented dividend payers and lower volatility stocks. Outside of the US, which is largely insulated from trade issues because imports and exports comprise only a quarter of GDP, as opposed to a worldwide average of over 56%, tariffs and their erratic application will be a more significant issue. On the trade front, Europe is effectively caught in the middle between the US and China and shows little sign of snapping out of its lethargy. If the Germans could overcome their long-standing bias in favor of fiscal austerity that would help stimulate European economies considerably. However, given their historic experience with hyperinflation, that seems unlikely.
At least the Brits have resolved the question of withdrawing from the EU, though the exact mechanisms of their doing so remain unclear. Perhaps for these good reasons European stocks remain cheap compared to the US, with current price to earnings ratios (P/E) in the 14% range vs 17%-18% in the US. On the positive side, European stocks are good dividend payers with average yields of over 3%. As is the case with the US, many dividends are running above current bond yields which is an important prop for equity prices. Financials look particularly cheap, with average price to book ratios below 1, P/E ratios of only 10 and dividend yields of over 5%. Nonetheless, Europe shows little sign of breaking out of its pattern of anemic growth and, as a result, we expect to continue to underweight the continent.
Asia, on the other hand, has the potential to be more rewarding for the long-term investor. It has half the world’s population, accounts for more than one third of the global economy (with an average growth rate of over 5%), yet its collective stock markets represent less than 20% of the market capitalization of the US alone. This is primarily due to two factors, both of which are likely to be transient: global investors are significantly underweight Asia; and valuations are cheap compared to the rest of the world.
With fears of a global epidemic growing, China is, of course, a bit of a wild card. However, oneof the benefits of having a command economy is that they can quickly provide lots of economic stimulus, as they did during the great recession of 2009-2010. Already, the Chinese are putting hundreds of billions of dollars into the economy to counteract the influence of the Coronavirus. Like the rest of Asia, if China sneezes, Japan will catch a cold. China is Japan’s largest trading partner and every one percent decline in Chinese growth is expected to cause a contraction of .2% in the Japanese economy. Other Asian economies will suffer more, with Korea estimated to lose .35% and Hong Kong, Malaysia and Thailand around .3% each. The US is more insulated, with the impact anticipated to be less than .05%, while Europe is in the middle, with an expected impact of roughly .15%.
However, Japan’s stock market remains cheap compared to historic valuations, and is also beginning to benefit from a new breed of activist shareholders who are shaking up the sleepy world of corporate Japan following changes in fiduciary law in 2014. In a market where half of the 3,700 listed companies are trading below book value, activists will have ample opportunity to generate value. Stock buybacks, once rare, are becoming more commonplace. They totaled over $60 billion in 2018 and have recently been growing at an annual rate of over 60%, according to Goldman Sachs.
Given the risks of the global economic scenario discussed above, we intend to continue to maintain a robust exposure to lower-risk, less correlated assets like fixed income securities and alternative strategies. With fully a quarter of global developed country bonds trading at negative interest rates, and many more trading at negative real rates, it will be difficult to make money on traditional bonds, though there are pockets of opportunity to generate higher returns in sectors like convertible securities and preferred offerings. Nonetheless, at this stage in the economic cycle, the main area where bonds can add value is by fulfilling their historic function of providing downside protection in the event of a stock market correction.
Similarly, our alternatives positions should not only help mitigate against global stock market declines, but also provide exposure to real assets like property and commodities. If there is an uptick in inflation these positions will be particularly valuable. Our exposure to precious metals and other alternatives will also help in this regard.
I hope this brief review will provide some insight into our thinking, and how our portfolios are structured.