Investing In The Bear Market—Royce
article 05-18-2020

Charlie Dreifus On Investing In The Bear Market

Charlie Dreifus details how he’s navigating the market and how he is evaluating companies in these tumultuous times.

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THINK

In light of the similarities and differences the current market has with previous significant declines, how are you investing? What metrics or other elements have been useful and important over the last two months?

I think we should assume that any decline of this magnitude, and especially one caused by a shock to the world order that has not been seen in recent history, is the beginning of a bear market until proven otherwise. Thus, in terms of my purchases, I’ve been deploying a modified dollar cost averaging approach: I buy more on down days and slow or halt purchases on up days on the assumption that the market will go down again. I also expand the amount I purchase the further a stock price falls.

One unique element about the current situation is that forecasting future near-term earnings cannot be anything more than a guess. Until the number of virus cases has peaked and we’ve found both treatments for those infected and a vaccine, no one can accurately forecast the degree of harm to the economies of the world. Therefore, we can’t forecast the revenues and earnings for a specific company with any confidence.

To establish parameters, one needs to make assumptions as to the degree a company’s revenues will be impacted by the effects of the virus and review pre-virus earnings levels and margins to try to guess where earnings might land as we come out of the pandemic. Frankly, I don’t see any other means of establishing “normalized earnings” at this moment.

“I’m relying on the hallmark metrics that I’ve always used, including low leverage, high free cash flow and cash conversion, and high return on investment, coupled with clean accounting and governance.” — Charlie Dreifus 

Given this, I’m relying on the hallmark metrics that I’ve always used, including low leverage, high free cash flow and cash conversion, and high return on investment, coupled with clean accounting and governance, which have all become even more useful and important in the current environment.

While the Fed has arguably acted too aggressively, potentially creating moral hazard by bailing out highly indebted businesses, these actions may also have reduced the probability of a depression. Does reducing that tail risk provide you with any comfort as an investor, especially in light of a nearly 15% unemployment rate?

For sure, an important part of the Fed’s job includes the responsibility to promote full employment. But I have questions around the means that are being deployed. Unless one has a state- controlled economy, I believe that job should not include allowing support for enterprises that are not productive or that exist merely through financially engineering, particularly if that engineering is done with the use of excessive leverage.

The pain caused to people in our country—and there is plenty of it toward which I’m very sympathetic—must be addressed by fiscal rather than monetary means. There’s evidence that Congress has provided at least some of that, however poorly executed. More may be needed. For example, additional aid may need to be given to state and local governments. The provisions of these safety nets, however, are the responsibility of the federal government and not the Federal Reserve.

If we have entered a “New Normal” with a perpetual Fed put in which business borrowing is encouraged, how are you thinking about adapting the attributes you prioritize in evaluating companies?

Great question. My initial reaction is that such an environment is not stable and is likely to destroy itself. Prudent and sound financial management will win out over the long term, as has been the case historically. Of course, there is also the fact that the Fed’s policies and priorities change over time. The fact that the Fed “put” is now in effect does not guarantee that it will be that way forever.

I will continue to strive to invest in companies that I find attractively priced on an absolute basis and that earn high returns on capital (giving them a moat-like status), deploy leverage modestly with high free cash flow and cash conversion, and adhere to accountability—that is, companies that use clean accounting and operate with responsible corporate governance.

 

ROYCE SPECIAL EQUITY FUND

 

Important Disclosure Information

Mr. Dreifus’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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