Managing Through a Recession

Many investors are becoming increasingly concerned that a recession may be on the horizon as North American markets continue to climb higher despite global trade concerns.

A recession is defined as a temporary economic decline during which trade and industrial activity is reduced.  It is typically identified by a fall in Gross Domestic Produce (GDP) over two successive quarters.

While our view of the current economic environment supports continued, modest growth for the near future, it is important that our clients understand that we are actively managing client assets according to changing economic conditions.

Croft investment mandates are weighted towards a specific allocation to our 3 core funds, TCG531 Equity Growth Share Class, TCG534 Income Share Class and TCG539 Option Writing Share Class. This allocation is based on meeting the objective and risk guidelines of our 3 standard investor profiles:

  1. Conservative
  2. Balanced
  3. Growth

Investors will fall in to 1 of the 3 categories based on their Investment Profile Questionnaire and further conversation with a Portfolio Manager.

The 3 funds used within each mandate are designed to complement one another with all being actively managed on a day to day basis to adjust to changing market conditions.

With that in mind, the Income Pool is 75% of the Conservative Mandate, 50% of the Balanced Mandate and 25% of the Growth mandate.

Conservative clients would be most sensitive to a market contraction given many have a
shorter investment horizon and are less tolerant to risk and volatility. Several adjustments may be made within the Income Pool to adapt to market conditions.  We can also increase exposure to the Income and Option Writing Pools and reduce the exposure to our Equity Growth Pool in the Balanced and Growth Mandates to further insulate a client’s portfolio from recessionary pressures.

The Income Pool is designed to have minimum market volatility, generate a steady stream of income and provide stability in our client’s portfolios. The Income pool is composed of four different “sleeves” (fixed income, high yield/low beta, covered call strategies, and long Puts)

The Income Pool has a 35% allocation to Fixed Income. During a recession, the yield curve traditionally inverts causing the Fixed Income allocation to increase in value.

The 29% allocation to the “high yield / low beta” sleeve is concentrated in the Telecom, Utilities, Real Estate sectors that exhibits certain degree of duration. The duration will cause these securities to increase in value

during an inverted yield environment.  In addition, this sleeve is invested in companies that have low revenue sensitivity to GDP growth.

The 36% allocation to covered call strategies is invested in companies that have just experienced significant drop in price and exhibited multiple contraction. The effects of a market pullback should be diminished because of already depressed multiples and the inherent hedging properties of short calls. During a recession the VIX (fear index) will be trading at elevated premiums and will provide increased income and hedging properties. This is an ideal environment for the Covered Call strategy.

Currently, there is a 9.10% SPY Put hedge acting as a type of “insurance policy” on the equity exposure in the Income Pool. This hedge will increase in value in an inevitable pullback in the market. This strategy has been in place since the end of last year and will continue to be an important strategy moving forward.

Because the objective of the Equity Pool is growth of capital, during expansionary macroeconomic periods the pool will invest in a variety of stocks across a variety of sectors with a strong focus on Momentum and Growth with a smaller focus on other style factors such as Value, Yield and Low Beta.

When macroeconomic conditions begin to mature and slow down we begin shifting our factor exposures to tilt more toward Quality
stocks.  These companies are normally large cap with features such as high Return on
Equity, low Earnings Variability and low Leverage.  Because these companies have strong cash flows and strong balance sheets they are exposed to less risk since they can support their financial position.

During a recession the focus shifts toward defensive sectors and stocks with Low Beta and Value factor exposures.  These are companies that tend to be less volatile than the broad market and would be expected to go down less when the broad market is falling.

With respect to options, during expansionary periods we may write Out-Of-The Money Covered Calls to enhance return and provide some downside protection while maintaining some upside exposure if the stock appreciates.  We can also choose not to write Covered Calls as to not limit the upside.  We may also write In-The-Money puts to capture high implied volatility through the time value of the option along with some intrinsic value.

During market corrections and recessions, we can hedge with tighter Covered Calls or with long put options.  At deep market troughs, we also would write In-The-Money puts on an expected rebound.

During a recessionary period, we would also hold a higher allocation to cash.

The Option Writing pool shares many of the same characteristics as the Income fund except for a higher concentration in option strategies that are designed generate cash flow. These strategies can be modified to benefit from a bearish to neutral market if we enter in to a recession.  This fund will also benefit from higher option premiums from an uncertain and more volatile market.

August 2018 – Momentum Meltdown

One of the most notable headlines for the month of July was the significant sell-off in 2 of the FAANG stocks. FAANG is an acronym used to describe the tech stocks which have been leading the market for quite some time. The group includes Facebook, Apple, Amazon, Netflix and Google.

These stocks have been very attractive to investors due to their upside momentum, however both Facebook and Netflix surprised the market with less than favorable guidance during their latest earnings report, sparking a momentum factor meltdown.

On the Canadian front, financials remained strong while materials (most notably gold) continued to sell off along side energy.

Fund Performance

TCG 531 Equity Growth Fund

For the month of July, the Equity Growth fund finished positive 0.68% while its benchmark, the TSX Total Return Index added 1.15%

Year to date, the Equity Growth fund is up 4.89% with the TSX TR benchmark trailing at 3.12%.

Lead manager Alex Brandolini confirms that broad performance within the Equity Pool was strong for the month of July except for Facebook and Netflix. Facebook detracted from pool results significantly at the end of the month leading to a drag in performance.

On July 25th, Facebook reported a beat on Earnings Per Share (EPS), but a miss on both revenue and average monthly users.  Further, CEO Mark Zuckerberg provided an outlook for operating margins
that disappointed investors.

On the back of these disappointing results, Facebook registered the largest one-day drop in market capitalization in history.

We feel concerns about margin compression are overblown since we believe Mark Zuckerberg and COO, Sheryl Sanderberg, along with their industry leading experience, will find ways to monetize content consumption.  Further, we believe there is a certain amount of conservativism built in to the guidance provided by Zuckerberg so he can return to a “beat and raise” cycle following this revenue miss.

Notable actions taken within the Equity Pool included selling Boyd Group Income Fund as it reached full valuation.  This was part of our ongoing strategy of actively managing and locking in profits on our momentum stocks. We purchased a couple of Canadian Momentum names with strong fundamentals on a pullback.  Strategic option writing also continues to be an active strategy to take advantage of highs and lows on some of the technology stocks on our watch list, as prices continues to chop about.

 TCG 534 Income Fund

Our Income fund finished the month of July up 1.20% compared to the Real-World Index Income benchmark which was down 0.15%. Year to date the fund sits positive at 3.84% compared to its benchmark which trails at 0.89%

Lead manager Mark McAdam repurchased S&P 500 put options as part of an on-going hedging strategy. Mark adds that the put options should increase in value as market fear and uncertainty increases and the value of the S&P 500 drops. This will act as a bit of an insurance policy, helping to offset some of the potential downside in the fund should the U.S. market sell off.

In addition to the re-introduction of the hedging strategy, we added to our tech sector position during the July sell-off – increasing the overall exposure by 10.3%

Profits were captured in the Financial Sector, resulting in a reduction of exposure by 11.50%

That said, the overall exposure to Equities was reduced and exposure to Bonds and Cash was increased.

The cash raised in July through the reduction in the equity exposure has been earmarked to take advantage of quality companies that experience a sell off due to short term, temporary issues.

Mark notes that the Sharpe ratio of the income fund increased to 1.85 from 1.26 in July and continues to reflect a better long-term Sharpe ratio over its benchmark as does our equity growth fund. This observation suggest that we are managing risk efficiently.

Many investors focus on returns without considering the amount of risk a Portfolio Manager has taken to achieve their numbers. The Sharpe Ratio is a metric which tracks the average return per unit of volatility or total risk.

Typically, the higher the Sharpe Ratio value, the more attractive the risk-adjusted return.

TCG 539 Option Writing Fund

Our Option Writing Fund is designed to drive cash flow using income generating option strategies regardless of market direction.

The fund finished June positive with a 0.49% gain, however, it lagged its benchmark, the Montreal Exchange Covered Call Writers index which finished the month positive 1.64%.

As of the end of July, the Option Writing Fund sits at a 2.13% return for the year, while the MXCW currently sits at 3.29%

Lead manager Richard Croft notes that the fund remains balanced between value and momentum stocks and is 77% invested with 23% in cash held for new opportunities as well as cash equivalents.

As mentioned last month, the average duration of time until expiration for the option writes remains on shorter side at 33 days.

Richard adds that shorter term options are being written more specifically on the momentum stocks where the option premiums tend to be attractive due to the increased short-term volatility. With many of the value positions paying dividends, longer dated options typically results in longer holding times and the collection of dividends.

While Facebook and Netflix acted as a bit of a drag on performance for July, positions in Apple, Amazon and Google balanced out the impact with their positive performance.

Current Outlook and Expectations

Looking forward, we feel July’s sell off in the tech sector was a positive signal for the health of the overall market as Momentum stocks typically underperform in the first month after a market correction, such as the one we saw in February, followed by strength and overvaluation in the subsequent months.

Momentum taking a breather historically has been consistent with the development of a broader bullish trend.

Evidence of this comes from current year and fiscal 2019 market expectations.

Despite Netflix and Facebook disappointing, Better than expected results in most reporting companies has caused analysts to revise their earnings and sales forecasts upwards.  This indicates that companies are still growing and makes investing in stocks an attractive opportunity.

Looking out further, we are paying close attention to margins.  In both 2011 and 2015, peaks in margin estimates accurately predicted market tops.  Given the CAPEX (capital expenditure) cycle that is underway and the potential for trade risks to slow down revenue, margins are something we continue to watch closely.

Finally, strength in the USD will continue to weigh heavy on gold and oil which will act as an anchor for the broader Canadian economy.

 As always, we will continue evaluate and adjust as market conditions change.