The management of the health crisis is paramount and will be the most critical determinant of the length, depth, and breadth of the economic downturn that is upon us.  The success or failure of aggressive mitigation efforts such as social distancing and sheltering in place strategies implemented by many states will dictate the intermediate future.  Ultimately, we will need widespread and effective testing and contact tracing capabilities to control the pandemic.  Questions abound regarding the economic recession; will there be a V-shaped recovery? Unlikely… U-shaped? Or L-shaped? Will the virus fade with warmer weather conditions and reoccur next fall like the seasonal flu virus?  Will therapeutic treatments emerge in the short or medium term?  Will a vaccine be discovered in a year or two?  How quickly might billions of doses of said vaccine be available?

Will there be long lasting behavioral changes as a result of COVID-19?  Will we ever shake hands again? Is remote working at scale here to stay?  How long will it take for certain percentages of the population to overcome anxiety regarding eating out, attending a concert or sporting event, staying overnight in a hotel room, riding mass transit or shoe-horning onto an airplane to visit a tourist destination?  Surely e-commerce, technology, and healthcare will continue to grow.  Global supply chains of strategically important goods will redomesticate.  How and where we work and live will experience some level of permanent change at the margin.  The scope and scale of those changes depends on the management of the pandemic from this point forward.   A shorter decisive resolution might trigger a shorter collective memory…

Our Stock Market Distress Playbook

During the 23-year history of our management team, we have experienced three significant equity market sell offs, including the burst of the internet bubble in 2000, the Great Financial Crisis of 2008, and now this coronavirus pandemic.  Each time, we return to a few key strategic portfolio management actions:  fine-tune what we already own, seek to add names we know well but had not owned due to elevated valuations, and  evaluate the risks and opportunities characterized by the events of the current crisis.

Fine Tune What We Own

First, we upgrade the quality of the balance sheets in your portfolio.  As you are aware, we are chronically “allergic” to leverage and debt in our positions.  That said, there is always room for improvement when the music stops, and a market crisis erupts. Generally this reunderwriting process leads us to hold larger balance sheets with more staying power.

Second, we reduce the gross exposure in the portfolio to reduce overall risk during the heightened uncertainty.  We entered 2020 with gross exposure of 119% and left the first quarter with 94% gross exposure at March 31, 2020.   Our net exposure began the year at 58%, bottomed out at 44% in mid March near the low point of the S&P 500, before rebounding to 55% through purchase activity and the market recovery by the end of the quarter.

We reduce cyclicality in the portfolio at the margin.  Again, you are aware that we chronically are underweight cyclical sectors of the market such as industrials, materials, technology, and consumer discretionary.  This time is no different.  When we start to see through the severity of the economic downturn, we would begin to reintroduce cyclicality into the portfolio through investments in quality balance sheets in these same areas.

Finally, we actively and aggressively manage our tax position.  We are loathed to deliver a taxable gain at the same time as a total return loss to our customers. Recall that more than 20% of the assets in the fund strategy is internal money.  As such we pay close attention to maximizing after tax returns for our clients.

New Additions

During the quarter, we took advantage of the market sell-off to purchase Visa Inc. (V) and MasterCard Incorporated (MA).  We admire both franchises given their international brand recognition and scope, pricing power, oligopoly status, and essential function in the economy.  They are also in a prime position to capitalize on the continued movement away from cash transactions (which COVID-19 is accelerating) and the rise of digital payments.  For downside mitigation, both companies maintain fortress balance sheets and strong liquidity, which we are especially attracted to in this uncertain environment.  Visa senior debt is rated AA-, and MasterCard senior debt is rated A+ by Standard & Poors.  Additionally, revenue and core profitability held up relatively well during the 2008 Financial Crisis with free cash flow generation through the period.  In this crisis, assuming weak March activity persists for the remainder of the year, we believe EPS downside is limited to a manageable double digit decline from 2019.  Historically, these franchises have traded at elevated multiples reflecting their quality and growth averaging 30x earnings and below a 3% free cash flow yield over the past 5 years.  As the COVID-19 crisis unfolded, we had the rare opportunity to purchase Visa and MasterCard at a 5-year low on P/E and near a 5-year high on free cash flow yields.  We appreciate the opportunity to own superior businesses at fair prices.  

Key Opportunities

Property and casualty underwriter stocks have been harshly punished by the market over concerns of potentially having to pay COVID-19 related claims under business interruption clauses in their commercial property policies as well as plummeting yields on fixed income investments hurting reinvestment rates and slowing book value growth.  While there is truth to the latter concern, we feel that the first one, which is the more material, immediate concern, is unfounded.  Our property and casualty holdings generally consist of personal lines insurers such as Progressive and Mercury General who have little commercial property exposure, or main street carriers such as Selective and Hanover Insurance Group, who write small commercial policies largely using Insurance Service Office (ISO) standard forms which specifically exclude coverage for a pandemic.  While not unusual for politicians to propose legislation in the aftermath of a large loss to extend insurance policies to respond to events specifically excluded (e.g. Hurricane Sandy, World Trade Center, et al), the U.S. judicial system has always ultimately enforced the principles of contract law.  We feel strongly that this will remain the case.   Reinsurance industry exposure to Covid-19 is difficult to handicap, and we are short several reinsurance companies in your portfolio.  However, we maintain a large long position in RenaissanceRe, a reinsurer with a dominant franchise in natural catastrophe reinsurance, a class of contracts with less COVID-19 exposure.

Insurance intermediaries, including Brown & Brown and Arthur J. Gallagher, stand to benefit from dramatically higher future rates for insurance which are in the offing.  These capital-light businesses charge commissions and fees and bear no underwriting risk.  We expect organic growth to dip in the next couple of quarters as the headcount-related premium lines such as workers compensation contract with rising unemployment, before reaccelerating into an economic recovery as insurance rates accelerate. 

On the bank side, our net exposure is among the lowest in the strategy’s 23-year history, which was a good thing during the first quarter.  We trimmed exposure due to a decent rally in bank stocks during the fourth quarter of 2019 combined with twin concerns about an overdue credit cycle and a persistent low interest rate outlook.  Today, banks in the U.S. are better prepared to handle this crisis than in 2008.  They have significantly higher capital levels and liquidity, plus many of the higher risk loan categories are now held by non-bank lenders, hedge funds, etc.  In other words, the capital ratios relative to risk assets are double where they were prior to the Great Financial Crisis, and the loan underwriting standards are significantly more stringent than 12 years ago.  They also hold fewer exotic instruments and engage in significantly less proprietary trading.  Their digital capabilities, built through large consistent investing in technology over the past decade, allow them to service customers seamlessly and remotely, which is currently essential.  Finally bank stocks are historically inexpensive on a price to tangible book value basis and have robust 5% dividend yields that look sustainable unless the downturn becomes materially worse, or the Fed reverses their current stance and forces banks to cut dividends to accrete capital.  Regulators and legislators are using the banking infrastructure to deliver stimulus to small businesses, i.e. they are part of the solution, not the epicenter of the problem as during the Great Financial Crisis.

That said, there are few safe haven loan categories this time around; especially at risk are: energy, hospitality, restaurants, retail, travel, leveraged loans, etc.  Also buybacks are suspended for the time being, and M&A activity has halted as well, both of which are core elements of the book value growth thesis for owning bank stocks.  Once we can see through the depths of the recession to recovery, we are likely to add bank stock exposure to participate in the ultimate cyclical rebound of the economy.

Outlook

The range of outcomes in the short to intermediate term is wide and hinges on the imminent outcome of the “bending the curve” effort to curtail the COVID-19 pandemic.  Economic contraction, trade and geopolitical concerns weigh heavily.  The upcoming United States presidential election is right around the corner and a shift in power could prolong market volatility. 

Interest and mortgage rates continue near historically low levels, inflation is non-existent, and a recession is here.  We are carefully monitoring aggregate corporate debt levels (especially BBB- debt which is a single notch above junk status), which now sit above pre-2008 crisis levels and loom as a problem without aggressive Fed buying through the latest quantitative easing program.  Unemployment has also spiked to double digit levels and has not yet stabilized.  

In our estimation, equity valuations remain at elevated levels, even after the first quarter sell off, due to the sharp decline in expected earnings for the rest of 2020 and into 2021.  Recovery in aggregate earnings will be slow as certain industries such as hospitality, entertainment, banking, and travel will take much longer to return to pre-coronavirus levels. Treasury and high-grade corporate bond yields look unattractive after the dramatic flight to safety rally during the current health crisis.  In any case, the values inherent in your portfolio should attract acquirers and other investors over time.  Meanwhile, we still believe equities are a superior asset allocation alternative to bonds over the longer term.

Steadfast, we remain committed to our goal of making you money while protecting your wealth.

- Your Team at Long Short Advisors

 

Disclosures

Risk Statistic Definitions: Standard Deviation measures the volatility of the Fund’s returns. Beta measures the Fund’s sensitivity to market movements. Sharpe Ratio uses the Fund’s standard deviation and average excess return over the risk-free rate to determine reward per unit of risk. R-squared represents the percentage of the portfolio’s movements that can be explained by general market movements. Upside/Downside Capture Ratio measures a manager’s ability to generate an excess return above the benchmark return in up markets and retain more of the excess return in down markets. Risk statistics are relative to the HFRX. Batting Average is a statistical measure used to evaluate an investment manager’s ability to meet or beat their index. Traynor Ratio measures excess returns per each unit of market risk, as measured by beta. Omega is a relative measure of the likelihood of achieving a given return. Max Drawdown is the peak-to-trough decline during a specific recorded period of an investment. Gross Exposure is the sum of the absolute values of the fund’s long and short exposures. Net Exposure is the fund’s total long exposure less the fund’s total short exposure. The Gross

Expense Ratio is 3.13%. The Net Expense Ratio is 2.91%.The Expense Cap is 1.95%. The Adviser has contractually agreed to waive or limit its fees to 1.95%.

Prospector Partners, LLC assumed investment management duties on 05-28-2015 and was formally approved by shareholders on 09-17-2015.

As of 3/31/2020, the Fund contained 63 long positions in the portfolio representing companies with what management believes represents long-term value and favorable characteristics such as a discount to market value, attractive free cash flow yields, and strong balance sheets. The Fund’s top 10 long positions represented approximately 26% of the portfolio and included Aflac (AFL – 2.0%), Berkshire Hathaway (BRK.B – 3.2%), Brown & Brown (BRO – 3.3%), Merck & Company (MRK) – 2.1%), Microsoft (MSFT – 2.2%), Nestle (NESN – 2.7%), PNC Financial (PNC – 2.5%), Progressive Corp (PGR – 2.3%), RenaissanceRe (RNR – 3.6%), and US Bancorp (USB – 2.1%).

 

The Fund may lose money due to fluctuations within the stock market which may be unrelated to individual issuers and could not have been predicted. The price of the securities which the Fund holds may change unpredictably and due to local, regional, international, or global events. These events may include economic downturns such as recessions or depressions; natural occurrences such as natural disasters, epidemics or pandemics; acts of violence such as terrorism or war; and political and social unrest. Due to the prominence of globalization and global trade, the securities held by the Fund may be affected by international and global events. In the case of a general market downturn, multiple asset classes, or the entire market, may be negatively affected for an extended and unknown amount of time. Although all securities are subject to these risk, different securities will be affected in different manners depending on the event.

The Expense Cap is 1.95%. The Adviser has contractually agreed to waive or limit its fees to 1.95% and to assume other expenses of the Fund until September 30, 2020, so that the ratio of total annual operating expenses (not including interest, taxes, brokerage commissions, other expenditures which are capitalized in accordance with generally accepted accounting principles, other extraordinary expenses not incurred in the ordinary course of business, dividend expenses on short sales, expenses incurred under a Rule 12b-1 plan, acquired fund fees and expenses and expenses that the Fund incurred but did not actually pay because of an expense offset arrangement) does not exceed 1.95%.

Investment in shares of a long/short equity fund has the potential for significant risk and volatility. A short equity strategy can diminish returns in a rising market as well as having the potential for unlimited losses. These types of funds typically have a high portfolio turnover that could increase transaction costs and cause short-term capital gains to be realized.

You should carefully consider the investment objectives, potential risks, management fees, and charges and expenses of the Fund before investing. The Fund’s prospectus contains this and other information about the Fund, and should be read carefully before investing. You may obtain a current copy of the Fund’s prospectus by calling 1.877.336.6763. The Fund is distributed by Ultimus Fund Distributors, LLC. (Member FINRA).

10133167-UFD-4/29/2020