The benefits of an active approach in market dislocation

The current financial crisis has been appropriately described as an artificially induced economic coma. Will science and public health policy drive the recovery as much as fiscal and monetary policy?

We are closely following scientific and government policy developments as countries work to contain the virus and lift constraints – all shaping the economic environment we will be facing for the next year or two until a vaccine is developed.

Biggest risks: Resurgence of the virus and overreacting to market uncertainty

A resurgence of the virus is a significant risk – either because restrictions are eased too quickly, or cooler weather returns and we see the virus come back strongly. Helping mitigate this risk is that governments should be better prepared for another potential increase in cases, much like South-east Asia and China were after their experience with SARS. That experience clearly left those countries in a better position to deal with the coronavirus than Europe and the US.

A second risk is more near-term, with investors either underestimating or overreacting to uncertainties and challenges as lockdowns are lifted. Equities are long-duration assets, so it’s appropriate that investors are looking out past the next few quarters at long-term growth potential and opportunities once we get past this period. What’s important to remember is the global economy was in reasonably good shape going into this crisis. The global consumer wasn’t overleveraged, unemployment was quite low, and generally speaking, corporate balance sheets weren’t overly stretched. All of that helps as we ultimately work through this crisis.

Retail – shifting from bricks and mortar to e-commerce

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In the retail sector we see an acceleration in the shift away from bricks and mortar operations to e-commerce as a result of social distancing and the closure of storefronts. Many people have become increasingly comfortable with the online purchase process. While this is not a new area of focus for us, we certainly remain optimistic about this secular growth trend. We continue to like MercadoLibre, a Latin American eBay or Amazon-type platform, which has seen increased adoption of their platform and has performed well in this crisis. Another example is Shopify, a company that provides subject-matter experts an e-commerce & logistics software and services, which also has performed well.

Digitisation of education

With the closure of schools we’ve seen parents and students more comfortable with the digitisation of education, and COVID-19 has provided a good testing ground for virtual and digital forms of education. We remain comfortable with our exposure to the after-school tutoring industry in China through TAL Education Group. At the end of January all of their learning centres went into lockdown, forcing their students to move from offline to online courses. As a result, we’ve seen a huge increase in enrolment over this time period. We think they are one of the few players that have the capability to sustainably offer both offline and online courses, which has continued to help accelerate their market position while we’ve seen the smaller players fall away.

Streamlining company processes

With the global economy going into lockdown in mid-March, companies have been forced to revisit their processes and look at the efficiency of their platforms due to growing cost pressures. Broadly speaking, we think companies that help businesses streamline their processes and help them make better decisions will be well positioned to grow moving forward. Zebra Technologies, a company in our portfolio, creates barcode scanners and mobile computers to facilitate automation in warehouses – a highly relevant product today given social distancing.

Redesigning global supply chains

The impact of COVID-19 has emphasised the need for companies to have diversification of their supply chains. In the past companies have been primarily focused on lowering costs, but now operational risks have come to the forefront. We’ve seen a supply chain shift from the early closures in China to places like eastern Europe, India, Bangladesh and Malaysia. When the lockdown hit those markets, we saw another shift in the supply chain back to China as their factories opened up.

We feel it’s important for a company to have flexibility in their supply chain, and expect supply chains will be redesigned based on the complexity of the product. For example, China has built itself up as the manufacturer to the world with lower complexity products such as apparel. We have seen shifts to countries such as Indonesia and India when labor costs in China have increased on a relative basis. For more complex products such as pharmaceuticals or electronic components, this will be a more difficult process and any redesign will take considerably longer and possibly be more disruptive in the medium-term. As we get to the end of the year, we will be watching for any fallout from suppliers as companies work through their inventories and start to assess real demand. One positive is that this period of supply chain disruption is happening in the midst of clearly weak demand. As we see lockdowns lifted, we’d ideally see supply chains and demand building up at the same time.

Healthcare: Short-term drivers and opportunities

In this crisis, we’ve seen a broad bifurcation in performance between the medical equipment and device companies on the one hand, and therapeutics companies on the other. Cochlear, a medical device company that manufacturers ear implants, is a prime example of this trend. They are seeing a fall-off in demand for elective surgeries or non-essential surgeries because of public policy restrictions and general reticence to go into a medical facility for any purpose other than an emergency. But once restrictions on elective surgeries are lifted, demand will come back over time. Therapeutics companies are faring much better right now with opportunities based on the continued growth of existing drugs, and for some, new drugs that have recently been launched or are in the approval process. A positive for these companies is that we haven’t seen a slowdown in the FDA approval of new drugs in the US, even while a focus has been put on COVID-19-related treatments. In our portfolios we own Regeneron, a company that has benefited from each of these drivers – strong existing drugs, new drug approvals and development of new drugs to treat COVID-19.

The pricing of COVID-19-related treatments will be important to watch as it plays out. What we’re hearing so far from companies, Regeneron included, is that they aren’t expecting these drugs or treatments to be significant profit drivers. Beyond clearly addressing a strong humanitarian need, will this approach shift the debate, at least in the US, on drug pricing? It may position the pharmaceutical companies more as heroes rather than the villains they’ve been portrayed as over the last few years.

Emerging trends – are they sustainable?

We think some emerging trends will stick as people have changed their habits or their preferences, but some may revert back once things open up. While videoconferencing is not new, it has gained good traction due to COVID-19, mainly for its ease of use. Working from home has also elevated the importance of cloud security. “Staycations” and self-isolation have led to an increase in gaming and e-sports as well as increasing adoption of food delivery platforms. Some doctor visits have shifted to telehealth given the social distancing and quarantine. Over the long-term, we don’t think the scale of these changes should be overestimated. Humans are social beings and like getting out and conducting business face-to-face. Looking at the history of pandemics, not much tends to change once they are controlled. We’ll see an acceleration of some of these trends, but do think the world two years from now doesn’t look radically different from the world from a year ago.

Maintaining a high conviction approach amid volatility

With our focus on free cash flow and on owning high-quality businesses, we expect companies in our portfolio to manage through this period relatively well. Given their innovation and financial flexibility and strength, many of these companies may emerge from this period in even stronger competitive positions. And few, if any, long-term secular drivers for the businesses will change.

Given those characteristics, and the limited overlap of economic drivers among companies in the Franklin Global Growth Fund, we haven’t seen the need to make many changes as a result of the pandemic. It may seem tempting to trade more frequently given the market’s volatility, but it’s easy to get whipsawed in here, and we’re not going to make short-term market calls. We have selectively pared some positions that have done well, and added to some of the laggards. And of course, we’re watching for new opportunities.

This is the same playbook that we used in past downturns, including the global financial crisis of 2008/09 and in the fourth quarter of 2018. We’ve found that maintaining conviction, limiting changes of holdings and modest rebalancing among positions have led to a faster recovery from drawdowns relative to the index and to peers. In short, keeping our focus on the long-term has served us well.

Don Huber and Francyne Mu, Franklin Global Equity Group

The benefits of an active approach in market dislocation
Don Huber
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