Why Strong Balance Sheets Matter
Our first in a series of webinars focusing on sustainable and ESG topics. Hear portfolio managers Scott Klimo, Elizabeth Alm, and Patrick Drum discuss why strong balance sheets matter whether you're investing in equities or fixed income.
Why Balance Sheets Matter
Craig Churman: So, we decided to make it a series and this is the first in the series and we really wanted to start with the fundamentals of Saturna’s investment process and the theme of why strong balance sheets matter. So, today we have Scott Klimo, our Chief Investment Officer, Elizabeth Alm, who focuses on the fixed-income markets and is really a specialist in the municipal markets, and Patrick Drum, who focuses on global fixed-income, and all of them have a unique insight into the way that we look at strong balance sheets and how they impact our investment process. So, welcome to the first of our seminars, and you all probably know Scott. He’s the portfolio manager for Amana Growth and Sextant Growth and he really focuses on the equity market and leads our investment research team as our Chief Investment Officer. I’ll start with Scott, and Scott, how did the equity performance of low-debt companies compare to the more indebted firms over the first quarter and as we got into the COVID market… how did that be affected in our investments?
Scott Klimo: Thanks, Craig. And good morning to everyone and good afternoon to those on the East and Central time zones. The first quarter was really a dramatic affirmation of the approach that we take in investing in low-debt companies and as our founder, Nick Kaiser, has often said, one of the best ways to make money is to not lose it. And that was demonstrated in the first quarter. Through March 23rd of this year, the stocks that had a debt to market capitalization ratio of less than 33% were… and when I say “the stocks”, this is taking a universe of the 500 largest cap stocks in the United States, so more or less the S&P 500, but those with a debt to market cap ratio of less than 33% declined a little under 31% from the start of the year through March 23rd. Those with a debt to market capitalization above 33% declined by 43%, so 31 versus 43. Pretty significant gap in performance there, between the low debt and the high debt companies.
Craig Churman: Scott do you want to just illuminate a little for those that need a reminder of where the 33% debt to market cap factors into your process?
Scott Klimo: Sure, so for the Amana Funds, which are invested according to Sharia guidelines, we have a number of financial metrics that are required for a company to be eligible for investment. And the most significant of those is the total debt to market capitalization ratio, which was decided upon by our Sharia advisers and our board of directors and Nick, back when the Funds were being established. And so, that is a pretty typical ratio. Other jurisdictions might use a somewhat different ratio than debt to market cap. They might use debt to total assets or something of that nature. And then additionally, we also look at accounts receivable relative to total assets. It cannot be in excess of 45% and then ineligible, or haram, income cannot be in excess of 5% of total sales.
Craig Churman: Scott, do you have longer term evidence of the benefit of investing in lower-debt companies?
Scott Klimo: Yes, we do. And I think this was very conspicuous during the first quarter because it was such a period of dramatic disruption and serious concerns about the viability of companies that didn’t have strong liquidity positions which definitely contributed to the outperformance. But even in a more normalized market environment, we have seen advantages to investing in lower-debt companies. Over the period… the end of 2014 to the end of 2019, so that five-year period, stocks with a debt to market capitalization of less than 33% provided an annual return of 15.3% while those with higher debt than that level, their return was only 11.2% and the return of the S&P 500 was 11.7%. Over the past three years, a similar and even more dramatic gap has been the case, so from 2017, 2018, and 2019, over that three-year period, low debt stocks were up 19%, higher debt stocks were up 12.7%. Now, we do have to admit that this doesn’t work in every single quarter, every single month of the year. And so, since March 23rd through the beginning of June, we have seen the higher debt companies somewhat outperform, so they provided a return of 50% while the lower-debt companies’ return was 47%. But that’s really pretty intuitive when you consider that there was a going concern issue with so many stocks and when the government came out and provided the various relief and bail out funds, companies that were on the brink of bankruptcy, such as airlines or cruise ships, for example, all the sudden had really dramatic, dramatic turnarounds. But I really am confident that over the longer term, the benefits of the lower debt positions will reassert themselves.
Craig Churman: And as long-term investors, you’re gonna buy and hold these companies through long cycles…
Scott Klimo: We’re certainly not trading government bailout programs, no.
Craig Churman: Oh, government bailout programs? That sounds like we’re gonna transition to Elizabeth now and talk about the municipal markets. So, Elizabeth, how have muni issuers been impacted by COVID and why does it matter to investors?
Elizabeth Alm: Thank you very much, Craig, and thanks everyone for joining. You know, municipal governments are really facing the prospect of massive operating deficits now due to the heightened need for services combined with the simultaneous drop in revenue. So, you are having more cost due to COVID, especially in virus-related Medicaid expenses. And the revenue shortfalls are really across the board in a scale that hasn’t been seen since the Great Depression. We’re talking sales taxes, property taxes, income taxes—the lifeblood of state and local revenue streams. For example, New York State, which was one of the hardest hit by the virus, is facing a $13 billion budget gap. So, to put this into context, and why it matters for investors, even beyond those in the muni market… Non-Federal government spending accounts for $4 trillion, or a little more than 1/5th of the US GDP. Really, the infrastructure of economic growth is built at the local level. Roads, airports, schools, employment ranging from public safety to teachers, healthcare workers, the backbone of the economy. For example, if school district revenues actually do drop the anticipated 15%, the country could lose 1 in 12 teachers. This is really an issue that we need to pay attention to. State and local governments didn’t even really fully recover from the 2007 to 2009 recession until last fall.
Craig Churman: Can you identify entities most at risk, and those that are well positioned? You mentioned the school districts…
Elizabeth Alm: Yeah, you know, when we’re looking at potential investments for our Tax-Exempt Fund, and municipalities, there are a few things that we look at to assess risk. First of all, what’s their fixed cost percentage? So, this is talking about, you know, their financial flexibility, so debt service, pensions, things that they can’t cut or adjust, in a period of a revenue downturn. We’re also looking at reliance on state funding. So, at the local level, or downstream credits including school districts or public university, how much do they rely on the state and what’s their vulnerability should the state need to cut those revenues? But most importantly are the rainy-day funds… you know, you have New York versus California, where New York only has around a 4% rainy day fund relative to their expenditures versus California which has 13%. They’re much better positioned. And finally, where’s the revenue coming from? For example, tourism economies such as Florida, Nevada, Hawaii are really most vulnerable in the age where we’re not traveling. For example, Florida gets around 70% of their revenues through sales taxes and tourists typically account for 20% of that total.
Craig Churman: Yeah… it’s unusual that you hear that New York is in a different sphere than California. Being in the Pacific Northwest on the west coast, we hear a lot about what’s going on in the state of California, and it’s interesting to compare New York and California. So, what’s driving the valuations and how can we find opportunities in this market?
Elizabeth Alm: You really… it’s driven by quality. And you’ll hear a similar story from Patrick, as well, in the corporate market. If you look at the Bloomberg Barclays muni indices, the AAA quality returned, year to date, 3.18% while the BBB returned -4% and just going back to New York and California, you’re also seeing a divergence in credit sentiment and performance that follows that divergence. For example, spreads have widened much more for New York versus California, even though they’re both going to face revenue shortfalls, delayed tax collections, but California has a larger economy as a percentage of GDP, higher level of rainy-day funds, as I’d mentioned earlier, and also New York was a larger hotspot for the pandemic.
Craig Churman: Yeah, New York was front and center early on. And I guess Washington has been a little slow to snap out of it, but we’ll see what happens and how that affects valuation. So, maybe we’ll switch to Patrick now, and he looks at the global fixed-income market and runs a global sustainable bond fund for us. Can you provide a brief overview of the fixed-income market and what you’re seeing, Patrick?
Patrick Drum: Absolutely, Craig. And it’s a pleasure to be a part of this and more importantly, I hope everyone is doing well. To put in a little context. The corporate credit market, and Elizabeth works very closely with me on the Sustainable Bond Fund as the Deputy Portfolio Manager and is a true value add to the team. But the corporate credit market has been really a dynamic market that doesn’t typically obtain a large part of the news cycle for a better lack of term. Unlike the Global Financial Crisis, which was predominantly centered on the banking and mortgage sector, this downturn is really impacting the global economy, just because it’s a full stop. We’re seeing industries that are essentially being hammered, from airlines, hospitality, travel, retail, property. And prior to the Fed’s actions, most of the corporate bond space was just driven to a race for liquidity. In early March, corporations were just primarily what I call a cash dash. Until the Fed stepped in and whereupon in March 15th, with the first QE program and subsequent others, it provided the stabilization for liquidity in the market. And as a result, corporations came to the market to issue debt in spades. To give you kind of an idea, the Securities Industry and Financial Markets Association… a real exciting name… but goes by the acronym SIFMA… as of June 1st of 2020, noted that investment grade issuances already exceeded $1 trillion as of June 1st. That is a 99% increase from last year at this time, where it was at $517 billion. Total issuance among investment grade issuers topped a little over $1.1 trillion. So, we’ve already… we’re just on the cusp of exceeding what was issued all of last year by June 1st. It gives you an idea how much these companies are trying to raise cash. High yield, on the other side, has only increased 30% year to date, to $140 billion. And that, in part, really identifies the bifurcation that’s existing, or that’s being observed in the market. Those who can get it are in a secure position and those who aren’t are not. And again, it’s a real dramatic outlay. To give you an idea, as of June 1st, there have now been, collectively, over 1,400 downgrades among the firms by the credit rating agencies. That is over an 80% increase from last year, where in 2019 there was just 802 total downgrades. Fallen angels has really been sort of one of the few highlighted attention news items in the market prior to the selloff. And a fallen angel is defined as a BBB- company that falls from investment grade, although low investment grade, to a high yield category. And currently there has been 25 fallen angels, up from 17 all of last year. And some of them are high profile names such as Macy’s, Delta Airlines, and Ford Motor Companies. Among this BBB- category, there’s over 110 companies that already have a negative outlook. The penalty for the downgrade is about a 300-basis point spread widening. It’s significant and meaningful.
Craig Churman: Thanks, Patrick. And your outlook, given the tight rated environment we’re in, and maybe as some markets approach negative yields, what are your thoughts there in terms of the outlook?
Patrick Drum: The outlook is gonna be the word low for longer is gonna be an extended word of loooongggerrrr. This environment is particularly challenging. What we’re been observing is so much… the capital now seems to be moving away from developed markets to high-yield, or excuse me, the emerging markets. Just because there’s a sense of stabilization that’s occurred with the broad central bank policies of quantitative easing, not just by the Fed, Japan, the ECB, but also emerging market countries are starting to engage in their own programs. And that’s moving capital to emerging markets that are now experiencing strong pickup. The US Dollar has declined quite a bit, making a far more favorable, from a total return perspective, for the non-US dollars issuers. So, it’s gonna be lower for longer, relative value and relative returns gonna be an incremental importance, but quality at the end of the day still matters.
Craig Churman: We have a question: do you expect a repeat of the Taper Tantrums when rates do start to rise?
Elizabeth Alm: You know, I think that it’s possible. Eventually rates will have to rise, but I think that as Patrick mentioned, we’re really expecting low, for a long time. At this point, we really don’t see when that’s going to change. I don’t know, Patrick do you have anything to add to that?
Patrick Drum: I don’t see a real Taper Tantrum environment really going to occur. The Fed has sort of crossed that line in the sand where they have to continuously provide the support in the market. And the challenge is that in the last three months, the balance sheet now exceeds $7 trillion. So, it’s increased by $3 trillion in a short window; we’re talking real money. And as a result, I think you’re gonna see a different sort of tool set come on out to help provide them the ability to issue debt and also provide support for the market.
Craig Churman: Okay… thank you, Patrick. Thank you, Elizabeth. Scott, anything you need to add in terms of the equity market and balance sheets? Because, I know you saw a rebound in some of the financials and in general, we don’t play in high debt companies or financials.
Scott Klimo: Yeah, I guess, just a quick word about the banks is that given what Elizabeth and Patrick have just said about lower for longer… that’s a difficult environment for banks to make money. How do you earn any sort of net interest margin? So, it’s going to be a challenging, I think, environment for them, and of course then there’s the whole issue of non-performing assets, which I think you’d really have to be remarkably and unrealistically sanguine to expect that those weren’t going to increase, so I’m perfectly happy not to have exposure to that sector for the time being.
Craig Churman: Yeah, and the next webinar that we’re gonna do in a couple weeks is all on governance, and particularly in the emerging markets. And then, after that we’re going to do a webinar in July that has to do with the supply chain in China, and particularly our overweighting in technology, given our process and the mandates we follow. That should be a very interesting conversation… Okay, this was to Patrick on the Participation Fund, is there a difference in balance sheet strength of the sukuk issuers compared to similar fixed income issuers in the corporate bond market? We’ll probably need to allow for about 45 minutes for this answer, right Patrick?
Patrick Drum: It can be short. I’ll say yes… and Elizabeth, she’s the Deputy Portfolio Manager on that fund as well, so she works very closely. The answer is even more so. So, the Participation Fund, for those who are not familiar, is our Shariah compliant Fund that focuses on capital preservation and current income. It is the proxy of a conventional fixed income fund, adhering to Islamic principles. That particular market is extremely dynamic and extremely… local context is everything. Liquidity is everything. And being able to navigate high grade issues has made a tremendous difference… doing the homework first is much more of a priority because the dividends, as a result of that work, pay off far more so in that environment. That’s in part what led the Participation Fund to, and I’ll do a little plug, to obtain it’s 5-star rating by Morningstar at the end of the first quarter of 2020. It’s both the high quality and also, there’s a lot of factors that came into play, and it’s a team effort. So, I want to thank everyone for supporting our work.
[Listener]: Scott, so as the title of this presentation about strong balance sheets… the last, what, 10, 11 years have all been technology, mainly technology, and most of these companies—Google, Facebook, Apple—have strong balance sheets. So, do we see this to continue, that these companies will continue to perform and so the best place to be is large growth, and mainly US?
Scott Klimo: That’s certainly been a key topic of discussion for some time now and kind of an interesting, you know, tangent, so that is people talk about the outperformance of the United States versus other markets. But if you do strip out the say, the FAANGS, just for shorthand, out of the US market performance, it turns out that international has actually done pretty much in line with the United States. So, it really has been that handful of companies that have driven index performance for some time now. And I guess my short answer to the question is yes. I think that’ll continue because I believe that this is an environment that if anything is going to solidify the position and the advantage that these companies have in the marketplace because of their size, their dominance, and because of their balance sheets and their financial flexibility. As Patrick mentioned, it’s been super easy, or relatively easy, for the investment grade companies, to raise funds relative to those that are not investment grade. And obviously if you’re Google, Alphabet, Amazon, Adobe, etc., anybody would be more than happy to give you money. And so, not that they need it, which is kind of the interesting thing. That’s always the case. You can always get the money when you don’t need it. It’s when you need it that you find it hard to acquire. But I think that yeah, absolutely, these are going to continue to be strongly performing companies and, in many cases, they’re built for a COVID environment. You know, a post-Coronavirus environment where so many of the trends that we’re moving toward, whether it’s remote work, which really hadn’t gotten a lot of traction but we’re now just seeing this explosion so that’s certainly accelerated going forward. Whether it’s e-commerce. Just today, Inditex, which is a Spanish-based clothing retailer that owns the Zara chain of stores, announced that they’re gonna close something like 2,000 stores and focus much more aggressively on e-commerce. Well, obviously the companies that we’re talking about here are very well-placed to take advantage of it, whether it’s because you manage cloud services like Azure for Microsoft, or because you are an electronics payments company, which is not one that we mentioned but Mastercard is a dominant company in this respect. Or even just the general increase in e-commerce which of course would be a tremendous benefit to Amazon, which has just been going from strength to strength for some time. I think it’s up 33, 34% year to date. So, yeah, a lot of words there but short answer, yes.
Craig Churman: Yes, so we would say strong balance sheets matter and all of these companies have strong balance sheets. And as Scott said, the international markets have done pretty well when you strip out the larger companies. So, I think we’re coming to the end. Thank you very much. I think we’ll keep it on time. Like I said, this will be recorded, and you’ll also get an invitation as we continue the series and into July and August, we’ll have even more webinars available. So, thanks everybody for your time. It was very enjoyable. Thanks to Scott and Elizabeth and Patrick. Nice job, and we’ll go back and go to work investment team and keep an eye on those balance sheets. Thank you very much.
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The S&P 500 Index is an index comprised of 500 widely held common stocks considered to be representative of the US stock market in general. The Bloomberg Barclays Global High Yield Corporate Bond Index is a rules-based, market-value weighted index engineered to measure the non-investment grade, fixed-rate, taxable, global corporate bond market. Investors cannot invest directly in the indices.
A FEW WORDS ABOUT RISK:
The value of the shares of each of the Funds rises and falls as the value of the securities in which the Funds invest go up and down.
Amana Income, Amana Growth, Amana Developing World, and Amana Participation Funds: The Amana Mutual Funds limit the securities they purchase to those consistent with Islamic principles. This limits opportunities and may affect performance. Each of the Funds may invest in securities that are not traded in the United States. Investments in the securities of foreign issuers may involve risks in addition to those normally associated with investments in the securities of US issuers. These risks include currency and market fluctuations, and political or social instability. The risks of foreign investing are generally magnified in the smaller and more volatile securities markets of the developing world.
Amana Growth Fund: The smaller and less seasoned companies that may be in the Growth Fund have a greater risk of price volatility.
Amana Participation Fund: While the Participation Fund does not invest in conventional bonds, risks similar to those of conventional nondiversified fixed-income funds apply. These include: diversification and concentration risk, liquidity risk, interest rate risk, credit risk, and high-yield risk. The Participation Fund also includes risks specific to investments in Islamic fixed-income instruments. The structural complexity of sukuk, along with the weak infrastructure of the sukuk market, increases risk. Compared to rights of conventional bondholders, holders of sukuk may have limited ability to pursue legal recourse to enforce the terms of the sukuk or to restructure the sukuk in order to seek recovery of principal. Sukuk are also subject to the risk that some Islamic scholars may deem certain sukuk as not meeting Islamic investment principles subsequent to the sukuk being issued.
The Sextant Growth Fund may invest in smaller companies, which involve higher investment risks in that they often have limited product lines, markets and resources, or their securities may trade less frequently and have greater price fluctuation than those of larger companies.
The Sextant International Fund involves risks not typically associated with investing in US securities. These include fluctuations in currency exchange rates, less public information about securities, less governmental market supervision, and lack of uniform financial, social, and political standards.
The Sextant Core Fund involves the risks of both equity and debt investing, although it seeks to mitigate these risks by maintaining a widely diversified portfolio that includes domestic stocks, foreign stocks, short and long-term bonds, and money market instruments.
Investment in the Sextant Global High Income Fund entails the risks of both equity and debt securities, although it seeks to mitigate these risks through a widely diversified portfolio that includes foreign and domestic stocks and bonds. Issuers of high-yield securities are generally not as strong financially as those issuing higher quality securities. Investments in high-yield securities can be speculative in nature. High-yield bonds may have low or no ratings and may be considered “junk bonds.”
The risks inherent in the Sextant Short-Term Bond and Sextant Bond Income Funds depend primarily on the terms and quality of the obligations in their portfolios, as well as on bond market conditions. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. Bonds with longer maturities (such as those held by the Bond Income Fund) usually are more sensitive to interest rate changes than bonds with shorter maturities (such as those held by the Short-Term Bond Fund). The Funds entail credit risk, which is the possibility that a bond will not be able to pay interest or principal when due. If the credit quality of a bond is perceived to decline, investors will demand a higher yield, which means a lower price on that bond to compensate for the higher level of risk.
The Saturna Sustainable Funds limit the securities they purchase to those consistent with sustainable principles. This limits opportunities and may affect performance. Investing in foreign securities involves risks not typically associated directly with investing in US securities. These risks include currency and market fluctuations, and political or social instability. The risks of foreign investing are generally magnified in the smaller and more volatile securities markets of the developing world.
Saturna Sustainable Equity Fund: Stock prices fluctuate, sometimes quickly and significantly, for a broad range of reasons that may affect individual companies, industries, or sectors.
Saturna Sustainable Bond Fund: When interest rates rise, bond prices fall. When interest rates fall, bond prices go up. A bond fund's price will typically follow the same pattern. Investments in high-yield securities can be speculative in nature. High-yield bonds may have low or no ratings, and may be considered "junk bonds."
Idaho Tax-Exempt Fund risks depend primarily on the terms and quality of the obligations in the Fund’s portfolio, as well as on bond market conditions. When interest rates rise, bond prices fall. When interest rates fall, bond prices go up. Bonds with longer maturities, such as those held by the Fund, usually are more sensitive to interest rate changes than bonds with shorter maturities. The Fund entails credit risk, which is the possibility that a bond will not be able to pay interest or principal when due. If the credit quality of a bond is perceived to decline, investors will demand a higher yield, which means a lower price on that bond to compensate for the higher level of risk. Fund investments are susceptible to factors adversely affecting Idaho, such as political, economic and financial trends unique to this relatively small state. Investing only in Idaho bonds means that the Fund’s investments are more concentrated than other mutual funds, and relatively few bond price changes may lead to underperformance compared to investments selected in greater number and/or from a wider universe