Annual Review 2020

* Index returns are total returns, including dividends.

A YEAR LIKE NO OTHER

“Unprecedented” is likely the most overused word to describe 2020, but with good reason. There is no better way to describe all that transpired this year. In just the last nine months, we have watched as the world economy experienced a wide‐scale shutdown the likes of which had never been seen before, creating economic and social disruption that was previously thought impossible.

During the scariest period in March, shortly after broad lockdowns were imposed worldwide to combat the COVID‐19 pandemic, doomsday scenarios appeared almost inevitable. The initial fear of the public health effects of the pandemic was quickly compounded by fear of the social and economic consequences of the restrictions taken to contain it. Above all was the fear of uncertainty: no one knew what would happen. Many were concerned that the worst possible outcome might be imminent and that the world would be plunged into a deep depression that would leave lasting scars for generations to come. For some, that concern turned to absolute belief.

Fear spread like wildfire in the securities markets, where we saw the steepest and swiftest declines across all asset classes in recent memory. In the stock market, the S&P 500 reached a low of 2,200 in mid‐March, down 35% from its high of 3,400 just weeks prior. The spread in yields between federal government and all other bonds widened to historic levels in a matter of days. Market activity was reflecting the age‐old mantra seen in all previous panics: dash for the safest asset that you know of—cash.

Faced with social and economic disruption on a scale that had never been experienced before, central banks and governments reacted swiftly by instituting stimulus measures of heretofore unseen size and scope. Central banks cut short‐term interest rates to zero (and in some cases into negative territory) and announced massive purchase operations of everything from government to corporate bonds. Governments announced support in the multi‐trillions of dollars for individuals, households, small businesses and corporations alike.

The actions of the central banks immediately thawed credit markets, reducing credit spreads to near pre‐pandemic levels in remarkably short order. Confident in the belief that central banks would stand behind the normal functioning of markets, investors flooded back to the assets that they had fled just weeks earlier. Companies that had previously been shut out of the market were suddenly able to raise capital again, strengthening their ability to ride out the storm.

Meanwhile, massive government assistance helped to keep individuals and households afloat as unemployment spiked to record highs, and provided a bridge to businesses that were forced to shut down or dramatically curtail operations. At the same time, consumer spending plummeted as there was little to purchase, and businesses quickly scaled down capital and spending plans as well, allowing savings to accumulate rapidly to improve balance sheets.

All these factors together led to a far healthier fiscal situation for households, small businesses and large corporations than many initially feared, and have helped economies – so far – avoid the elevated credit losses that are typical of a recession, much less a recession as significant as this one. In fact, credit experience has even improved in some categories. In the end, the world’s economies have bounced back at a record pace in the second half of 2020. Nine months into the pandemic, current macroeconomic conditions have, astonishingly, surpassed even the most optimistic predictions that many economists were making during the turbulent days of March.

A HISTORIC STOCK MARKET RALLY

Equity markets recovered even more quickly than the broader economy. Propelled first by the sudden influx of massive liquidity provided by central banks, and later by signs of an improving economy, stock indices rallied to their previous highs following a bear market at the fastest rate in history. The most widely‐cited stock index, the S&P 500, marked a new record high just 126 trading days after falling 20% from its then‐existing peak.

The market rally reached even loftier highs in November, when news came out that multiple safe and effective vaccines would soon be widely available. Suddenly, the end of the pandemic was in sight, and optimism about the strengthening economy gained further steam. Buoyed by the prospects of a quicker return to normal than previously expected, the vaccine news precipitated a dramatic recovery of the stock prices of companies largely left behind at the beginning of the first rally, particularly those classified as “value” stocks.

While the vaccine news precipitated a significant shift from high‐momentum “growth” stocks to the out‐of‐favour “value” category, the former group still outperformed the latter in 2020 by a record margin. On a one‐year basis, the Russell 1000 Value index trailed the Russell 1000 Growth index by 36% in 2020, the largest gap since the two indices came into existence. Extended to three‐year and five‐year rolling periods, the annualized return difference is 17% and 11% respectively, both of which also stand as record disparities. The last time the returns showed such inequality was in 1999, the year that marked the height of the last tech bubble.

Annualized Returns for the Year Ending 2020

Annualized Returns for the Year Ending 1999

The Russell 1000 Growth index currently trades at 42 times its last full year of earnings, also ranking as the highest multiple for the index alongside that of 2000’s tech bubble. While some might believe that future growth in the earnings of the underlying companies in the index will eventually justify such a lofty valuation multiple, the reality is that up till now we have not seen that sort of upswing. Over the last five years, the earnings of the index have compounded at just 5% while the price of the index has grown at an annualized rate of nearly 20%.

It was almost to be expected that a historic year would usher in historic number of initial public offerings (IPOs). In just the last six months of the year, 379 companies went public in the U.S., exceeding the yearly marks set over the past two decades. The fact that many of the newly‐public companies are losing money is not deterring speculators from jumping in with the hope of selling quickly at still higher prices. Such activity has engendered a positive feedback loop whereby rising prices spur more buying that drives prices still higher.

How long such wide disconnects between price and underlying value will last is anyone’s guess. If history is any indication, bubbles can expand for absurd lengths of time before they eventually burst. However, as we have stated numerous times before, we believe that it is foolish to buy things for no other reason than because prices have recently risen. We strive to be long‐term investors, not speculators. And over the long term, it is the value of an asset and price paid for it that will ultimately determine the return the investors will receive.

HIGH QUALITY AT A REASONABLE PRICE

As market prices ran up significantly in November for a broad array of stocks, we found an opportunity to acquire shares of Becton Dickinson, whose stock prices had modestly fallen amid the rally.1 Becton Dickinson is a highly profitable medical products company best known for producing disposable medical equipment such as needles, syringes and catheters. The company has a strong history of delivering shareholder value, having grown earnings per share more than 25‐fold since it became public in 1987, from $0.40 to over $10 today.

Becton Dickinson has been selling medical products for more than 120 years, its enviable market position gained from maintaining strong competitive advantages in scale and distribution, and, most importantly, a solid reputation built on a long history of operating in its key markets. The latter is especially important in sectors that are as heavily regulated as the medical device industry, as these strict guidelines create high barriers to entry for new competitors. It is an oligopolistic market sector in which Becton Dickinson is one of a handful of very large players who enjoy strong fundamentals.

Recently, the company had experienced muted sales growth following the recall of a key product, poor integration of a large acquisition completed in 2017, and a series of senior management changes to remedy these missteps. Entering 2021, we believe that the issues facing the company are temporary and will largely be behind them by the end of the year. New management appears particularly focused on resolving key issues and have already made good progress in doing so.

Near‐term headwinds notwithstanding, we believe that Becton Dickinson stands to benefit from strong increased demand for its products as the largest global vaccination program in history gets underway. Longer term, we believe that the company will continue to experience growth rates in revenue given increased healthcare spend and an impressive history of developing new products. At a current year price‐to‐earnings multiple of 19 times, we believe that we are purchasing an above‐average company at a below‐average price.

LIGHT AT THE END OF THE TUNNEL

When the books are finally written on how the world recovered from this pandemic, the role of extreme external intervention, both monetary and fiscal, will no doubt be prominently featured. However, the post‐mortem should also highlight a far more important factor: the innate resilience of human beings and our economic system.

Throughout 2020, we saw disruption and uncertainty on a level that modern society had never experienced before. What was incredible, and overlooked by many, was how quickly we adjusted and adapted to our new reality. We upended our lives, worked from home whenever we could, found connection with family and friends over Zoom and Facetime rather than in person, launched new products and services when existing ones were no longer suitable and, of course, developed safe and highly effective vaccines for a novel disease in record time.

With the end of the pandemic now in sight, the dark cave we were in last March now looks more like a tunnel. And the light at the end of it grows brighter by the day.

Thank you for your continued confidence and support,

The Evans Team