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Adjusting to the New Normal

Greg Dean's picture

open pdf versionThese are unprecedented times and I feel it is important to communicate with clients during this market volatility on what we are doing with our portfolios and why.

On March 27, 2020, I sat down with my colleague, Sonia Mahadeo, where I offered insight into what the small cap team learned from talking to over 35 companies globally the week of March 16, 2020 (first full week at home) and how we’re spending our time in turbulent markets. Below is a summary of the call.


What’s going on? How would you characterize how the markets are functioning through this crisis?

The situation is changing quickly, and it’s also been difficult seeing how this crisis is impacting many individuals. Information has been rapidly changing and this info is being distilled into stock prices. Over the long-term, markets act in a rational way, but in irrational ways over the short-term. I also empathize with clients – it’s not easy to see your wealth on paper decline quickly, and I want to emphasize my commitment to communicating with you to ensure we are here to help you get through this.

The Cambridge small cap team has been committed to our investment process. Amid the market volatility, this means that we’ve been making calls, talking to companies, forecasting cash flows, and asking questions to update our investment thesis. In the span of a few weeks, we have reached out to many companies and had 30-60 minute conversations with over 50 of them so far.

What’s the big picture take away you’re hearing from management teams?

Before I answer that question, I think it serves as a good reminder to our clients that Cambridge has always been focused on conservative balance sheets and management teams that plan for a crisis before a crisis strikes. In our conversations with companies, we have focused on the company, strategy and impact. Simply put, the least prepared companies will have the highest default rates and risks impairing our clients capital. Fortunately, we don’t believe we are exposed to those sorts of issues assuming we aren’t all still at home in six months.

Many companies are taking steps to ensure they are well positioned on the other side of the crisis. This includes communicating with lenders, and ensuring they are proactively doing what they need to do in the event that they need to access capital. Management teams have also been proactive in managing the impact on a wide range of stakeholders, for example, mitigating layoffs, controllable costs, reducing executive’s salaries, etc.

Overall, we like companies that are well prepared, treating employees fairly, have a high margin of safety and conservative balance sheets.

How do your calls with management teams influence the investment thesis? How does this dictate certain actions you’re taking, such as exiting a position quickly/slowly?

We did not own any companies heading into this that we needed to exit swiftly; however, we’ve chosen to exit select positions as we have found better opportunities.

I think it’s important to highlight that when an industry suffers short-term pain, it does not have a linear impact. Take for example, the hotel industry. If you only own one hotel and can’t make mortgage payments, the impact is different compared to whether you’re a hotel chain that owns 40 hotels outright. The local hotel may not have the resources to manage the crisis as well as the chain, and it could represent an opportunity for the hotel chain to purchase distressed smaller competitors with great locations and strong brands.

How a company will fare through the crisis is a determining factor of how quickly/slowly we will add to a position. We are committed to the investment process and we are sticking to what we’ve done before, making decisions to exit a position quickly or slowly depends on if there are better opportunities in companies we want to add to the portfolio to improve the overall portfolio and moderately reducing position in companies  with less attractive internal rate of returns.

What opportunities are you seeing at the moment? Can you discuss a particular company, the firm’s business model and the risks associated?

We continue to look for world-class cash machines which I want to pay a reasonable price for and hold over the long-term. Specifically, I look for companies that have low leverage, high insider ownership, high margins, high return on invested capital, low cost relative to peers and a scale/size benefit. These companies will take advantage of challenging times and come out stronger in the long-term.

Taking that into consideration, we’ve recently added an Irish hotel chain to the portfolio from our watchlist. We’ve been following the company since its initial public offering in 2016 and have met with the management team several times. The stock price moved from approximately €6.00 to €1.75, and the cost to build hotels were around €3.50 per share. The company presented an opportunity because it was trading at 50% below replacement cost and growing organically, developing new hotels or acquiring properties. Today it constitutes a small weight of the fund, but it’s current price relative to its risk factor is great. Insiders have been buying and we are buying alongside them.

We’ve taken the opportunity to buy three or four companies that have been on our watch list for a while (thee are companies with clean balance sheets that sell essential components and systems), and the only reason we didn’t own them was valuation. For example, we’ve added a couple of European distributors that earn over 20% returns on capital and are very good at acquiring companies. They are also diversified by end market and product. Because we are building our position, I can’t disclose names, but we are excited about the opportunities to make our high-grade portfolio more resilient.

What are you excited about and what worries you at this moment?

My biggest worry is that we don’t know where markets and the economy are going and when this crisis will be behind us. I’m also concerned about a second wave of illness in countries where COVID-19 has previously been contained. There’s also the human impact on everyone – a prolonged delay of interpersonal contact has had a profound impact on people’s day-to-day lives.

I do see reasons to be optimistic. For example, the Russell Index has 3x debt to earnings before interest, taxes, depreciation and amortization (EBITDA) vs. Cambridge Global Smaller Companies Fund which has 1.2x debt to EBITDA. This presents a huge safety net for clients.

I’m also excited about the companies that we own within the portfolio. These are businesses that will come out stronger on the other side and will compound wealth for many years.

Many of you know that the Cambridge investment team invests our own money alongside our clients. We want to make sure we are adding companies that are better or of similar quality that are cheaper and constantly increasing the value of the portfolio. We’re building our portfolio everyday and there’s no room for complacency.


You can listen to the full podcast of approximately 19 minutes. For future reference, this and other insights from the Cambridge investment team can be found on Cambridge’s website under Insights.

Any feedback is appreciated, so feel free to enter your questions and comments into the comment section of this blog and we will get back to you.

 

Thank you for your continued support,

Greg Dean
Principal and Portfolio Manager

 

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Published April 13, 2020

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