Observations On Investing Through Market Disruptions And Crisis

[What are the ramifications for investment managers in dealing with a business environment of accelerating change and the seemingly ongoing assaults on the investment markets like major financial disruptions, industry crises, and once-in-a-hundred-years events? What kind of investment mindset is needed to navigate this growing complexity and uncertainty? Does that add more pressure on investment managers in their reviews and analysis of the management of their portfolio companies?

To explore these questions, we reached out to Institute member Larry Pitkowsky, Co-Founder, Managing Partner of Millburn, NJ-based registered investment advisor GoodHaven Capital Management & sole-Portfolio Manager of a public no-load mutual fund GoodHaven Fund (ticker: GOODX) and managed accounts since the firm’s reorganization in December 2019. Prior to forming GoodHaven, Larry was a Portfolio Manager of the Fairholme Fund.

We asked questions to understand how he is applying his value investing approach in his investment portfolios through recent market disruptions while receiving strong Morningstar ratings. Having reorganized his company into what they call GoodHaven 2.0 in 2019 right before the break of the COVID crisis, he has practical experience in personally managing a business through industry conditions like market collapse, liquidity crisis, and capital raise difficulties.]

Hortz: Do you see changes happening in the underlying business environment and how are you responding to them?

Pitkowsky: In the past, we have long observed that underlying business trends and consumer purchase and expenditure decisions moved much more gradually and slowly (and logically) than the volatility exhibited by stock and bond prices. We have always strived to use this disconnect to our advantage by actively looking for potential value opportunities.

However, we note that in recent years, actual consumer and business decisions, as well as spending patterns, are much more volatile than in past years. I am talking about actual underlying business trends, consumer and business behaviors on spending as to where they are spending and how they are spending; basically, how money moves around. The real economy now moves fast too, much faster than it used to.

I think it is appropriate to look at the current banking crisis as an example. Take the concept of how a traditional commercial bank is structured. The problem is look at the speed at which deposits can move around today. At Silicon Valley Bank you had $42B that left in one day on a bank with assets of around $200B.That is a huge percentage! But if you have an institution where depositors can leave very quickly, it creates an enormous liquidity problem. What does that mean for future bank regulations, for different financial institutions? I do not know. But it is another example of how in the real world, consumers and businesses are moving faster than they ever did in the past. It is something that an analyzer of businesses needs to think about.

It does not change what we do as value managers but I think it is important to think about what those ramifications are for businesses and industries as it creates more business volatility. We already have stock market volatility, but the addition of a faster business dynamic leads us to a stronger reinforcement of the need to deeply understand and analyze corporate management. We need to understand how they are responding to this new business environment of accelerating rates of change. You have to make sure your companies are structured to withstand the business volatility that is now part of day-to-day life. So, we do not think this alters what or how we do things, but it is something we look at and think more about.

Hortz: How do you determine how good a corporate management team truly is?

Pitkowsky: Part of being a company and management analyst is being a bit of an investigative reporter. It’s not all numbers on a spreadsheet. It does not quite work that way. In evaluating a company’s management, you have to ask yourself a couple of questions. Have they done what they said they will do? Have they been straightforward in the past when problems have arisen? How have they responded to previous industry challenges or disruptions? Do they try and present financials in a clear, understandable, and conservative way? Do they have serious skin in the game like owning stock as true owners? Is there a history of integrity in the organization?

These are the things that we normally ask ourselves. Answers to those questions can be gleaned from looking backwards on management’s previous experience and actions. At some point, as an executive and as a person, you get the reputation that you deserve.

Those of us that are older have seen different market disruptions and we also recall the old adage that there is a certain amount of “rhyming” going on during all these periods of disruption that we look out for. Andy Grove’s quote applies well here – Bad companies are destroyed by crisis, good companies survive them, great companies are improved by them.”

Hortz: As an investment manager, what do you do as a crisis hits or dislocations happen? How do you handle a crisis?

Pitkowsky: First thing I would say is that the proverbial 100-year flood seems to keep showing up every 2-3 years economically. Is that the nature of markets and economies now? Beats me! I leave that to those who pontificate for a living. I just know that it seems like they continue to show up more frequently. So, I have two sayings for any financial crisis: 1) by Rick Mears, the racecar driver, who said – To finish first, you must first finish and 2) by Winston Churchill - Never let a crisis go to waste.

So, the first thing I do is look at where we have allocated capital, what we own, and I think about the current situation. What if things get worse, what are the knock-on effects, what are the possible contagions, what are the ramifications? I make sure that I feel that our investments can withstand and hopefully use the period to their advantage. We answer the question Do we feel our companies can navigate the current environment? And if not, we make the necessary portfolio adjustments. We also consider exposures we have to vendors and counterparties. Then I go hunting. By running unleveraged portfolios, we always have a bit of cash around so, at the end of day, we are looking at the landscape for mispriced opportunities. That is the way to handle any crisis.

In every crisis there are always plenty of unknowns. If you are looking for outsized long-term returns, there is always going to be some uncertainty. But we retain the same value mantra that we are not looking to take a lot of risk, but we are looking for a lot of reward. So, you need something that is mispriced or misunderstood. They are always out there somewhere. You just need a very discerning filter for something to make the grade.

During a crisis, there is often more to look at and having cash and emotional fortitude matters a great deal. By the way, crises are usually real to some extent, but the opportunity comes from being able to see beyond the crisis, and investing during it while not knowing exactly how long it might last. However, if you are buying cheap things that get cheaper and the businesses are not impaired and you have the resources to keep adding, you can end up with some amazing long-term investments on the other side of such periods.

Hortz: How do you determine, in the middle of the storm, if your portfolio companies can navigate the current disruption or crisis environment?

Pitkowsky: Well in a crisis one’s balance sheet and liquidity matter a lot as often access to capital and or/borrowing is temporarily gone or too costly. So that is the first thing to consider – can the company manage through an environment like that for a while? Obviously, some businesses are less cyclical than others. Some types of goods/services can get postponed and some cannot. If it is a more cyclical company, the balance sheet matters even more. Do they have the ability to reduce costs if needed? Management needs to be both paranoid and worried AND aggressive and opportunistic – one without the other does not lead to real success.

Hortz: Can you give us a few examples of what good management looks like?

Pitkowsky: Sure – let us take Jefferies (JEF). Some years ago, CEO Rich Handler told the world “I am going to take this mid-level investment bank and move it into the big leagues and improve the business mix and the return on equity – and if Mr. Market ignores our results, I will buy back a lot of stock and shrink the shares outstanding – at a good price”. He has done just that and the numbers speak for themselves. We are at a low point in the investment banking cycle for M&A and IPO’s and so Jeffries’ return on equity is depressed, but that is the opportunity and today it trades below tangible book value per share which I think will prove over time to be a good entry point. Rich has also weathered more than his share of crises and proven himself each time and is himself a big owner of JEF shares.

Next is Devon Energy (DVN) – which we came to via their merger with WPX Energy years ago. CEO Rick Muncrief is very talented and has been battle-tested over the years. DVN was the first management team to go to the now fashionable fixed-plus-variable dividend policy for an energy company. An E&P company like Devon needs a healthy commodity backdrop to be a decent business and we feel good about that – even though we are not oil/gas guys. DVN’s current stock price – without assuming oil prices improve – looks like around a P/E of 10 or less and a dividend yield in the 5% range. And DVN’s got a rock-solid balance sheet and some great acreage.

Hortz: Can you share any advice or recommendations for advisors on value management strategies for their client portfolios?

Pitkowsky: We have written for years now about the structural makeup of financial markets today with so much day-to-day trading dominated by non-fundamental investment strategies which continues to create enormous price volatility and periodic market dislocations. It is advantageous to use this market dynamic to our long-term advantage.

Having seen this trend of disruption developing faster and more volatile, I feel the prospects for value investing or opportunistic investing are only increasing. The volatility created by these market forces, and the underlying increasing business volatility we discussed previously, are just part of the current ecosystem. All this leads to more opportunities if you are an opportunistic long-term investor armed with a value mindset. Remember it is about being roughly right over time about the companies you invest in, having a variant perception, and buying them at an attractive price so you can get an attractive future return with less risk.

Looking at the history of value investing, Ben Graham said “The market is there to serve you, not to guide you.” I take that to mean, applying value principles of being a little bit paranoid and a lot opportunistic. Continue to make sure that you understand what you own, know the capabilities and strengths of the management teams in your portfolio companies, and think about everything from a risk management standpoint. Continue to think about market, company, and industry dynamics that have not taken place before, the way they have in the past. And then you can be comfortable in being opportunistic. I feel we are well-positioned entering this period as a long-only value manager.