SC: The red bars in your graph indicate that this
tyranny of large-cap tech seems to have slowed down, if not even
reversed a bit since Labor Day.
illustrating a real risk in markets at present. Narrowly led markets
tend to be more fragile. If investor sentiment turns against a small
handful of large companies, this can be reflected in the overall market
averages, as we saw in September and early October.
But there’s good news here, too, as not every company has participated
in the strong rally that the broad indices indicate. For an active
manager such as BBH, plenty of investment opportunities remain, and, for
the most part, our managers have deployed cash since February in
pursuit of these opportunities. It is important to remember that active
management requires a balance between seeking returns and managing risk.
One of our managers recently noted: “It is also important to highlight
something we did not do during the recent market plunge: Namely, seek
opportunities among the hardest-hit names and industry sectors without
regard to quality. … We did not relax our quality standards and
long-term compounding approach in order to rent beaten-up stocks with
one eye on the exit.” This is precisely the response we look for from
managers. Discipline is important in any market environment, but it is
critically important in periods of heightened volatility.
How are companies adjusting to this “new normal” operating environment
of pandemic, lockdowns, fluctuating demand and disrupted supply chains?
It differs from company to company and industry to industry, but a
common theme is that the pandemic and associated economic distress are
serving to accelerate many trends already underway. Companies have had
to integrate technology more thoroughly throughout their business models
and are discovering that there are silver linings to remote working for
many employers and employees. Companies are rethinking the role, or
even the necessity, of real estate – whether in the form of a corporate
office or bricks-and-mortar retail. Costs that were previously thought
to be fixed turn out to be more variable than managers would have
thought a year ago. Companies are reconsidering the wisdom of far-flung
supply chains and bringing suppliers closer to home, or even duplicating
them in an effort to establish more robust and durable sources for
SC: How are company balance sheets changing?
Similar to what we saw in the wake of the global financial crisis,
companies are paying more attention to the strength of their balance
sheets, preferring to pay down debt rather than raising dividends, and
letting cash balances rise to protect against future uncertainty.
I think we’ll learn a lot more about these trends in public markets as
the earnings season unfolds, but let me now turn to Ben Persofsky, the
Executive Director of BBH’s Center for Family Business, for insight into
the private sector. Ben, you spend a lot of time with our clients who
own and manage private businesses. How is the private sector dealing
with this unique set of challenges?
There are many similarities to the experiences of public companies. In
the early days of the pandemic, most of the businesses we work with
suffered a clifflike drop in demand, with the exception of those
companies providing mission-critical services, such as retail food
processing and distribution. The retail sales statistics that you and
Tom discussed demonstrate a wide range between the winners and the
losers, and we’ve seen those same dynamics play out in the private
SC: Are there common themes across this wide range of experiences?
Yes. One challenge that every company faced, and is still facing, is
worker safety. In the early days of the pandemic, it wasn’t entirely
clear how COVID-19 was transmitted, and it was difficult to obtain
necessary protection equipment, such as N-95 masks and plexiglass. It’s
better now, but companies have to remain vigilant as infection rates are
rising in parts of the country. A second common theme, which Suzanne
touched on, is supply chain management. Disruption to global supply
chains got a lot of attention, but domestic supply chains were disrupted
SC: How helpful were the various aspects of the CARES Act?
It was critical economic life support for many companies. Indeed, most
of the details of the CARES Act were specifically targeted toward
smaller employers. As is the case with any large government program,
there were challenges in implementing things like the PPP, and smaller
companies scrambled to compile the necessary information to apply to the
program. However, the program generally worked. It enabled companies to
retain employees while providing a much-welcomed financial cushion that
allowed companies time and resources to adapt to these new challenges.
One of the reasons I love working with private companies is that the
creativity and innovation in the middle market is inspiring. Necessity
really is the mother of invention, and we’re seeing a lot of invention
SC: And how helpful has the Federal Reserve been in lowering interest rates?
All else being equal, lower interest rates are better. Falling interest
rates don’t turn bad strategic decisions into good ones, but a lower
cost of capital may serve to accelerate strategic investments that are
fundamentally sound on their own merits. It is important to note,
however, that a 0% fed funds rate doesn’t translate into free money for
businesses. Having learned the lessons of 2008, many lenders long ago
established interest rate floors on their credit facilities, thereby
limiting the minimum rate a borrower would pay, regardless of the Fed’s
decisions on interest rates.
SC: What does the
mergers and acquisitions (M&A) market look like given the
combination of economic challenges, low interest rates and the potential
for tax code changes?
BP: M&A activity
stopped on a dime in the second quarter, as you would expect given the
sharp downturn in financial markets and unprecedented economic
uncertainty. Having said this, we’ve been impressed by how quickly
activity has bounced back in the third quarter, driven partly by a
revival of transactions that were put on hold in the spring, but also,
as you note, by a drop in interest rates. Obviously, the economic and
pandemic uncertainties haven’t evaporated, but the prospect of changes
to the tax code following the election is prompting many owners who have
been thinking about a transaction to think long and hard about
completing it before year-end.
SC: Are you expecting a surge in M&A activity in the fourth quarter?
It wouldn’t surprise us, and it would be in keeping with what we’ve
seen in the fourth quarters of previous election years. But it’s not a
one-decision question. There are some businesses that would benefit from
a Biden presidency, for whom the prospect of a transaction might be
delayed in anticipation of better earnings growth in the next few years.
Of course, higher capital gains taxes would argue for a transaction to
be completed in 2020, in case a Biden administration raises taxes
retroactively to the beginning of 2021. As with most implications of
changes in tax law, the fact pattern differs from company to company.
This is a good segue into discussing the elephant (and donkey) in the
room. We’ve danced around the obvious changes that may follow a change
of control in the White House or Congress. Tom, you’ve done some
historical work on this topic. Conventional wisdom holds that Republican
control is better for markets and business than Democratic leadership,
but history argues otherwise, right?
that’s right. Interestingly, if we look back across the history of the
S&P 500, the equity market has performed better during Democratic
administrations (14.2% annualized average return) than Republican
administrations (8.5% annualized return). The best historical scenario
has been when the president is a Democrat and the GOP controls at least
one branch of Congress. In those periods, the annualized market return
has been 16.6%.