Portfolio Intelligence podcast: will consumer spending propel the economic recovery?

John Bryson:
Hello, and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consultant at John Hancock Investment Management. And as always, the goal of this podcast is to help investment professionals deliver better outcomes for their clients and their practice. Today is March 10, 2021, and I'm thrilled to have Sandy Sanders, senior managing director and portfolio manager at Manulife Investment Management, join the call. Sandy is the lead manager on John Hancock Fundamental Large Cap Core Fund and the corresponding separately managed account. Sandy, welcome to the podcast.

Sandy Sanders:
Thanks so much for having me, John.

John Bryson:
So Sandy, I've listened to you over the years and got to know you really well. And when I think about your investment approach, I know one of the key tenets to your approach is to build a bull case, a bear case, a base case, and a worst-case scenario for any investment. Can you walk us through that process?

Sandy Sanders:
Absolutely. Now this is a process that we've had for a long time, essentially going back to 2002. And what we do is we call it our seven-step research process where we basically look to look at a company that has a strong competitive advantage, and then go through a detailed, fundamental assessment and look to pay the right price, and that's 70 cents on the dollar or less. And the way we get to that price is essentially we do a range of value framework. We do four scenarios. These are discounted cash flow models, minimum of five years. And we start with a best case, do a base case, a bear, and a worst. And the base case is what we think the stock is worth today. That's based on that minimum of a five-year forecast going forward. So that essentially would be the intrinsic value. And so think of it as that's the hundred cents on the dollar.

Sandy Sanders:
So if a stock we think is worth a hundred dollars in the base case and it's trading at $70 this morning, 70 divided by 100, it's 70 cents on the dollar. So that is essentially in a nutshell our overall process. It takes about a month of work to get to there. And then we follow it on an ongoing basis, updating. We have about 200-plus companies that we're following actively with this range of value framework that we update every quarter. And so every morning when we come in, we basically have a list of names of all these companies ranked by cents on the dollar. And that's how essentially we invest, making sure that we pay the right price for our stock.

John Bryson:
Now I love that approach because I think most investors when they're making a purchase of a stock or a bond or a mutual fund, whatever it might be, they kind of have the bull case in mind, but they don't think through the other scenarios quite as much. So having a bear case and a worst-case scenario, I think really helps people kind of set expectations and kind of puts a realistic spin on things. Now with this approach, if you look at periods of stress like we saw last March in 2020, how does this process of having the worst case or the bear case help your approach overall?

Sandy Sanders:
That's a great question because our worst-case scenario, we're essentially embedding that's the nuclear scenario. Essentially the sales margins asset turn assumptions in the model are very, very weak. We assume a very deep recession, the company loses market share, sales are way below expectations and margins go down. And so it's something that we don't think is going to happen, because remember, we believe the base case is what the future looks like, but we have to model in that worst case. And what turned out in March actually last year is that many of our companies in the portfolio and in our active inventory actually got down to those worst-case prices. And it was a tremendous opportunity that doesn't come around too often, but it gives you that margin of safety, because when you think about that worst case, the company, for we had multiple companies actually last year, down at their worst case it was embedding that profits. Essentially earnings don't come back for a decade versus the 2019 level.

Sandy Sanders:
And we looked at essentially the starting point of the recession, where you had a relatively healthy consumer; you had a housing market that had just basically crawled back to long-term averages of 1.4 million starts. And you had a very healthy banking system. A banking system after 10 years of U.S, Federal Reserve stress test. So I saw that as a potential real opportunity, given the stocks are trading at these worst-case values, but we thought that those were highly unrealistic assumptions, John, that just wouldn't come true given that the only thing we were essentially missing was a vaccine. And so therefore we started to become very active in that March and April period last year, buying stocks when they're embedding these worst-case scenarios that we just didn't think would come true.

///John Bryson:
I think there's a lot to learn there for the end investor to have a worst-case scenario built in. I think it does two things and I'd like your take on it. One, it kind of outlines how much pain can you take and if the worst-case scenario does happen, are you comfortable with that pain? And two, if that scenario takes place, it's a great signal for a buying opportunity. Would you agree and is there anything else you'd add for an end investor to think about how they can incorporate your range of valuations approach?

Sandy Sanders:
The way we think about it, it's all about the margin of safety that you pay for a stock. So we want to make sure that when you buy a stock, it's embedding very low expectations. So it's a depressed price that's embedding essentially a sales and earnings profile that we think is much too pessimistic and the company's going to do much better than what the stock is embedding. And so that framework allows it to then come in and we're looking for generally upside to downside, more than two to one. We want to see two times the upside versus the downside.

Sandy Sanders:
Now if we're getting down to a worst-case level like we saw in March of last year, often we're looking at three, four, even five times a risk/reward, which is just rare. I saw it in March of 2009 during the previous cycle. We had the portfolio getting down to the mid-50 cents on the dollar back in the March of 2009 framework. And last year, the portfolio was approximately around 58 cents on the dollar, in that neighborhood, and just is very unprecedented to get down to those levels. So this framework gave us the confidence to essentially step up to many different positions at that time because of that great margin of safety.

John Bryson:
That's great. I think the takeaways around your comments around the margin of safety and have realistic expectations are critical in really any environment. So that's excellent. So let's talk about what's going on right now. I'd love to get your thoughts on where we stand in terms of the economy reopening and what impact that might have on the market. And if we look at this possibility, do you change your approach in any way?

Sandy Sanders:
Yeah, it really is quite a year that we've been through and this is my third cycle that I've seen investing money. In this one, each are different, but what we see here is that the starting point as I mentioned earlier, the starting point really matters for a recession. So in 2007, I started to see essentially the significant bad balance sheets of the banks with all the subprime securities. You had a very overleveraged consumer. You had a housing market that was surging to all-time highs and it looked like there was a lot of cracks emerging. So we got very defensive and I started to become very concerned during that period. This time, what I saw I was that you had a bit of the opposite. You had strong consumer, the housing market was normal and banking system solid.

Sandy Sanders:
And so that's why we started really to be become active last year in that March and April period, thinking that these worst cases just weren't worth the reality. And so now, John, as we look today here in 2021, we know who's president. We basically have three vaccines available and you've got a very low interest-rate environment. There's been record stimulus, monetary and fiscal. And essentially when I look at the growth, you're looking at reacceleration from the cyclical side of the economy. The consumer drives the bus, as we know that there has been some damage there clearly with the unemployment picture, but there's just been a stimulus plan passed in the Senate; it's working its way through the House currently. And I do believe that earnings are expected to pick up quite nicely this year, that I do believe the current consensus for GDP is 5.9% right now, based on street estimates. That level has not been hit since 1983. Earning stocks always follow earnings. And so earnings are moving higher this year.

This podcast is being brought to you by John Hancock Investment Management Distributors LLC, member FINRA, SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and other conditions warrant and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment strategy discussed will be successful or achieve any particular level of results. Any economic or market performance information is historical and is not indicative of future results, and no forecasts are guaranteed. Investing involves risks, including the potential loss of principal.