After closing out the first quarter with the worst monthly performance since the Great Depression, equity markets broadly moved to recover nicely on their way to the best quarter since 1998.  What does an investor do next?

As impressive as that recovery is, it can be directly attributed to a small subset of the market.  Technology, certain retailers, and communication services companies did the heavy lifting to get us back to pre-COVID levels in the market, though we have not yet reached the highs set in February.  This also speaks to the huge divergence in year-to-date returns, from a -35% loss in the Energy sector compared to a 15% gain in Technology.  We believe this is a proportionate reflection of how certain parts of our current economic landscape are thriving, while others are in utter peril.

What follows are our views about how to benefit as we manage our way through a pandemic of uncertain duration.  These broad positions are designed to capitalize on areas we think are poised to display continued leadership and reflect themes we are utilizing to better insulate portfolios from approaching challenges.

Technology – Our primary overweight allocation heading into the second half of the year is in Technology. This overweight is not new for us.  However, we have expanded positions in multiple industries where we had been previously underweight or had no exposure. Some of these positions are in the areas of on-line traffic and quality management, platform security, and semiconductors enabling artificial intelligence and 5G.

We continue to favor positions that benefit from our transition to remote work and a general preference for self-distancing, though we are aware that short-term sentiment will shift away from these positions in the event of an approved vaccine and full re-opening of the economy.  One threat to technology and communication companies more broadly would be any tangible level of government intervention into their business models.  While we cannot control the outcome of any course of action, we are not convinced that some sort of breakup would not still be beneficial to shareholders.  That is, depending on the form, some separations could unlock value.

Health Care – We like certain aspects of health care as reflected in positions in medical device and technology firms.  We have long believed that medical technology companies carried common traits to their similarly named counterparts in the Technology sector.  These include recurring revenues in the form of consumables and services, ecosystems that permeate labs and research facilities across countries, and a level of quality end users associate with reputable brands.  These traits serve to make revenues highly sticky and repeatable.  Some of these companies suffered temporary setbacks as health care systems restricted elective procedures and individuals stayed away from doctor’s offices and hospitals.  Others are benefiting as scientists rush to develop treatments, tests, and vaccines for COVID-19.

Consumer Discretionary – Within the consumer-facing areas of our portfolios, we have maintained or increased our overweight allocations to key brands and platforms that are benefiting from a shift in consumer behavior or a continuance of trends we identified before COVID-19 arrived.  These range from positions in home improvement/construction firms, apparel brands with exceptional e-commerce and direct-to-consumer initiatives, video game companies, and retailers that offer value to shoppers without sacrificing quality.

On the other side of the spectrum, we continue to remain underweight segments of the market we feel are at varying points of secular decline.  These sectors were some of the hardest hit in March and showed the biggest rally in April.  Moves like this are typical of most bear markets and we used the short-term price recovery in some of these businesses as opportunities to reduce exposure.

Energy – One need only look at travel demand, a surge in demand for electric vehicles, and evolving consumer trends to see that traditional fossil fuels are facing multiple challenges.  The companies that explore for and harvest carbon-based fuels will take years of effort and a better economic environment to address and overcome those challenges.

Banking – Banks find themselves in a precarious spot as businesses suffer and individuals find themselves out of work, all of which can affect loan quality.  Additionally, the current interest rate environment makes it harder for banks to drive revenue.  Further, alternative financing and payment platforms are gaining traction with younger consumers and should be on investors’ radar.  Threats from these competitors are longer-term in nature.  Regulatory hurdles have proven to be challenging, giving incumbents more time to build out their technology platforms.  We maintain positions in a few select “money-center” banks, believing they are best capitalized and adequately positioned to act as banks of the future, but broadly we are underweight the industry.

Real Estate – Real Estate appears to be structurally challenged as we believe no one has a good idea what commercial real estate demand will be like over the coming years.

The economy may be impaired through 2021.  For some businesses, this is dire news, and for others an opportunity.  As things stand, we are most concerned with looming decisions to be made regarding COVID-19 and their consequences.  How will students return to school in the fall, how fast will the hospitality industry recover, what is the fallout from $4+ trillion in fiscal and monetary stimulus (with more to come) and any policy missteps, and what is the result of an accelerating flow of bankruptcies?  Forthcoming elections will also add volatility as we debate future tax rates, regulatory reform, and spending plans.

We have come a long way from the market bottom on March 23, and many of the businesses we own are justified in trading at current levels.  As we manage our way through the policies and outcomes in our fight against the coronavirus, we will continue to be cautious in our investment decisions and projections.