Key Takeaways

• Each economic crisis presents different challenges, and the COVID investment environment ‒ marked by aggressive stimulus and consumer strength ‒ has certainly been unique.
• A favorable monetary and fiscal backdrop, along with ongoing bouts of volatility, have created value in some unexpected areas of the market thus far.
• As we enter the next phase of recovery, we believe opportunity may be found in identifying companies with pricing power that can grow earnings and cash flow in an environment where we are likely to see structurally higher inflation.

Transcript Expand

Adam Hetts: Welcome to Global Perspectives. Today we speak with Nick Schommer. Nick is an Active Dynamic Equity Portfolio Manager with a contrarian philosophy, and I think dynamic is also a polite way to describe the market behavior these days. So it’s good time to talk to Nick. Nick, thanks for joining us.

Nick Schommer: Yes, thanks for having me.

Hetts: Yes, my pleasure in having you in real life in the studio for the first time for this podcast.

Schommer: It’s almost like we’re back to normal.

Hetts: Almost. Like I mentioned, you’ve got this contrarian philosophy. And so, Nick, can you start maybe just by kind of introducing yourself, telling us about your background and how your past has sort of formed this contrarian approach you’ve got in your investing?

Schommer: Yes, that sounds great. First, I guess maybe just to start, I think contrarian elicits a lot of thoughts in investors’ minds. So one thing I like to do is just define how I think about contrarian investing. And I had this Peter Thiel quote that sits on top of my computer monitor in the office and it says, “The most contrarian thing of all is not to oppose the crowd, but to think for yourself.” And I think that’s a perfect summation of myself as a contrarian investor. So we’re not blanketly just opposing the crowd, but really are independently thinking and trying to find those opportunities where our viewpoint is different than others in the market. And hopefully, the market comes around to our viewpoint over time.

So maybe a little bit about my background and where that independent thinking comes from. So I grew up in northern Colorado and then went to the United States Military Academy at West Point. And there, I had a very interesting background. And one, you’re just, you’re going to school with people from all 50 states of the country. You’re serving in the army, with people from all different aspects of life in different perspectives. And then during that military service, I deployed to the Middle East twice during that timeframe. So having that perspective in addition to my travels, I think really helped form a more global perspective and understanding of other points of view. And in this world of social media where we can become as insular in our worldview as we want to become, I think it’s increasingly becoming a differentiating factor in terms of how we think about the world and just really valuing that global perspective and people’s different inputs and how they get to that belief. And I think that’s really important as an investor to have not only that sound framework for how you invest in how you see the world, but also to really challenge yourself and to challenge your thoughts and be willing to be around people who challenge your way thinking. I think that’s really important as a contrarian investor.

Additionally, it’s probably more of a personality thing. I think maybe it comes with being in the military, having an ability and willingness to invest in volatility is a really important trait. And I think it’s a sound trait of a contrarian investor. There’s times you’re going to look dumb. I like to joke, “I’m never afraid to look stupid.” Try not to do it too often but you know, some of the greatest investments are made when things are the most difficult and the most uncertain. So having that ability and willingness to invest into volatility is really important as a contrarian investor and I think it comes from my background and personality as well.

Hetts: Well, thank you for your service and thank you for weaving the show title under your response a couple of times there. I mean, talk about opportunities to look stupid or stand up in the face of volatility with the last year-and-a-half we’ve gone through, do you have a good example, of the last year-and-a-half. It was the kind of scariest time for you as a portfolio manager, maybe the most uncertain time, but you felt like you had to stick to your guns?

Schommer: Yes, I think one of the most obvious is March, April, May, June of 2020 right in the heart of the COVID pandemic and things were very uncertain and we made investments then in copper miners, in the gaming sector. It’s pretty hard to invest in a casino stock when the casinos are closed. You have to have a little bit of optimism on a recovery, a health care solution to the pandemic. But when a casino company is earning zero revenue and – literally, they had to go find the locks to the casinos because the casinos haven’t been closed in decades – it’s a pretty uncertain environment.

Hetts: I mean, back in March, April, May of 2020, yes, casinos are closing down. Everything’s closed down and there was just no visibility on what was happening and just the fear of it was so existential, searching for sectors like gaming. So what is it that told you that, very rationally, we were, of course, going to get through that and then that was actually a good buying opportunity and they weren’t going to be close forever?

Schommer: Yes, I think there was a couple of things, steps to the process. One was an understanding of the government and what was taking place. And I think we’ll probably talk about just the financial crisis and how that relates to the COVID pandemic because we tend to anchor to the last crisis in our thinking. But if you go back to the financial crisis, the federal government’s very slow to pass fiscal stimulus. The Fed was very slow to act to provide support to the markets and it was the complete opposite this time. We saw a very aggressive Fed. When the Fed made the decision to really start buying assets and to include new asset classes in their purchases, that was a really key input. And in particular, when they made the decision to buy high-yield bonds, it really backstopped a market that, traditionally, the government has not. And it had to change how you thought about investing because typically, going into a recession, you don’t want to own companies with financial leverage and those weren’t good investments going into the pandemic. But at the bottom of the pandemic where we were in the depths of the darkness, you had to really understand a couple of things. One, that the Fed had backstop liquidity. So if your companies with financial leverage had an adequate liquidity profile and maturity stack that they could make it through the crisis, they could be good investments. And then you had to have an understanding of, could there be a health care solution to this crisis? And I guess we’re … I don’t know what number of variant we’re on today, so it’s probably hard to say the pandemic’s over, but it’s probably fair to say we’re moving more to an endemic phase.

But one of the things that really helped us is always having a belief and viewpoint that there would be a health care solution to the pandemic and optimism that science would win. And every great scientific mind around the world was chasing a vaccine and a solution. And understanding that we would get to the other side so that when you’re looking at a gaming company, are you saying, “Can this company make it through a very difficult period? Do they have the liquidity to make it through the other side? And then when they do, what will the profile of the business look like?” So that’s what we were thinking about.

There’s a couple other things they were thinking about. And this COVID pandemic was very different than the financial crisis in terms of how it impacted people and society. So if you go back to the financial crisis, the consumer was crushed during that timeframe. Twenty to 25% of all houses were underwater. If you think about the suburbs, they were particularly hit hard. That strip mall in the suburbs was the epicenter of the housing crisis. And the urban city center actually did pretty well during that time period. The pandemic was the exact opposite. The more rural you were in society, the more you were in the suburbs, the less health care risk you felt, the more you felt like you could live life a little bit. And if you posed that to somewhere like New York City which was literally the epicenter of the pandemic, there’s probably not a place that was hit worse than New York City. And if you think about the casino model, about half the business is in regional markets. And when society was shut down, the regional casino became the de facto entertainment for a lot of people. So they had the stability of a regional casino to help them get through to the other side. And obviously, a place like Las Vegas is going to take longer to recover, but I’m fairly confident that Vegas is seeing its recovery and Vegas is going to see a great recovery.

Hetts: And you mentioned earlier in the response about, there’s a bit of danger and kind of anchoring your expectation of this recovery or crisis, thinking back to the 2008 global financial crisis. So I guess maybe talk a little more about why that anchoring to the GFC is dangerous and how this is kind of a different recovery, structurally, than what people lived through or what they think about most recently from 2008.

Schommer: Yes, so there’s a few things. Obviously, this was a health care-induced crisis which meant we had a very sharp, immediate drawdown and shutdown of global societies. And probably the thing that you can most closely relate it to would be a natural disaster. So if a hurricane hits, Hurricane Katrina hits New Orleans, that city is immediately shut down and wiped out and it’s a very sharp draw down. But it also means that when there’s a health care solution to a pandemic or the hurricane has receded, that you can have a very sharp snapback in terms of economic activity and you can have a nice V-shaped recovery. And what we needed was a confidence that we would have a health care solution. And through the work that we did with our health care team, we had confidence that we would get to a vaccine. We always thought that by the end of 2021, and I guess we’re almost at the end of ’21 today, that we’d have a vaccine and the vaccine probably actually happened faster than most people expected. But it’s enabled that V-shaped recovery.

And at the same time, the federal government was very active through fiscal stimulus to send checks to the consumers who were hurt during this time period because of the muted economic activity. So between getting stimulus checks from the federal government, the stock market being very robust, the housing market being very robust, the U.S. consumer today is in an incredibly healthy position. I was at a conference last week and the Bank of America CEO was talking and the average checking account is typically about $1,400. And today, that average checking account has $6,000 in it. So it’s a very robust, healthy U.S. consumer.

And if you anchor back to the financial crisis, it would be the exact opposite. The consumer was decimated. I mean almost a quarter of the country had houses that were underwater. The consumer balance sheet was in a very poor position. Consumers didn’t have mobility and what that led to was a very debt-heavy, muted recovery to the financial crisis. So coming out of the financial crisis, I don’t believe we had a year of economic growth above 3% and that’s obviously very different than what we’ve seen here in 2021, where you had a pretty sharp snapback into economic recovery.

Hetts: Yes, so if it was so much of a slog recovering from the global financial crisis, you think about the way things felt late 2009, you know, a year or so after the trough of the global financial crisis, compared to where we’re at now, late 2021, a year-and-a-half after the trough of the March 2020 sell off, how does that look and feel different, as an investor? What do you focus on now that you wouldn’t have been focused on in 2009? If you want to talk sectors or styles or whatever, how is your mentality different now than it would have been in 2009?

Schommer: Yes, the financial crisis was a very deflationary event. So there’s a couple of secular deflationary things impacting society today, the aging population, the digital disruption that’s taking place by a lot of the technology companies that’s leading to deflation across society. And that’s what drove stock market and really company performance for the decade post the financial crisis. You really wanted to be levered to secular growth companies that didn’t depend upon robust economic activity to drive business performance. And we were in a period of very muted inflation where you didn’t really have to think about the impact of inflation.

That’s different than today and it’s not just the pandemic. There’s one really big thing that also happened and that’s that globalization ended. I kind of get weird stares sometimes when I make the comment that globalization is over. I think it’s not quite as shocking when I say it today as maybe when I said it two or three years ago. But whether it was Brexit or it was the election of Trump in 2016, there was a nausea by the developed world population that globalization has gone too far and that shareholders had received too much at the expense of developed market labor. And what that means going forward is I expect a period where labor is going to get an increasing share of the pie and we’re going to see strong wage growth for a number of years, particularly at the lower income levels of society. And that impacts how you think about investing because we’re not in a completely deflationary environment. There is going to be a structurally higher level of inflation. I don’t think it’s going to be runaway. It’s not going to be the transitory levels we’re seeing today, but it’s structurally higher going forward. So sectors like the financial sector could be more investable when interest rates need to be higher. One thing that’s really important is investing with companies that have pricing power and have the ability to absorb the inflation.

So a lot of companies benefited from globalization because they could reduce their costs at the same time, they’re growing revenues and create that operating leverage, and that was really good for shareholders. Going forward, it’s the companies who have the top-line revenue growth, whether it’s through volume or pricing power, that they’re able to absorb a higher level of expense growth in their business because of a higher level of inflation that are going to be the stocks that you want to be invested or the businesses you want to be invested with. So it’s a little bit different this time.

Hetts: Yes, you’re using the “S” word, “structural,” there. But you’re talking about wages seem to be the driving structural change that we’ve got going forward and you’re kind of talking about companies that can defend against some of this inflation with pricing power. But you’re talking about it still more as a negative, as a risk. But if we have this structural inflationary regime driven by wages, where is the opportunity in that going forward?

Schommer: Yes, so I don’t want to come across as negative because I think this is a great thing for society. So I want to take a step back and think higher level. Like we went too far and there’s too many inequalities and there wasn’t enough broadening of success enjoyed for all. So it’s good that wages are going to be higher. Like, I think that’s good for society. But that doesn’t mean it’s going to be good for every company and it’s going to be good for every stock. So it means you really have to sharpen your pencil and really focus on those companies that have the ability to operate in grow earnings and grow cash flow in an environment where expense growth is going to be structurally higher than what’s been in the past.

Hetts: Are there some examples of situations where this kind of structural inflation is actually beneficial to companies? Beneficial to society, sure, but you know, where it’s not a risk to manage but actually something that can be harnessed and actually improve certain companies or sectors?

Schommer: Yes, so in general, a little bit of inflation is good for equities. I think it’s important to remember that equities are inflation-protected assets. A company’s revenue is in nominal terms, so particularly if they’re able to pass on price more than the inflation they’re seeing in their business, that’s good for their business. And in general if you have a little bit of inflation, that leaves a little bit higher revenue growth and you can create more operating leverage in your business. So that’s a good thing. So I don’t want to take away that inflation is just negative or a risk particularly for equities. If I own a 10-year Treasury bond that yielded 1.4% and I thought that inflation was going to be above 2% every year for the next decade, that has risk inherent in that decision to continue to own that bond. So I’d much rather be an owner of equities going forward and I think you just have to make sure you own companies that have the ability to absorb this structurally higher level of inflation we’re going to see.

Hetts: So I see you’re knocking the bond market there a little bit, but I know you collaborate a lot with our fixed income team. So maybe talk about why that’s important for you as an equity investor, spending so much time with our fixed income team.

Schommer: Yes, so our partnership with our fixed income team has been incredibly helpful and a really big part of the success we’ve had over the last couple of years. And it has been every year, but I would say it was particularly true during the pandemic. Our fixed income team here at Janus Henderson in Denver is largely a credit-focused fixed income team, so they do a lot of similar work on companies that we do, but they come at it from a different angle. They’re looking at the balance sheet obviously first and they’re looking at cash flows. And that typically is a little bit different than how equity investors start their analysis of companies. They tend to look at the income statement and then look at the balance sheet and cash flow statement.

Part of my background is, when I started in the industry in 2007, I started as an analyst covering the financial sector right before the financial crisis, so I got a decade’s worth of education in the next couple of years. But as a financial analyst even on the equity side, you start by looking at a company’s balance sheet first and understanding it. So having that similarity in terms of a starting point or just analysis of a business, I think it’s helpful for that dialogue between the two of us. But what’s particularly helpful is they see companies that maybe I don’t see and they see him first. So particularly our high-yield strategy, they’ll own the bonds of a high-yield issuer and they want the credit spread tightening that goes with the deleveraging of that company.

And typically as a company gets about three times levered, the story turns from being a fixed income appreciation story into an equity appreciation story, and to be able to make that handoff and be able to leverage the years of work they’ve done around a business with financial leverage before we’ve even started our work is incredibly helpful.

And then from a macro perspective, I talked about how we got comfortable investing in the gaming space really during the pandemic and not that far removed from the pandemic, being able to collaborate with our fixed income team and be able to hear what they’re saying the Fed’s involvements in their markets means was incredibly helpful. And we did buy a number of companies with financial leverage in May and June of 2020 in particular, and it was their analysis and their insight that helped get us comfort to be able to make those investments. So it’s been a really great partnership and those guys do really good work and have been very helpful to me as a contrarian investor.

Hetts: Yes, they’re a great team. I’ve seen you all at coffee together and it’s good to see that collaboration across asset classes. Maybe the last thing Nick you can leave us with is, given that contrarian approach, maybe give us one of the ideas you got that you think is contrary to consensus right now.

Schommer: Yes, so it’s interesting because we’re, I guess we’ve had our fits and starts, but we’ve been in a 10-year-plus bull market for equities, so it’s not like there’s a lot of things that are contrarian, at least not from a high level in the market today. But I think one area that is contrarian, it’s really become out of favor, is the health care sector, in particular the pharma and biotech sector. I think it presents a pretty unique opportunity here going forward. So when I think about what the market or consensus viewpoint on the health care sector is, there’s concern around drug pricing that’s obviously been in place here for a couple of years. There’s concern around government policy and how it’s going to impact the health care sector.

But I think a lot of that is largely priced in and what we’ve seen from the current administration is a little bit of moderation in terms of policy or bills that do get passed versus what’s been first put out. And I think that’s probably true for every administration. I don’t think it’s unique to this one. But I think as we go into 2022, what we’re going to see is a sector that trades at one of its biggest discounts relative to the market in its history, equivalent to Clinton Care in 1994, Obamacare in 2008, so a sector where you’re not paying much for exposure. But companies that typically have high margins, they do have inflation pricing and they have really high visibility in terms of the duration of their growth, and you’re able to buy it at one of its more attractive valuations relative to history.

And as we go forward, there probably is increasing volatility in markets. I think as we’ve learned through, like we were talking earlier, I don’t know if we’re on the fourth or fifth variant of COVID, but clearly that creates starts and stops in the economy and volatility associated with that. I think health care is going to be a sector where we’re going to have very nice stable visible earnings and free cash flow growth and the policy uncertainties that really weighed on the sector should begin to lift, particularly as we approach the midterm elections and we probably see a more moderation of the federal government.

Hetts: Alright, thanks Nick for leaving us with that thought on health care and thanks for coming and everything. Very interesting. And thanks listeners for joining Global Perspectives and we’ll look forward to talking again in 2022.

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