CGIIX’s Hillenbrand: Opportunities in Oversold Cyclicals and Longer-Term Secular Growth Names

First published: March 24, 2020

In a turbulent period for the markets, Calamos is hosting a Calamos CIO Conference Call Series for financial advisors. Below are notes from a call Thursday, March 26, with John Hillenbrand, CPA, Co-CIO, and Senior Co-Portfolio Manager for Calamos Growth and Income Fund (CGIIX). John is also Head of Multi-Asset Strategies and Co-head of Convertible Strategies. To listen to the call in its entirety, go to www.calamos.com/CIOequities-3-26

John’s comments build on what he had to say on a call last Thursday, March 19. Highlights of that call follow. To listen to the March 19 call, go to www.calamos.com/CIOequities

March 26 Update

• Economic conditions. Fiscal and monetary responses are attempting to ring-fence the damage caused by the economic shutdown. This is likely to happen, but implementation will need to be watched carefully.
• Liquidity and technicals. Both are getting better versus last week when conditions seemed a bit more chaotic.
• Valuations still look very favorable, and the focus is now on trying to pick the winners—differentiating between stocks that are cheap for a reason versus cheap stocks that are just cheap.
• Signs of a market bottoming. We are seeing some of those signs now as liquidity conditions calm, volatility lessens, and earnings announcements begin.
• Portfolio positioning. Positioning seeks to balance out short-term rebound winners (cyclical but oversold) along with longer-term business model winners with the goal of providing an asymmetrical risk/reward profile, with more upside equity market participation than downside. See this post for an update on CGIIX's risk-adjusted performance.
• Asset class opportunities. From an absolute return perspective, equities have the most appeal, but from a risk-adjusted perspective, convertibles lead.

Economic Conditions

• It’s unclear when the virus issues clear up globally, but it is just a matter of time. Developed markets need to ramp up their testing dramatically before we get any return to normalcy, but this is also is a question of when, not if.
  

  “From an absolute return perspective, equities have the most appeal, but from a risk-adjusted perspective, convertibles lead.”

• We are seeing the impact of the slowdown on the service economy globally—in services PMI, and the unemployment claims data released on March 26.
• The question is now whether fiscal and monetary policy measures are big enough and can be implemented well enough to ring-fence the damage. The areas we are watching most closely include:
  • A lack of liquidity for large corporations could transform into insolvency issues. The Fed is taking care of liquidity pressures with a variety of programs, both on the Treasury side and corporate side, so we believe this is an issue that can be managed, by and large.
  • We don’t want to see small business shutdowns or low income workers’ unemployment issues bleed into the real estate market or the banking system. It would be a significant headwind if commercial real estate and residential real estate values drop dramatically and set a lot of individual bankruptcies into motion. We believe the fiscal plan put forward by the Senate can help mitigate that substantially but it’s a question of timing and implementation.
  • A general asset class price decline is happening, and income for current employed could be down this year. Both of these could impact consumer spending and sentiment. We think the Fed’s actions and fiscal policy are helping, but we might need something to kick start the economy to stimulate the areas that haven’t been addressed already in stimulus plans.

Liquidity and Technicals

• Liquidity and technicals still aren’t great, but last week was likely the peak of liquidity issues as individuals, businesses, and asset managers all rushed to get liquidity at the same time. This appears to have abated somewhat, and things are looking better and feeling better.
• Equity markets have seen some rotation and a rebound in prices, including a bounce back in some of the most battered market segments (like travel, leisure and highly indebted names) as there’s more certainty about fiscal measures that can help these areas.

Valuation

• Valuations are very attractive, based on the Calamos Economic Profit Model—a long-term discounted-cash-flow based valuation model that looks at return on capital through time.
  • The model looks at upside, base case and downside scenarios. Names with more upside than downside land in the better (cheapest) quintile rankings.
  • Last week, about 50% of the S&P 500’s weight was in the two cheapest quintiles, which is a very favorable risk/reward profile.
  • Now, it’s about 48%, so there’s been a bit of a rally, but there are still plenty of cheap stocks.
  • By comparison, at the end of January, conditions were the opposite, with 50% of the S&P 500 in the worst two risk/reward quintiles. This represents a significant change over a six-week period.

Signs of a Market Bottoming

• In his remarks last week, John identified several signs of a market bottoming, which he revisited:
  • Liquidity rush calms. Conditions can still get better, but there has been meaningful improvement supported by increased certainty in fiscal policy.
  • A reduction in volatility, especially in fixed income and more specifically, Treasury bonds. The VIX is back down to below 60, after peaking at about 82 last week. The MOVE Index, which measures volatility in the Treasury market, peaked at 164 and is now down to 87.
  • Progress in virus treatment/work mitigation strategies. There’s been a lot of news, and a lot of noise. This is also a case of when, rather than if. Progress will come, but the timing is unknown. Not only is this a medical issue, but it is also a government policy issue (shelter-in-place) at the local, state and national levels. These government policies are vulnerable to over and under reactions.
  • Earnings announcements can provide clarity. Corporate announcements can separate macro from micro. As more announcements come out, we expect the market’s fear-driven selling to give way to decisions that have more of a fundamental framework.
    • So far, earnings announcements do seem to have a calming effect, even if companies aren’t sharing long-term guidance.
    • One positive that’s been coming out in announcements is that going into the slowdown, the global economy was actually improving. So, we haven’t entered this slowdown on a weak footing.
    • Nike illustrates some of the advantages that large multichannel global retailers may have, in that the company was able to stay connected with customers and resume selling into China relatively quickly.
    • There have also been signs of strength in technology hardware, where work from home trends create demand for cyclical areas. The question is now about how sustainable this will be, or if it’s more of a one-time bounce.

Calamos Growth and Income Fund Positioning

• On the equity side, the focus is on balancing the portfolio between (1) names positioned for a short-term rebound and (2) long-term business model winners supported by secular themes.
  • Short-term rebounders. This includes some names that are a bit more on the cyclical side that have been oversold versus intrinsic value. There might be some balance sheet risks, but not too much, as the team is not seeking out the highest beta, highest risk.
  • Longer-term business model winners, supported by longer-term trends. John believes that the trends that were in place prior to the downturn will continue, including cloud computing, virtualization, increased health care spending, “the big get bigger” multichannel retail, and localization of global supply chains. The team is seeking out companies that have dislocations between equity valuations versus thematic tailwinds.
• Calamos Growth and Income Fund utilizes a multi-asset class approach. On an absolute basis, John believes equities represent the best opportunity, followed by convertibles, then high yield. Equities have been sold off most dramatically. High yield could benefit as spreads have widened substantially and have only started to come back in just a little. John is skeptical about value in the Treasury market, although not calling for significant losses.
• From a risk-adjusted return standpoint, the convertible asset class is most attractive. As hybrids, convertibles are positioned to benefit from a rebound in equity valuations, a narrowing of credit spreads, or both. This is in addition to the attractive valuations in convertibles themselves.
• The Fund is positioned with the goal of providing an asymmetrical risk/reward profile, with more upside equity market participation than downside. This is addressed on two levels.
• Top-down positioning and appropriate re-balancing across asset classes, based on where the team sees the best risk/reward across asset classes.
• Asymmetry built into the securities in the portfolio, which comes through options—either outright options or the options embedded in convertible structures. Right now, current market volatility has made the purchase of outright options a bit more challenging. Convertibles represent a more attractive opportunity in the current environment.
• In regard to selecting individual convertibles, the team is focused on finding issues with the appropriate balance between equity sensitivity and fixed income sensitivity. The current market provides sufficient opportunity for the Fund.

Summary of Key Views (As of March 19, 2020)

• Natural disaster responses provide a framework for how to view the pandemic and how it might be resolved. We know how to do this, but we must work through it with both the government and private sector.
• In regards to liquidity conditions, the system is bending but not breaking.
• In terms of valuations, some companies are cheap for good reason, but many are just cheap—the victims of forced selling.
• Near term, we see the bottoming in the market being driven by a calming of liquidity conditions and the Treasury market, fiscal policy implementation, vaccine progress and containment of the outbreak. The upcoming earnings season can provide clarity and stability to the markets, helping to separate the macro events and the micro events.
• Likely winners in long term: large companies, multichannel retail, online retail, software as service, cloud and virtualization companies, beneficiaries of re-drawn supply chains, companies providing health and food/travel safety innovations.
• Likely losers in long term: low return on capital and overcapitalized companies, smaller businesses in retail and restaurants, energy names hurt by the economic downturn and OPEC+ upheaval.
• Calamos Growth and Income Fund is differentiated from peers by its multi-asset equity-oriented approach; the portfolio includes an actively managed mix of equities, convertible securities and risk-managed option strategies.
• Top-down and bottom-up research (including comprehensive capital structure analysis) seek to provide a favorable asymmetrical risk profile, capturing more equity upside than downside.

Additional Details

There is a way out of this crisis, modeled after responses to natural disasters. We know what we need to do, we just need to do it.

• The pace of government and private sector response will likely be slower than we may like, but we have the collective knowledge to address the pandemic, including support to individuals and businesses.
• China and other countries have shown how to slow the infection rate and provide treatment. We’ve seen some success but we know it takes time, with economic activity ramping up slowly.
• Governments are needing to confront the trade-off between saving lives and economic growth. Slow activity will last longer than a couple of weeks, as governments prioritize health and safety.
• But at some point, we will have to get back to work. Doing a better job testing could make a positive impact in the U.S., as would more focused mitigation strategies versus broad national mitigation strategies. Then, the private sector could move forward. With better treatment options and workplace safety in place, this would help the economy get back on course.
• The bigger issue relates to needing the government to help restart the economy. In the wake of natural disasters, the government’s response has often been not as quick or thorough as it needs to be. In this case, the economy is already slowing up and we are still awaiting a comprehensive fiscal response. The faster we can move, the better.
• We are concerned about the loss of income for small businesses and low-income individuals; this could create pressure in our service-driven economy. Emergency loans to small business will be crucial. As has been the case following other natural disasters, small business is especially vulnerable in the current crisis.

Liquidity Conditions: The System Is Bending But Not Breaking

• Individuals, businesses and owners of financial assets are all trying to raise cash at the same time, putting stress on liquidity overall.
• The Federal Reserve and other central banks know how to fix this and are putting in the appropriate facilities in place.
• So, here too, we know what to do, and it’s happening, so conditions are likely to improve.

Valuations: Many Opportunities Have Emerged in the Wake of Panic Selling, But Selectivity Is Key

• We’ve seen extreme valuation moves in risk assets, exacerbated by ETF moves, CTAs, and hedge funds.
• There are some companies that are cheap for a reason, but some companies, particularly high-quality companies, are just cheap. Our return on capital model points to very favorable risk/reward profiles in half of the large cap universe (modestly extreme result). We are going through those names for opportunities.

The Near-Term Signs of Market Bottoming Process We Are Watching For

• A calming of the liquidity rush, which could happen in the next one to two weeks as Fed measures push in.
• Certainty on fiscal plans.
• Some reduction in volatility; we have seen some calming in the Treasury market.
• Earnings season will soon be underway. Better information should help separate macro events and micro events. What are companies doing, what are they seeing, what do their balance sheets actually look like, what are their funding requirements?
• The market has been in a mode of “shooting first and asking questions later,” greater clarity on how businesses are dealing with challenges can provide stability to the market.

Winners and Losers

• John expects a continuation of the “big get bigger” theme that favors companies with the capital and resources to survive and thrive, like online retailers and multichannel retailers.
• The team sees tailwinds for companies that are capitalizing on increased spending on healthcare and food safety measures, including developers of vaccines and treatments, and innovators in food, dining and travel safety. After 9/11, changes were made across the airline industry to get people back on planes, we expect something similar to occur in terms of health measures.
• Continued opportunities in software as service, the cloud, and virtualization.
• Alternative supply chains: The pandemic has raised new issues in how goods move from point A to point B; companies that can solve these problems are positioned advantageously. This also dovetails into the localization of global supply chains that began during the trade war.
• Companies on the losing side include areas with overcapacity and low economic returns—companies that can’t survive the macro shocks, including small business retail/restaurants, the energy sector. 

Calamos Growth and Income Fund: Differentiated Approach Drives Results

• The Fund seeks equity-like returns with less equity risk through a multi-asset equity-oriented strategy.
• John’s team combines top-down process and bottom-up analysis. Top-down focuses on where we are in the economic and market cycle; this guides the Fund’s level of equity exposure.
• Bottom-up analysis is supported by an integrated research team focused on identifying the most attractive companies, and then the most attractive opportunities in the capital structure (for example, common stock, fixed income, convertible, or option).
• At all times, John’s team seeks to have an asymmetric risk profile embedded in the portfolio, with assets and instruments in the portfolio providing more upside than downside.
• Differing from other multi-asset peers, this asymmetric risk profile is often supported with an option strategy, generally implemented through positions in convertible securities (which are essentially a fixed income security with a long-term option).  
• Convertibles also provide a lower-volatility way to participate in a riskier equity that the team likes.
• The Fund will also pair equities with listed options, and use puts to mitigate downside exposure.
• The Fund relies on a complex mix of assets, by intent. The asset allocation (stocks, converts and fixed income) may not tell the whole story of equity exposure. Options can be in or out of the money to varying degrees, convertible securities vary in their levels of equity and fixed income sensitivity, and puts can limit exposure to downside.

We stand ready to help, let us know what you need. For more information, contact your Calamos Investment Consultant at 888-571-2567 or caminfo@calamos.com.