As we move forward into 2021, we believe we are on the precipice of monumental change. For years, the average stock in the S&P 500 has done little, while the largest stocks in the indices have driven returns. A significant rotation is taking place, as we’ve recently begun to see widespread regime change in favor of the average stock in the S&P 500, and away from the behemoths that have been bolstering returns for years.

Matthew Erickson | Senior Portfolio Manager Tweet
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“What’s Your 20?”

I first recall hearing the phrase, “What’s your 20?” in the 1977 movie, “Smokey andthe Bandit”, starring Burt Reynolds and Sally Field. If you are unfamiliar, the film depicted a stunningly intricate plot line. In 1977, it was illegal to sell Coors beer east of the Mississippi River. A wealthy Texan named Big Enos Burdette and his son Little Enos were sponsoring a race car driver in Atlanta’s Southern Classic and they wanted to celebrate his big win in style, so they sought out the services of two bootleggers, Bo “the Bandit” Darville and Cledus “the Snowman” Snow, to deliver 400 cases of Coors from Texas to Georgia within 28 hours. Along the way, the Bandit picks up a hitchhiker on the run from marrying Sheriff Buford T. Justice’s son, and from there on a multi-state car chase ensues. 

While perhaps it may come as a surprise to some of you that this film did not go on to receive the distinction of being Oscar worthy, it did bring to the forefront of pop culture vernacular the phrase “What’s your 20?” – CB radio lingo for “What’s your location?”. In the financial services industry, we believe this phrase will increasingly be used to refer to what one’s investment performance was in 2020

Suffice it to say, with the onset of a global pandemic unlike the world has seen since the Spanish flu of 1918, and with sensational market volatility in global equities not experienced since the Great Depression, many investors were caught off guard and wholly unprepared for how to navigate such a tumultuous landscape.
The dramatically sharp declines we experienced from the market reaching all-time highs on February 19th, to the market lows put in little more than one month later on March 23rd peaked at a loss of more than -35% for the S&P 500.
Even if one did reenter, it was highly unlikely they were able to do so within the first 3 days of the market moving up off the bottom, during which the S&P 500 remarkably recovered 20%!
A precipitous drop of this magnitude over such a short period of time surely tested the mettle of every market participant. Many succumbed to fear, locking in their losses by going to cash at precisely the wrong time and failing to reenter the market.
2020 S&P 500 Daily Returns Bar Chart

Similar to the Great Recession of 2008 and the bursting of the Tech Bubble from 2000-2002, 2020 will forever be remembered as the ultimate measuring stick for one’s investment discipline.

In previous articles, we’ve defined the ethos of the Polaris investment approach (reference Winning the Game and Winning the Game – Part 2). On a superficial level, our primary objective is very similar to that of many of our peers, in that over time our goal is to generate superior performance for our investors, as compared to our noted benchmarks. However, unlike many of our competitors, we firmly believe that the path one takes to get there is of the utmost importance.

Rather than focus solely on upside performance, we aim to achieve long-term outperformance first and foremost by providing our investors with relative downside risk mitigation. If one can simply reduce exposure to outsized declines, one need not take on exceedingly high risks to outperform. After all, if you take greater risk than the market and your timing is wrong, you could very well find yourself having to try to dig out of a much deeper hole. Additionally, when faced with outsized declines in an already perilous market environment, investors experiencing losses in excess of the benchmark are also far less likely to remain invested.

Consider the rate of return required to recover from a significant loss. For example, should an investor lose -40% of their principal investment, they will require a gain of 66.67% just to get back to even. Additionally, a loss of -50% requires a gain of 100% to recoup losses, while a loss of 60% requires an astounding 150% gain. You get the picture, the deeper the hole one digs, the greater the performance required to get back to even, and the harder and harder it gets.

Rather than focus solely on upside performance, we aim to achieve long-term outperformance first and foremost by providing our investors with relative downside risk mitigation.

Loss/Gain Bar Chart Projection

Managing risk allows your investments to spend less time recouping losses and more time building actual wealth. We think that’s important.

Let’s not kid ourselves, 2020 was an extremely difficult year for all of us, and on a myriad of levels, both personally and professionally.

Yet surprisingly, what began as a train wreck for the global equity markets, ultimately proved to be a very good year, with the S&P 500vfinishing up more than 18%. Unfortunately, we know that the vast majority of investors fell dramatically short of this mark. So how did we do?

Across all of our Polaris equity strategies, we were able to generate significant risk-adjusted returns for our investors in 2020 – with alphas ranging from 4.56 to as high 22.67, betas as low as 0.65, and standard deviations across the board lower than our respective benchmarks. While on the surface this may almost seem incredulous given the backdrop we were given to work with, for those more familiar with our tactical approach, 2020 provided us with outstanding opportunities.

In order to provide further context for how it was that were able successfully navigate the markets in 2020, below we’ve provided some additional commentary specific to three of our most highly sought-after strategies: Rising Dividend Growth & Income, Global Growth,and Focused Value.

Rising Dividend Growth & Income:

The Polaris Rising Dividend Growth & Income Strategy (otherwise known as RDG&I) is a moderate allocation strategy with a baseline allocation of 60% individual stocks and 40% fixed income ETFs. RDG&I is the largest and oldest strategy at our firm, with currently more than $490 million in AUM and roots dating back to 2007. This strategy invests in only dividend paying stocks for the equity portion of the portfolio, with a focus on more value-oriented companies. The fixed income portion of the portfolio utilizes a quantitative rotational discipline, seeking to exploit underlying trends in the bond market; either in favor of fixed income that is more highly correlated to the equity markets, or more traditional flight to safety assets like U.S. Treasuries.

RDG&I is a tactical portfolio. When equity market conditions are deemed to be constructive, this strategy may hold up to 80% of the portfolio in stocks. Conversely, when fundamentals are weak or deteriorating for risk assets, we can raise as much cash as our investment team believes to be warranted.

We began 2020 in RDG&I with a slightly bullish allocation, with our equity exposure hovering around 70% for the first month of the year. As market conditions deteriorated more rapidly in February and into March, we reduced our equity exposure to as low as 30%. Within our fixed income sleeve, we increased our holdings in Treasuries. While the S&P 500 dropped more than -12% in March, and our blended 60/40 benchmark (60% Russell 1000 Value TR / 40% Bloomberg Barclays U.S. Aggregate Bond TR) for RDGI declined nearly -10%, our defensive posture enabled us to preserve capital for our investors, as we were down a much more palpable -5.25% for the month. From peak to trough, from February 19th to March 23rd, RDG&I was down little more than -13%, versus a loss of roughly -21% for our benchmark and more than -33% for the S&P 500. By significantly reducing our downside exposure during these difficult times, not only were our investors better equipped to more rapidly recoup their losses, we were also afforded the opportunity to do so while
taking less risk. Our disciplined approach provided our investors with a much less emotional ride, making it far easier for them to remain invested.

Given the shock we witnessed in the markets, as well as to our economy at large, it wasn’t until mid-year before we returned to our neutral allocation of 60% equity in RDG&I. Once we moved beyond the political uncertainties of the election, we incrementally increased our equity exposure during the 4th quarter up to 70%; while also rotating our fixed income sleeve into vehicles with a much higher correlation to equities, such as high yield bonds and convertibles.

By year-end, RDG&I had generated a gross return of 11.17%, versus a total return of 6.47% for our 60/40 blended benchmark. The path we took to get there incurred significantly less risk, as is evidenced by our beta of 0.78 (implying we took 22% less risk than our benchmark), alpha of 5.53, and our standard deviation of 14.80 versus 17.34 for the bench. In 2020, this strategy captured 107.09% of the upside of our benchmark, but more importantly only 86.41% of the downside.

Polaris Rising Dividend Growth & Income 2020 Performance Chart
2020 Rising Dividend Growth & Income Monthly Returns

Global Growth:

Our Global Growth Portfolio is the most unconstrained strategy we run at the firm. As the name implies, this strategy takes a global approach to the equity markets. From a geographic perspective, we can hold us much of the portfolio in either domestic or international stocks as deemed appropriate. Additionally, while our baseline allocation for this strategy is to remain fully invested, when equity market conditions are unfavorable, we can raise as much cash as necessary to mitigate downside risk.

We began 2020 fully invested, with an equity overweight in domestic growth. When market conditions began to deteriorate in mid-February, we raised cashed, shifting the underlying equity exposure to reflect prevailing market conditions and decreasing our equity exposure to as low as 48% intra-month in March. From peak to trough, during the market downturn, our benchmark (the MSCI ACWI NR) lost more than -33%, while in contrast the Polaris Global Growth Strategy declined less than -20%. Additionally, we made a tactical shift in our underlying holdings, buying companies that were beneficiaries of newly imposed Covid lockdowns, such as: Teledoc (TDOC), Docusign (DOCU), Clorox (CLX), Netflix (NFLX), and Walmart (WMT).

During the fourth quarter we began to observe a regime change, with leadership moving away from the Covid winners and into return to normal stocks. As such, we began to sell our shares in companies such as Clorox and add to those that would stand to benefit greatly from a reopening of the global economy. At which point, we added companies such as Delta Airlines (DAL), Under Armour (UAA), and TopBuild (BLD). We also began to increase our holdings in international stocks, adding recovery winners such as Baidu (BIDU). 

By year-end, Global Growth had generated a gross return of 20.78% versus a return of 16.25% for the MSCI ACWI NR. More importantly, we were able to do so while taking on significantly less risk, as evidenced by our beta of 0.75 and alpha of 7.19. Our up-capture for the year finished at 89.97, while our down-capture came in significantly lower than our benchmark, at 73.09. When our investors needed it most, we preserved capital. And when it was time for the markets to again move higher, we were able to navigate the course in a riskadjusted manner, making timely tactical shifts in our underlying holdings. Whereas our benchmark failed to make a sustainable return to being positive on the year until early November, Global Growth was already back in positive territory by mid-July. This reiterates our prior statement, “Managing risk allows your investments to spend less time recouping losses and more time building actual wealth.”

Polaris Global Growth Retuirns
2020 Global Growth Monthly Returns

Focused Value:

Unlike Rising Dividend Growth & Income and Global Growth, which adhere to a much more unconstrained ideology, Focused Value ascribes to a more style-centric approach; in this case falling into the Morningstar Category for U.S. Large Cap Value. As such, our intent is to remain fully invested at all times, though we retain discretion to raise as much as 10% in cash in an effort to reduce exposure to outsized declines. During January and February, we were positioned for what we thought would be a weakening dollar environment, increasing exposure to commodity related companies and those with greater revenue generated from abroad. That did not materialize and after two months we found ourselves lagging the Russell 1000 Value TR (our assigned benchmark for this strategy). As market conditions deteriorated further, we moved our cash position up to our maximum allowable threshold of 10%. We also dramatically shifted our underlying holdings into more defensive companies, with up to 25% exposure to both consumer staples and health care by mid-March; owning companies such as Kroger (KR), Walmart (WMT), Merck (MRK), and Bristol-Myers Squibb (BMY). By significantly lowering our portfolio beta during this time, we were able to consequently avoid a large portion of the declines in our benchmark, as the Russell 1000 Value finished down -17.09% on the month, whereas we lost only -10.72%. As markets began to swiftly move up off of the bottom in the final week of March, we added companies such as Ally Financial (ALLY), Skyworks Solutions (SWKS), and Cisco (CSCO). Divergences between flight to safety stocks and more opportunistic sectors had becomeextreme, and so we began chipping away. As the recovery became more engrained throughout the rest of year, we became moreaggressive with buying cyclical value stocks. Coming out of deep recessions, deep value cyclicals are notorious for providing strongleadership and we wanted to take advantage of what we believed to be significant mispricing in the space. During Q4, we witnessed a strong rotation into value stocks that candidly, had done little in years. At the time, we believed this may be the start of a very long overdue rotation in the markets (as growth had dominated for more than a decade). As such, we beganbuying companies that had long been out of favor, and in many cases had been in bear markets for several years, including General Motors (GM), Tapestry (TPR), and General Electric (GE). Fortunately for us, many of these laggards garnered tremendous momentuminto year-end. By the end of 2020, Focused Value had generated its strongest relative calendar year of outperformance over its benchmark since inception, besting the Russell 1000 Value TR by nearly 20% (with a gross return of 22.29% vs 2.80% for the bench). More impressively, we were able to generate this outperformance while remaining at or near fully invested the whole time, with a beta of 0.96 and an eye-popping alpha of 17.56. By exploiting significant dislocations and sector rotations in the market, were able to generate an up-capture of 128.19 and a down-capture of only 80.83..  

Summary:

“Life is a storm, my young friend. You will bask in the sunlight one moment, be shattered on the rocks the next. What makes you a man is what you do when that storm comes.”
Alexandre Dumas
(The Count of Monte Cristo)
While every investment manager aspires to generate winning performance each year, what truly defines them is how one handles the adversity and challenges presented during the worst of times. 2020 was a challenging year for investors. Many succumbed to the perils. For those cognizant of the underlying rotations and trends present in a year like 2020, beneath the surface lies opportunity.
In this illustration provided by Bespoke Investment Group, they’ve broken down market leadership during 2020 into 6 different “Acts”. Note, during the outsized declines we faced early in the year, and throughout each phase in our recovery, we’ve witnessed a rotational change in leadership.
For a tactical manager, staying on top of such rotational changes is paramount; not only does this provide investors with the opportunity to generate winning performance, it provides one with a roadmap for when to reduce risk. As a tactical manager, we believe downside risk mitigation to be the bedrock of our success.

While 2020 may have been unique with respect to the size of the dislocations we witnessed, from a rotational perspective, the markets will forever be defined by a never-ending game of musical chairs. The best of us are attuned to these changes in market leadership. Far fewer possess the wherewithal and foresight to exploit them.

As we move forward into 2021, we believe we are on the precipice of monumental change. For years, the average stock in the S&P 500 has done little, while the largest stocks in the indices have driven returns. A significant rotation is taking place, as we’ve recently begun to see widespread regime change in favor of the average stock in the S&P 500, and away from the behemoths that have been bolstering returns for years. For those with the foresight to see this happening, there are tremendous opportunities ahead. Allocating increased exposure to sectors whose trends are expanding, while reducing exposure to those under contraction will be key. In order to do so, one must be willing to look different than the respective weightings of their benchmarks. For those unfamiliar nwith how to navigate these changes, they’ll soon find themselves in uncharted waters. For a tactical manager like Polaris, we can’twait to exploit them.