EQUITY STRATEGY REVIEW · the prevalence of zombie companies since the 1980’s3. From 1995 to...

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EQUITY STRATEGY REVIEW JUNE 2020


❖ As COVID-19 carries on, we are taking a fluid approach to the markets, updating relative

preferences real-time as management of the virus, policy response, and corporate and consumer behaviors evolve.

❖ Given recent developments, we have increasing conviction in Europe over the US, though we still believe the US has several structural advantages longer-term. Additionally, we are seeing increasing evidence suggesting the recovery will be consumer-led, bringing us to favor the consumer sectors.

❖ While the unprecedented level of fiscal and monetary stimulus has de-risked equity markets in the short-term, we are cautious of the long-term impacts. In our opinion, “lower for longer” interest rates perpetuate the existence of “zombie companies” and run the risk of stunting economic growth.

❖ Given this environment, we expect to see a growing bifurcation between winners and losers in the market, highlighting the importance of “quality” company characteristics like free cash flow generation, capital allocation, and the quality of the business model and management.



The COVID-19 crisis is restructuring our economies in fundamental ways by accelerating structural trends like e-commerce, while creating new ones as we think about re-shaping strategic value chains or the way we work. Christine Lagarde, president of the ECB, noted these trends centered around “proximity” within the manufacturing sector but “distancing” within the services sector1. The major questions we must now ask ourselves are not only what will be the shape and speed of the recovery, but more importantly, how will the economic landscape be reshaped at the other end of the tunnel.

The nationalization of risk

The long-term company characteristics we target remain largely unchanged as we believe that the long-term growth outlook has taken another step back due to increased debt levels (stimulus related).

The unprecedented fiscal and monetary stimulus boils down to a “nationalization of risk” as solvency risk was merely shifted from the corporate sector to central banks and governments. While this significantly de-risked the equity market in the short to medium-term, it is hampering growth in the long term by throwing a lifeline to “zombie” companies within the economy thereby increasing the potential for value traps. While we do not want to fight the Fed in the short-term, we need to be aware of the policy consequences in the long-term.

The Bank of International Settlements (BIS) published a research piece in 2018 to this effect2. Their analysis indicates that weak financial institutions and low interest rates structurally increased the prevalence of zombie companies since the 1980’s3. From 1995 to 2017, the share of such companies grew from roughly 3% of the market to 12%.

The research further revealed that loose monetary conditions increase the probability of remaining a zombie company. In short, we now have more companies on life support and for a longer period of time. Deutsche Bank recently estimated that almost 20% of all US corporations now qualify for “zombie” status4.

The consequence is that zombies weigh on economic performance. They are less productive and their presence crowds out investment and pulls talent away from more productive firms.

This is one of the main reasons we believe we will see a growing bifurcation between winners and losers within a wide range of industries over the medium to long-term. Major crises, similar to the one we are in now, only accelerate the trend and highlight the importance of company characteristics like free cash flow generation, capital allocation, the quality of the business model and management.

Moving targets

While our long-term thinking and broad direction remain unchanged and many unknowns persist, our relative preference for end markets or regions is evolving real time. We are monitoring measures of consumer and corporate behavior as economies re-open, as well as newly proposed or approved fiscal and monetary initiatives. So, was there any new news that impacted our thinking over the last 4 to 6 weeks?

Improving optionality in Europe

As Europe has managed the health crisis better than the US, the old continent seems to be coming out of the crisis on a more sustainable footing. As a result, domestic demand from consumers and governments should continue to recover as the virus is kept in check. In contrast, a series of localized shutdowns could make the recovery in the US slower and bumpier going forward. To this effect, the spread of the virus in the US has been compared to an evolving forest fire, rather than a series of waves.

Europe’s labor market institutions are softening the blow on the back of generous furlough schemes. Economists at the European Central Bank found that, in the absence of these benefits, the drop in worker’s income would have been 22%, compared to the 7% experienced to date5.

The impact of the furlough schemes is also reflected in the evolution of the unemployment rates. Whereas US unemployment went from 3.5% in March to 11.2% in June, Eurozone unemployment climbed from 7.2% in February to “only” 7.4% in May.

An important initiative that has come to the fore is the 750 billion

Market Observations Lode Devlaminck, Managing Director, Equities

EXHIBIT 1: FISCAL RESPONSE AS A PERCENT OF GDP

Source: EU Commission, BNP Exane Estimates (as of 06/24/2020), DuPont Capital



Euro EU recovery fund. While it is far from sure that the proposal will be enacted in its current form, it constitutes an important catalyst for the region. The plan does not only propel the fiscal stimulus for Europe (as a % of GDP) beyond the rest of the world (Exhibit 1), it also enables or strengthens other initiatives like the monetary stimulus of the ECB, the Green deal adoption, and some fiscal relief in Southern Europe. More importantly, the plan could be cause for an equity re-rating as it reduces the “Eurozone” risk premium and the bond spreads within the Eurozone.

At the same time policy uncertainty is decreasing in Europe, we are witnessing growing policy uncertainty in the US. The federal response to COVID-19 is impacting the polls as are potential changes to the tax and labor policies, which are starting to seep into market expectations (Exhibit 2).

When we combine a lower starting point, driven by a larger economic and earnings downdraft in Europe, with higher economic sensitivity, better management of the pandemic, and potential tailwinds from the EU recovery fund, we have to consider improved optionality in Europe (especially in more domestically oriented consumer cyclicals).

A major long-term challenge for Europe will be how to implement policy without simply propping up the afore referenced zombie companies. In the long-term, it can’t be denied that a more flexible labor market is a major positive for the US.

A consumer-lead recovery

We were initially more concerned that the unprecedented spike in unemployment would lead to a pickup in “precautionary” savings, which could in turn lead to a broad-based impact on consumer spending. However, fiscal measures in the US and furlough schemes in Europe are turning out to be much more supportive of consumer spending than originally thought.

Exhibit 3 shows that the extra unemployment benefit of $1,200 USD ($2,400 per family) for lower and middle-income families in the US, on average, more than compensated for the loss of income. This combined with lower net expenditures as a result of lockdowns (forced savings) led to a significant jump in net savings.

Higher income consumers, on the other hand, have been under less pressure as they tend to have jobs that allowed them to continue to work from home. At the same time, they have seen a significant rebound in their wealth on the back of a remarkable rebound in equity and fixed income markets. The net result is that pent up consumer demand is stronger and will likely be longer lasting than we fist anticipated.

The heart-breaking statistics of COVID-19 reveal that the health

and economic impacts are not evenly distributed across social, demographic, age and wealth lines and as a result, the social and emotional impacts seem to be more significant than the economic impacts.

The main concerns we have regarding the sustainability of consumption center around the renewal of the unemployment support, the high initial unemployment claims, and the permanent destruction of jobs and its effect on the longer term unemployment rate.

Source: policyuncertainty.com (as of 06/29/2020)

Exhibit 3: Average Change in US Consumer Wallet (on an annual basis)

Exhibit 2: Relative Policy Uncertainty US/Europe

Source: Credit Suisse, BEA, Bloomberg Note: All figures are measured on an annualized per capita basis. Change from February 2020 to April 2020.



Market Outlook

This remains first and foremost a health crisis and it is hard to see a full and sustainable return to normalcy without a vaccine or credible treatment. Even as the authorities continue opening up the economy, consumers and companies may be hesitant to spend and invest. This “fog of uncertainty1” cannot be fully lifted without a medical solution.

One of the structural impacts of the crisis and of the resulting fiscal and monetary policies will be a growing bifurcation between winners and losers within a broad set of sectors. In the short term, this trend can be masked by the sharp economic rebound (albeit off a very low bottom) and a Central bank induced drop in the discount rate and risk premium.

While the US is structurally better placed in the long-term due to its labor market flexibility and sector composition, optionality in Europe has, at least temporarily, improved on the back of a better response to the health crisis, a lower starting point, and the EU recovery fund.

From an industry perspective we have warmed up to selective domestic consumer-oriented cyclicals on higher than expected disposable income and pent up demand.

Sources:

1 ECB, Christine Lagarde, “The path out of uncertainty”, remarks at the inaugural session of the Italian National Consultation, 06/13/2020

2 BIS. Ryan Banerjee & Boris Hofmann, “The rise of zombie firms: causes and consequences”, 09/23/2018

3 Zombie companies are defined as firms that are unable to cover debt servicing costs from current profits over an extended period (or realistically repay the debt over the long term).

4 Ai-cio.com & Deutsche Bank Securities, Torsten Slok, “Attack of the zombies: Potential Deadbeats are almost 20% of companies, says DB”, 06/19/2020

5 Bloomberg Opinion, Ferdinando Giugliano, “Why Europe’s in better shape than the US”, 07/06/2020

Performance (gross/net) as of June 30, 2020 (Preliminary)

* Gross of Fees Net returns are calculated using highest fee on ADV. Returns greater than one year are annualized. Please see the last page for important performance disclosures.

U.S. Equity % QTD % YTD % 1yr % 3yr % 5yr % 10yr % 15yr Inception

DCM Value Creators—US Large Cap* (inception date – 01/01/2017) 22.7 1.6 14.6 15.8 — — — 17.2

Net of Fees 22.5 1.3 14.1 15.2 — — — 16.6

S&P 500 Index 20.5 -3.1 7.5 10.7 — — — 12.0

DCM Value Creators—US Mid Cap* (inception date – 01/01/2017) 18.7 -12.1 -5.1 8.8 — — — 9.0

Net of Fees 18.6 -12.3 -5.6 8.2 — — — 8.4

S&P 400 Index 24.1 -12.8 -6.7 2.4 — — — 3.8

DCM Small Cap Equity* (inception date – 04/01/1999) 24.4 -18.4 -13.2 -0.3 2.9 10.5 6.9 9.3

Net of Fees 24.1 -18.7 -14.0 -1.1 2.1 9.5 6.0 8.4

Russell 2000 Index 25.4 -13.0 -6.6 2.0 4.3 10.5 7.0 7.7

DCM Merger Arbitrage* (inception date – 06/01/2015) 1.7 -2.9 -0.6 2.5 3.3 — — 3.1

Net of Fees 1.6 -3.1 -1.1 2.0 2.8 — — 2.6

3 Month T-Bill 0.1 0.5 1.6 1.7 1.1 — — 1.1

Non-U.S. Equity % QTD % YTD % 1yr % 3yr % 5yr % 10yr % 15yr Inception

DCM Emerging Markets Equity* (inception date –10/01/1999) 17.0 -16.1 -10.7 0.1 2.4 2.1 7.0 8.4

Net of Fees 16.7 -16.6 -11.8 -1.1 1.1 0.9 5.8 7.1

MSCI EM Index 18.1 -9.8 -3.4 1.9 2.9 3.3 6.3 7.1

DCM International Equity* (inception date – 01/01/2017) 15.8 -10.3 -4.1 1.3 — — — 5.7

Net of Fees 15.6 -10.6 -4.7 0.7 — — — 5.1

MSCI EAFE Index 15.3 -11.5 -5.3 0.8 — — — 4.4

DCM Global ex-US Small Cap Structured* (inception date –01/01/2015) 24.2 -10.9 -0.5 1.9 4.5 — — 5.4

Net of Fees 24.0 -11.3 -1.3 1.1 3.6 — — 4.5

MSCI AC World ex USA Small Cap Index 22.8 -12.8 -4.3 -0.2 2.5 — — 3.8



During the second quarter, the US and global equity markets sharply rebounded from the pandemic-induced lows of March. The rebound was driven by a “flattening of the pandemic curve” achieved by global social distancing, as well as the un-precedented stimulus provided by the US government’s direct stimulus programs and Federal Reserve policy, which served to lower rates and support fixed income markets through a new bond buying program (inclusive of corporate debt).

With the US economy on track to experience its worst quarter-ly economic contraction and sharpest rise in unemployment in history, it begs the question, how much of this is a temporary or “cyclical” phenomena? As a long-time industrials cyclical investor, I have often asked this question of the traditional heavy cyclical industries such as construction machinery and heavy industrial equipment. However, this pandemic has made the vast majority of companies and industries appear cyclical for the first time in history. For investors with a long term time horizon, an ideal framework for handling this situa-tion is to focus on “normalized” through-cycle earnings power and to use this to anchor the foundation for valuation. When an industry is cyclically depressed due to temporary lack of demand and/or oversupply, industry participants collectively take actions to adjust – suppliers cut production, inventories

normalize, demand returns, pricing stabilizes, and production rises. During this cycle, corporate earnings follow in step with the cycle troughs and peaks. For long-term investors, it does not make sense to value companies on trough earnings, as long as you are confident its really a trough. One must “look through the valley” to the other side when things are more normal again. This process must now be applied to nearly every company as the pandemic has caused a cyclical trough demand shock for the vast majority of businesses.

The key challenge is being cognizant of a few factors:

• Is the demand trough temporary or cyclical in nature?

• Might there be a new normal that differs from history?

• How long might the return to normal take?

• Has there been permanent damage to the industry supply or demand drivers?

• Has the industry structure been altered in any way?

For many traditional industrial companies who produce capital equipment that are critical to the economy, it is unlikely that the long term demand for their products will become obsolete due to the pandemic. The real debate is how long and when

Value Creators - US Large and Mid Cap Kevin Fogarty, CFA, Portfolio Manager and Senior Equity Analyst

US Mid Cap

Value Creators S&P 400

US Large Cap Value Creators

S&P 500

Debt Level

Debt/Capital 71.3 38.4 48.8 49.5

Debt/Equity 138.2 157.3 222.2 136.2

Debt/EBITDA 2.4 3.0 1.9 2.4

Growth

Dividend Growth 5 year 16.2 9.8 14.2 11.9

EPS Growth 3 year 20.7 18.9 25.1 21.0

EPS Growth 5 year 18.9 12.4 15.3 13.1

EPS Est Growth 3-5 Year 8.7 9.7 12.0 9.9

Dividend Payout Ratio 21.0 59.2 24.5 49.4

Profitability

Return on Equity 24.8 13.7 27.5 23.2

Return on Assets 13.6 6.7 11.7 9.2

Valuation

Price/Earnings using FY2 Est (ex Negatives) 24.7 29.6 28.9 27.6

Price/Cash Flow 14.2 8.8 18.5 12.1

Price/Book 4.7 2.0 5.5 3.3

Price/Sales 4.9 4.0 6.3 5.4

Dividend Yield 1.0 2.0 0.9 1.9

Exhibit 4: Value Creators Portfolio Characteristics (as of 6/30/20)

As of June 30, 2020 Source: DuPont Capital, FactSet



might demand return to pre-pandemic levels. However, for other consumer and business services oriented companies, the answer is less clear. Depending on the ultimate depth and duration of the pandemic, certain consumer and business be-haviors may be permanently altered. Although it is difficult to estimate the impact on certain industries, we are using the above framework to assess potential opportunities.

During the second quarter, the value creators had mixed per-formance. The Large-Cap Value Creators portfolio outper-formed the benchmark by 211 basis points, returning 22.65% vs. the S&P 500 index’s 20.54% return. The Mid-Cap Value Creators portfolio underperformed its benchmark by 536 basis points, returning 18.71% vs. the S&P 400 index’s 24.07% re-turn.

In both portfolios, we had made modest adjustments to posi-tions in March toward companies with lower risk of perma-nent loss of capital based on the four factors we mentioned last quarter: (1) balance sheet strength, (2) ability to operate through the crisis, (3) potential for recovery to normalized

levels, and (4) probability of permanent damage to the busi-ness. In the large-cap portfolio, we benefited from these changes as overweights in pandemic-resistant businesses such as Amazon, Google, and Facebook helped drive outperfor-mance. However, in the midcap portfolio, a significant portion of the recovery rally was driven by lower quality businesses, as the Fed-driven friendly corporate credit markets bolstered many potentially troubled balance sheets. As the mid-cap portfolio typically holds positions in companies with better than average business quality in terms of financial leverage, its recovery lagged the index by a significant margin during the second quarter.

As shown on the previous page (Figure 4), the portfolios have better than average financial leverage and cash flow durability relative to the benchmarks. We believe this better positions the portfolios as we continue to navigate this storm. We also believe the higher than benchmark Return in Equity and Re-turn on Assets and resulting expected cash flows will be key drivers of the portfolio over the long-term.

Among the myriad repercussions that the pandemic has had for equity markets, perhaps the most durable on a multi-year horizon will be the extent to which existing transformational or demographic trends – both familiar or nascent, value-creating or growth-eroding – have accelerated. Given our research efforts accentuate sustainable and structural trends at the industry level and operational excellence and innovation at the corporate level, the prevailing market climate, though volatile, has been conducive to the outperformance of such high quality, growth profiles. Capex and consumption patterns in many end markets have been disrupted by COVID-19, but may ultimately split across more distinct or divergent trajectories.

However, it is equally important to consider and monitor the other side of the coin, namely, those industries where fundamental competitive dynamics, barriers to entry, and regulatory frameworks are onerous, and market-listed participants struggle to meet our investment and conviction thresholds. The corresponding underweight stances are deliberate sources of active risk and must be rationalized and calibrated accordingly.

Take, for example, the banking industry, in which we have long

had an underweight. Despite recently skyrocketing risk premia seen across the Energy and Airlines industries, it is Banks that remain the single largest block of return-constrained companies within the developed markets ex-US universe.

In 2009, former Federal Reserve Chairman Paul Volcker caustically quipped that “the only thing useful banks have invented in 20 years is the ATM”. Barclays Bank launched the first operational cash dispenser in 1967, giving the European banking sector claim to this pioneering mantle. Since then, however, Europe certainly cannot be excused from Volcker’s broader argument that “I have found very little evidence that vast amounts of innovation in financial markets in recent years has had a visible effect on the productivity of the economy”. Traditional banking activities should be, in the information era, an inherently commoditized business. Low regulatory appetites for other risk-taking business lines are reflected in high capital adequacy requirements and regular stress tests which show little sign of abating.

At a macroeconomic level, recent events and monetary response have ensured that interest rates are shifting further along the “lower for longer” spectrum towards the realm of QE Infinity. In

International Equity Andrew Smith, CFA, Associate Portfolio Manager and Senior Equity Analyst



addition to the prolonged net interest margin pressure this exerts (lending-deposit spread), the medium-term credit risks are now far more elevated than at the turn of the year. For now, governments and monetary authorities have essentially underwritten and backstopped the most severe liquidity and solvency risks in the economy. However, as these support programs expire, the creditworthiness of many businesses and households may be structurally different than those modeled and assessed previously.

In fact, evidence from the past decade (Exhibit 5) shows that even before the latest round of stimulus, systemic levels of aggregate indebtedness in Europe are high on a GDP-denominated basis. If anything, it appears that government economic policy response has served to crowd out commercial borrowing levels in the private segments. Another chronic overhang for private lenders; minimal pricing power coupled with volume headwinds.

The question that we attempt to address when constructing our portfolio is, are the quasi-permanent headwinds facing European banks (dismal pricing power, anemic demand, unfavorable cost structures, “political football” status) already embedded in low forward valuations (substantially below book value in many cases)? Relative valuations versus the broader market are undeniably cheap, but many banks are only trading at a modest discount to their own absolute long-term averages. Cheapness does not exist in a vacuum and there are few readily identifiable catalysts around which to build conviction. In our opinion, banks would have to start providing evidence that they have over-provisioned too cautiously against non-performing loans or show a greater appetite for expensive and politically-onerous cost savings. One final favorable top-down tail risk could be the establishment of “bad banks” in the Eurozone to sequester toxic assets from banks’ balance sheets, immunize their legacy effects, and provide

a more solid foundation for remaining businesses. Interestingly, if past is prologue, we recall that Japanese banks outperformed in the wake of similar, long-gestation clean-up initiatives in 2002.

So, are we poised for a similar value-centric rally of European banks? Many broader Japanification precedents appear to be playing out in Europe. However, we currently find that the necessary reforms and conditions for financial sector rehab remain elusive. Ultimately, any such move may only represent a consolidation phase within a longer-term absolute downtrend.

Furthermore, if one is tempted to play such deep Value recovery, it would arguably be more effective to do so via a geographically diverse factor or sector ETF. In a relatively concentrated portfolio of fewer than fifty holdings, we need to weigh the opportunity costs of diluting exposure to self-sustaining high ROE (return-on-equity) compounders in other sectors. Back-testing results show that the power of such compounding metrics tends to be underestimated on a recurring basis, particularly in Europe.

Exogenously, European banks are hostages to stagnant interest-rates, on average, more sensitive to Treasury yield moves than U.S. banks. From a bottom-up perspective, a reluctance and inability to meaningfully repair their balance sheets a decade ago continues to haunt them. From a capacity perspective, Europe is over-banked, a situation tied to a lack of true cross-border consolidation and is therefore fraught with nationalistic political deadlock.

Finally, alternative digital and transaction platforms are gaining traction. The Saudis were famously astute in acknowledging that “The Stone Age didn’t end because the world ran out of stones, and the age of oil will not end because we run out of oil.” Similarly, from a fundamental perspective, abundant cheap money and the availability of credit may be the least of banks’ headaches.

Exhibit 5: Debt as a Percentage of GDP

Source: Berenberg, Eurostat

2008 Household Corporate Government Total 2018 Household Corporate Government Total

Belgium 56.4 149.0 127.5 332.9 Belgium 58.7 170.2 137.1 366.0

France 55.6 118.6 101.2 275.4 France 57.1 142.9 112.4 312..4

Germany 55.7 54.8 83.5 194.0 Germany 53.3 54.1 76.1 183.5

Greece 65.5 66.8 176.6 308.9 Greece 60.0 65.1 186.0 311.1

Ireland 93.2 197.9 112.5 403.6 Ireland 52.1 259.3 75.3 386.7

Italy 43.2 81.0 127.0 251.2 Italy 41.2 73.5 138.9 253.6

Netherlands 115.8 165.7 78.0 359.5 Netherlands 110.0 175.9 76.5 362.4

Portugal 86.1 134.0 143.0 363.1 Portugal 72.6 111.7 146.7 331.0

Spain 77.8 124.3 123.0 325.1 Spain 64.5 104.4 130.8 299.7

UK 84.9 87.9 88.8 261.6 UK 83.3 83.0 107.3 273.6

= Debt/GDP greater than 90% = Debt/GDP greater than 240%



Federal governments and central banks worldwide have reacted quickly with forceful fiscal and monetary policy in response to the COVID-19 pandemic. These policies are intended to supplement incomes and funnel liquidity into banks and financial markets to prevent a sharp credit contraction. So far, these policies have been successful in thwarting a worst-case scenario from an economic perspective. These strong actions, in addition to proactive healthcare measures, allowed emerging equity markets to regain their footing and rebound during the second quarter.

Country level performance generally experienced a reversal from the first quarter. South Africa, Indonesia, and Brazil were among the hardest hit equity markets during the first quarter, but rebounded the most this quarter. Each of these countries has a higher than average industrial commodity dependence within its economy and lower sovereign credit strength. Recovering commodity prices and easing credit stress allowed them to rebound strongly off the bottom.

Unlike country returns, sector returns did not experience a reversal in relative performance. The healthcare and technology sectors continued to outperform, and the financial sector continued to lag behind. The continued outperformance of these sectors is likely due to the unknown duration of the current pandemic. The healthcare and technology sectors will be less negatively impacted, and may even be aided by a continuation of the current crisis. Conversely, the financial sector will experience higher losses if this pandemic continues to linger. The unknown duration is also heavily influencing style returns with growth continuing to outperform. There was a reversal in commodity sectors, which tracked the improvement in oil and industry commodity prices.

We were able to find a number of interesting investment opportunities during the quarter. One such purchase was Kimberly Clark de Mexico. Kimberly Clark de Mexico is the largest producer of sanitary products in Mexico. The company’s business lines have a steady growth profile and a dominant market share. We believe the company is well managed, as evidenced by its strong returns and historical capital discipline. The shares were trading at an attractive valuation despite these strong characteristics due to concerns regarding Mexican economic growth and currency valuation, which we felt were over-exaggerated. Another purchase during the quarter was Sinopharm Group. Sinopharm Group is a pharmaceutical and medical device distribution company. The company has experienced consistent and profitable growth over the past ten years, along with the overall growth in the Chinese healthcare

market. Changes within the Chinese healthcare billing/payment procedures created uncertainty in investor’s minds and depressed the company’s valuation. We believe investors underappreciate the company’s long-term growth prospects and ability to effectively navigate these changes.

The near-term economic outlook is very different across emerging markets. Economic activity is returning to normal in countries such as China, South Korea, and Taiwan that were the first to experience and exit the COVID-19 pandemic. Economic growth has been slower to recover in countries such as Brazil, Mexico, and India that are still experiencing high levels of COVID-19 cases. The valuation backdrop for emerging markets accounts for that uncertainty, we believe. Valuation metrics within emerging market equites appear very attractive relative to long-term averages, which should provide a favorable starting point for returns going forward. The funds valuation metrics are lower than the benchmark with better financial characteristics. We believe this will lead to favorable performance as we exit this global healthcare crisis.

DuPont Capital

Emerging Markets MSCI Emerging Markets Index

# of Securities 71 1,385

Active Share 68.6 --

Price/Earnings 10.0 14.6

P/E using FY1 Est 11.2 15.0

P/E using FY2 Est 9.4 12.3

Price to Cash Flow 7.9 9.5

Dividend Yield 3.3 2.6

Est 3 Yr EPS Growth 33.9 32.7

Est 5 Yr EPS Growth 15.2 17.4

Price/Book 1.2 1.6

ROE 11.9 10.5

ROA 8.7 7.7

LT Debt to Capital 19.7 22.4

Market Capitalization 91,549.8 82,678.3

Exhibit 6: Summary of Portfolio Characteristics

As of June 30, 2020 Source: DuPont Capital

Emerging Markets Equity Erik Zipf, CFA, Head of Emerging Markets Equity



The modus operandi for a quant investor is capturing factor premia. Just as hunters study their prey - observing movement, feeding habits, and other patterns of behavior - we seek to understand and gain insight into trends in factor premia, pivoting into areas of the market where we believe factor premia to be most easily captured. One of the fundamental ways we try to achieve this is by tracking daily factor returns, looking to gain insight from historical trends as they develop through time. However, individual factor premia can behave very idiosyncratically, which makes interpretation and prediction tricky. To overcome this, we aggregate factor premia into groups where they tend to perform in a more predictable fashion. Exhibit 7 shows returns for factor groups for the Russell 2000 during the first and second quarter.

As background, the Russell 2000 fell -31% in 1Q20 and gained 23% in 2Q20 to close the first half of the year down -15%. A similar market pattern was observed in 2009, 2012, and most recently 2016. Comparing recent factor behavior to these prior periods, we find the results tend to be pretty predictable. Quality factors, for example, increased 5.8% relative to the market in 1Q20 as market participants chased more profitable companies with stable margins and low leverage. Quality then underperformed the market by 10.3% in 2Q20 as investors shifted into the beaten-up companies in a risk-on environment backstopped by large liquidity injections from the Federal Reserve. This is simply a repeat of history and makes sense to us. The same can be said for the Momentum and Sentiment factor groups.

On the other hand, Value factor performance has been confounding to the point that we have asked - at what point does the hunt for value premia become too illusive to pursue?

In our 1Q20 update, we noted how over-extended the value premia had become with the valuation spread for Value factors reaching near historic highs in the market downdraft (the spread has only been higher twice in the last 100 years). Past observations would strongly suggest that Value would outperform in a market rebound. However, while Value did rally early in the recovery, it ended up reversing course and actually performed worse in the rebound than it did in the downdraft. Plainly put, this disturbed us greatly.

Most market followers are aware of the trouble the value premia has encountered over the last 10-15 years. As a student of financial history, it is not easy to abandon a premia with such an established long term track record. But the world of Fed intervention via quantitative easing and low/falling growth rates seems to have changed the game for Value.

To help us better assess the factor landscape, we recently developed a factor allocation benchmarking model. The model relies on historical trends, but has a short-term component allowing for greater sensitivity to current trends in factor premia behavior (Exhibit 8). The short-term component currently suggests a 5% weight to Value, which essentially agrees with the premise that Value is becoming almost too illusive to bother pursuing.

With respect to the US Small Cap Portfolio, we moved our Value allocation closer to the short-term model view during 1Q20. However, beginning in 2Q20, we increased Value back inline with what the longer-term component would suggest, hoping to catch an uplift from the market rebound. Unfortunately, as detailed above, the hunt was unsuccessful, and we fully expect to reduce our value weight going forward.

US Small Cap, Structured Equities Caleb Piper, CFA, Portfolio Manager and Senior Investment Analyst

Exhibit 7: Year-to-Date Factor Premia

Exhibit 8: Factor Allocation Benchmarking Model—Short Term Component

Source: DuPont Capital

Source: Bloomberg, DuPont Capital



During the quarter, M&A volumes and deal count were down sig-nificantly due to COVID-19. The decline was not a surprise, as companies devoted more attention to internal crisis management rather than weighing time-consuming deals and integration risk. Furthermore, the due diligence process was hindered by the ina-bility to conduct onsite asset inspections and participate in face to face negotiations. After all, M&A is a relationship process and there is only so much that can be accomplished via Zoom. Recent conference calls with M&A bankers have tried to paint a brighter picture with reports that prospective buyers are using drones to remotely inspect assets. We are cognizant that bankers are almost perennially bullish on future M&A prospects, but we are sympa-thetic to their view that the M&A cycle has been paused rather than entirely derailed. Once M&A starts to rebound, we expect most corporate deals to use stock as currency, as the economics of the deal depend on the relative stock valuation between the buyer and seller at a point in time. In a cash deal, there is more risk to the buyer around the timing of the cycle. In merger arbitrage, we focus more on the potential arb spread rather than the particular consideration, although implementing stock deals may depend on the available short borrow in less liquid deals.

Going forward, we believe new deal volume will be impacted by a few factors. As discussed previously, COVID-19 has slowed deal making and we expect a re-escalation in the number of cases will have a similar impact. We also expect cross-border M&A may be hampered by rising protectionist measures as several host coun-tries have recently floated proposals to protect domestic compa-nies in sensitive industries from unwanted M&A advances. Last, we believe deal activity may be subdued until after November’s US presidential election when management teams will have better visibility of the regulatory and economic environments.

Although several pending deals successfully closed during the quarter, deal breaks that have entered litigation are occurring at a much higher rate than in the past. Typically, deal breaks occur during downcycles as buyers second guess the rationale for the deal, or the weakening economic environment erodes the deal economics. In these cases, the buyer alleges that the target has suffered a material adverse event (MAE) and breached ordinary course covenants. However, as discussed last quarter, the burden to prove an MAE is quite challenging. In the entire legal history of Delaware chancery court, there has only been a single proven MAE - the Akorn/Fresenius deal in 2018. In that case, the court ruled that an MAE must be durationally significant, meaning the target’s weakness must last years rather than months or quarters. Given COVID-19 was only declared a pandemic in March 2020, it is

far too early to definitively conclude that economic weakness is durationally significant. As such, precedent should favor the seller. Furthermore, several of the merger agreements specifically carve out pandemic effects, so COVID-19 would not qualify as an MAE regardless of duration unless it could be proven that it has had a disproportionately negative impact on the target relative to its peer group. However, a disproportionality test is only conducted if an MAE is determined meaning durational significance would still need to be proven. This creates a very high hurdle favoring the sellers in litigation.

Buyers are alternatively pursuing “back door MAE” strategies by arguing that recent actions by sellers during the pandemic have breached ordinary course covenants to conduct business con-sistent with past practices. There is no strong legal precedent around such claims, leaving significant uncertainty about how the courts will interpret what constitutes “consistent” and what are reasonable deviations in times of stress.

Recent litigation highlights just how gray this area can be. For ex-ample, in a case involving Simon Property Group (buyer) and Taub-man Centers (seller), the buyer alleged that the seller was not ag-gressive enough in restructuring actions such as cutting salaries and furloughing employees. However, in a case involving Advent (buyer) and Forescout Technologies (seller), the buyer argues that the seller’s headcount restructuring was a deviation from ordinary course. In one case, the buyer insists the seller did not reduce headcount enough, while in the other case, the buyer claimed the seller’s job reductions were inappropriate.

Courts will likely be reluctant to get mired in the details of whether a five or fifteen percent headcount reduction was appropriate during the pandemic. We instead believe the courts will consider the actions of company peers in determining what is ordinary course. We also expect future merger agreements will be far more specific on the actions permitted under ordinary course.

We see these types of strategies as a “Hail Mary” - if the buyer loses, they would at worst have to complete a deal already agreed to. Why not take a risk, prolonging the deal so there is more time to see the potential effect of economic weakness on the target? In most cases, however, courts have upheld the sanctity of merger contracts. By allowing buyers to wiggle out of deals whenever the economy weakens, courts could open Pandora’s box. It is always difficult to predict the nuances of specific case outcomes, but we feel comfortable in most instances today, that sellers have strong justification and legal protection to enforce the merger agree-ment.

Merger Arbitrage Harris Arch, CFA, Portfolio Manager and Senior Equity Analyst Dan Moore, CFA Portfolio Manager, Merger Arbitrage



During the second quarter of 2020, global equity markets rallied significantly from the trough reached during March. The strategy managed to outperform its benchmark by 139 basis points (bps) with a tracking error of about 2%. In the first half of the year, the portfolio accumulated 188 bps of alpha.

By factor, beta recovered some of the losses accrued during the first quarter while positive exposure to liquidity and growth also helped relative performance. The performance of valuation factors in aggregate remain neutral, as does the momentum factor.

By sector or industry, information technology, real estate, consum-er discretionary, consumer staples, and communication services were all contributors to positive relative performance during the

quarter. Detractors included health care, industrials, and materi-als. Energy, utilities, and financials were largely neutral.

The global COVID-19 pandemic continued to dominate market sentiment. The major indexes recovered most of the losses suffered during the first quarter, however, differences among gov-ernment policies have started to add an additional layer of uncer-tainty on the market. For the intermediate time horizon, we still believe market volatilities will remain elevated. We believe risk management will be key to navigating the volatility, and therefore, we are not taking any outsized bets at the moment.

Global Small Cap (ex. us), Structured Equities Juncai Yang, CFA, Portfolio Manager and Senior Investment Analyst



About our firm:

DuPont Capital Management is an SEC registered investment advisor based in Wilmington, Delaware. Since the firm’s establishment in 1993, we’ve had a long history of developing global investment opportunities in both traditional and alternative strategies across equity, fixed income and alternative investments. Our investment team structure gives us the ability to be flexible and adapt to changing market conditions. DuPont Capital’s focus is delivering consistent investment management results for our clients. Our history of institutional asset management is rooted back to 1942 when our former parent company, DuPont, established a pension plan for its employees. Corteva Inc. succeeded DuPont as sponsor of the DuPont Pension Plan in 2019. DuPont Capital is a wholly owned subsidiary of Corteva and continues to manage the legacy DuPont Pension Plan.

DuPont Capital’s President and CEO, Valerie Sill believes in education and diversity of experience as represented in our investment teams which are comprised of PhDs, engineers, medical doctors, and scientists. We believe their global expertise creates a portfolio implementation edge that benefits our clients.

For additional information, please contact:

Mr. William Smith Managing Director Business Development and Client Service (302) 477-6204 [email protected]

Important Disclosures:

The information contained in this memorandum is intended for the sole use of understanding and evaluating the impact of market events and is not designed or intended to be used for any other purpose. The document may contain forward-looking statements, which are based on current opinions, expectations and projections. DCM undertakes no obligation to update or revise any opinions or statements herein. Actual results could differ materially from those anticipated in forward-looking statements. Information contained herein has been obtained from sources believed to be reliable, but DCM does not guarantee the accuracy, adequacy or completeness of such information. An investment in securities includes risk of loss. There is no guarantee that any investment in the securities mentioned will be profitable. Past performance is not indicative of future results.

This document is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument or as a recommendation to invest in any of the securities or financial instruments discussed herein. Registration of an investment adviser with the SEC does not imply any level of skill or training. No part of this presentation may be reproduced in any form.

Composite Performance - Disclosures

December 31, 2019:

1. DCM is an investment adviser registered under the Investment Advisers Act of 1940. DCM is a wholly owned subsidiary of Corteva, Inc. 2. Performance results reflect the reinvestment of dividends, income and other earnings 3. Gross-of-Fees returns are presented before management and custodial fees but after all trading expenses. Net-of-Fees returns are calculated by deducting the highest applicable fee rate in effect for the respective time period from the gross return. Actual fees may vary depending on, among other things, the applicable fee schedule and portfolios size. DCM’s fees are available upon request and also may be found in Part II of our Form ADV. 4. Securities and other instruments in which the composite invests may be denominated or quoted in currencies other than the U.S. dollar (Base Currency). Changes in foreign currency exchange rates can affect the value of an investor's account. This risk, generally known as “currency risk,” means that a strong U.S. dollar (Base Currency) will reduce returns for investors while a weak U.S. dollar (Base Currency) will increase those returns. 5. Past performance is not indicative of future performance. It should not be assumed that results in the future will be profitable or equal to past performance. These performance disclosures apply to all of the DCM investment performance data presented herein.

Composite Descriptions:

DCM Small Cap Equity (inception date – 04/01/1999) includes all accounts that are primarily invested in U.S. small cap equity securities utilizing a value-based strategy. This strategy, which is industry neutral, utilizes a multi-factor model that includes proprietary estimates of normalized earnings, normalized cash flow, sustainable growth, and quality. The composite benchmark is the Russell 2000® Index.

DCM Value Creators - US Mid Cap (inception date – 01/01/2017), formerly named DCM US Mid Cap Value Creators, includes all accounts that are primarily invested in U.S. mid cap equity securities utilizing a value-based strategy. Investments are focused in companies having a favorable competitive environment, excellent management teams, superior fundamental outlooks, and return incentives well-aligned with shareholders. Through in-depth fundamental research supplemented by quantitative screening, the portfolio targets investments possessing these characteristics which we believe have the greatest potential to generate superior per share value creation throughout economic cycles. The composite benchmark is the S&P 400 Index.

DCM Value Creators - US Large Cap (inception date – 01/01/2017), formerly named DCM US Large Cap Value Creators, includes all accounts that are primarily invested in U.S. Large cap equity securities utilizing a value-based strategy. Investments are focused in companies having a favorable competitive environment, excellent management teams, superior fundamental outlooks, and return incentives well-aligned with shareholders. Through in-depth fundamental research supplemented by quantitative screening, the portfolio targets investments possessing these characteristics which we believe have the greatest potential to generate superior per share value creation throughout economic cycles. The composite benchmark is the S&P 500 Index.



Composite Descriptions (continued):

DCM Merger Arbitrage (inception date – 06/01/2015) includes all accounts that invests in pending merger and acquisition deals, seeking to capture the spread between the target’s current price and the deal price upon close. The strategy invests in both cash and stock deals. In cash deals, the strategy is long the target’s equity security. In stock deals, the strategy is long the target’s equity and short the acquirer’s equity, according to the deal terms. Portfolio weightings are dependent on the risk and return characteristics of the pending deal. The strategy makes use of leverage (by borrowing securities for shorting). The composite benchmark is the 3 Month T-Bill.

DCM Global Ex -US Small Cap Structured Equity (Inception Date – 01/01/2015) includes all accounts invested in global small cap (Ex-US) securities that utilize a quantitative value-based strategy that ranks stocks based on several measures of value, sentiment and improving risk. Portfolio optimization influences stock weighting. This strategy is industry and country neutral. The composite benchmark is the MSCI ACWI Ex-US Small Cap Index.

DCM International Equity (inception date –01/01/2017), formerly named DCM EAFE High Conviction, includes all accounts that are primarily invested in non-US equity securities. Portfolio holdings include equity securities from developed and on occasion emerging markets. This strategy uses a bottom up fundamental approach investing in stocks that trade at a discount to their intrinsic value, supplemented by measures of business quality and improving fundamentals. The composite benchmark is the MSCI World Ex-US Index. Effective 01/01/2020, the benchmark changed for this composite to the MSCI World Ex-US Index from the MSCI EAFE Index.

DCM Emerging Markets Equity (inception date –10/01/1999) includes all separately managed and sub-advised accounts that are primarily invested in equity securities incorporated in emerging market countries. The strategy invests primarily in ordinary shares; however, it can also invest in American Depository Receipts (ADR), Global Depository Receipts (GDR) and US dollar-denominated equity securities. This is a value-based strategy which seeks to broadly diversify holdings across emerging market countries, striving to overweight companies that are attractively priced (low price-to- earnings, price to book and/or price to cash flow ratios) relative to other companies in the index. The composite benchmark is the MSCI Emerging Markets Index

Benchmark Descriptions:

The Russell 2000® Index is based on 2,000 small-cap companies in the Russell 3000® Index. The index returns are calculated on a total return basis with dividends reinvested. The returns for this index do not include any transaction costs, management fees or other costs.

The S&P 400 Index is a market-capitalization-weighted index of 400 U.S. publicly traded companies with mid-range capitalizations. The returns for this index are calculated on a total return basis with dividends reinvested, however do not include any transaction costs, management fees or other costs.

The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. The returns for this index are calculated on a total return basis with dividends reinvested, however do not include any transaction costs, management fees or other costs.

3-Month T-bills are issued by the U.S. Government and mature every three months.

MSCI ACWI (All Country World Index) Ex-US Small Cap Index, which captures small cap representation across 22 of 23 developed markets countries (excluding the US) and 26 emerging markets countries. With 4,210 constituents, the index covers approximately 14% of the global equity opportunity set outside the US. This index is net total return which reinvests dividends after the deduction of withholding taxes. The returns for this index do not include any transaction costs, management fees or other costs.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. This index is net total return which reinvests dividends after the deduction of withholding taxes. MSCI uses the maximum withholding tax rate applicable to institutional investors. The returns for this index do not include any transaction costs, management fees or other costs.

The MSCI World Ex-US Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US. This index is net total return which reinvests dividends after the deduction of withholding taxes. The returns for this index do not include any transaction costs, management fees or other costs.

EQUITY STRATEGY REVIEW · the prevalence of zombie companies since the 1980’s3. From 1995 to...

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