Not unlike the regenerative quality of an Australian summer bushfire, equity market corrections are a necessary evil of healthy and well-functioning markets. More often than not, they allow share markets to recalibrate and consolidate over the shorter-term, whilst also acting as an agent to transfer capital from weaker, short-term hands into those that can benefit from a longer-term mindset.
While the recent correction has eroded value in the immediate short term, we continue to remain optimistic about the corporate outlook for Australian-listed businesses and the opportunities ahead for both portfolios.
In this wire, we discuss how we are thinking about markets right now. We also revisit our five-point checklist for ensuring portfolios are meaningfully protected through inevitable periods of downturn while being well positioned to participate in a resultant recovery.
Certainly, with global interest rates still close to generational lows, it is not an overly brave call to suggest that interest rates across the world are heading higher over time and equity portfolios need to account for this risk. The great unknown, of course, is the timing of these moves and we expect to see continued equity market volatility with each leg up in US long bond yields.
The most recent sell-off has brought equity markets valuations back to more appealing levels, not just across Australian small and mid-cap companies but also more broadly. Across the US equity market, for example, significant retracements across both the S&P 500 and NASDAQ occurred at the same time as ~78% of companies delivered better-than-expected third quarter earnings results.
While share prices declined in-line with global averages over the month, reported EPS growth for US companies hit +24.9% (noting S&P 500 profit margins grew by 12% year-on-year, their largest 12-month increase in history). This divergence in ‘P’ from the ‘E’ has seen 2018 now register the third largest contraction in price/earnings multiple in a calendar year in over 40 years.
S&P 500 Change in Calendar Year Price/Earnings – 1976-Present
Source: Credit Suisse, Factset, Standard & Poors
While rising US bond yields and an increasingly aggressive US Federal Reserve will ultimately lead to further equity market volatility, we would suggest that both factors also likely lead to continued support for the US Dollar from here. While there were little asset classes for investors to hide in October, the US Dollar provided one avenue of solace, generating a further +2.1% rise on a trade-weighted basis – its seventh consecutive month of appreciation.
A sizeable number of businesses within Australia that are generating high levels of earnings growth are doing so via exposure to higher-growth offshore markets. With an AUD-domiciled cost base and US/Euro revenues, we expect a number of these businesses to continue to benefit from the tailwind provided from a stronger US dollar.
Australian economy looks positive
Closer to home, we remain positive on the trajectory of the current economic cycle, albeit recognise we are in the later stages of the bull market run and more normalised volatility from here is expected. Australian businesses are continuing to find good opportunities to grow (and grow quickly), margins are expanding and access to capital remains cheap.
While equity market volatility has been further compounded by domestic concerns around the East Coast housing market, financial regulation and an increasingly tepid outlook for discretionary retailers, Australian and international boardrooms are still deploying capital aggressively.
October saw another month of larger corporate M&A deals, with Navitas (NVT), Healthscope (HSO) and MYOB (MYO) all receiving initial or increased takeover offers, while WorleyParsons (WOR), Webjet (WEB), Ramsay Healthcare (RHC) and Freedom Foods (FNP) all announced major acquisitions.
In a low-growth domestic environment, we continue to believe that businesses that are displaying an ability to generate above-market rates of earnings growth will continue to be rewarded. The price at which we can access those businesses will ultimately be determined by the ebb and flow of market sentiment in response to the latest global macro news point.
Recent equity market volatility represents a return to more normalised levels (following a 2017 calendar year that experienced the lowest levels of equity market volatility on record) and we remain expectant that price volatility will grow an increasing feature over the months ahead.
For bottom-up, active stock pickers, more volatile equity market environments should deliver increased opportunities to generate outperformance – with an improved opportunity set ahead courtesy of the recent reset in valuations, we continue to remain optimistic of delivering solid returns on our invested capital
Portfolio Management through times of Volatility
Through periods of heightened market volatility, it is natural to receive some questions from investors around portfolio construction and how we, as long-only investment managers, can look to ensure that portfolios can be protected through periods of inevitable downturn. You can read our five-point checklist in full here, or our summary below.
1) Focus on Balance Sheet
As a general rule, we will always tend to avoid highly geared businesses across both Funds and instead favour companies where we have a high degree of comfort in their ability to self-fund all near-term obligations. Strong balance sheets not only ensure that shareholders will avoid emergency-type capital raisings through times of acute market distress, but also provide management with the lucrative optionality of being able to deploy capital into acquisitions at a time when competitors may be forced sellers.
2) Focus on Quality of Business
While balance sheets indicate financial leverage; we also want to have a thorough understanding of operational leverage (or how sensitive a company’s earnings are to an underlying driver or economic variable). Ultimately, higher quality businesses are those that are able to demonstrate a resilience of earnings regardless of the underlying market cycle and won’t face critical headwinds in the face of global recessionary environment. While earnings growth may slow, higher quality businesses are not likely to present a scenario in which shareholders could face a permanent loss of capital. Our exposure to businesses with more economically resilient business models or non-correlated earnings streams will tend to increase through periods of broader market uncertainty.
3) Don’t Overpay for those Businesses
Excluding periods of heightened market volatility or distress (when even excellent businesses can sometimes be available at attractive prices), business quality doesn’t generally come cheap. The ultimate return generated on capital invested is always a function of the price paid and there is little upside in paying overtly high prices for even the best quality businesses. Investing, to us, starts and finishes with valuation and ensuring appropriate parameters exist around valuation metrics for each portfolio inclusion (and of the portfolio as whole) ensures capital is invested sensibly and actively rotated when valuation support is removed.
4) Remain Mindful of Liquidity
Like highly geared balance sheets, it is not until one faces periods of heightened financial stress that the underlying liquidity of an investment (or lack thereof) becomes immediately apparent. Smaller and micro-cap companies tend to wear the greatest cost of tighter liquidity conditions during market drawdowns and we are mindful to ensure a large proportion of both portfolios are invested in easily tradeable securities.
5) Invest Alongside You
Finally, whilst not a structural measure, we always remind investors that we have our own personal wealth invested directly alongside their own. The entirety of our own personal liquid investments are held within the Ophir Funds – the protection of capital in the Funds for us means the protection of our own entire savings pool. This ensures that we think and act like unitholders, with only our unitholders best interests in mind.
This was an extract from Ophir's November monthly letter to investors