The Monash portfolios had delivered strong returns prior to the COVID-19 sell-off. How were you positioned leading into the sell off?

We had been taking profits in January as some of our stocks neared their price targets. We ended the month at 20% cash, up from 8% in December 2019. That February cash level was relatively neutral for us. We are a long-biased hedge fund and our average cash weight since we started 8 years ago has been 25%.

The news on COVID-19 out of China got worse over the first two weeks of February. Our initial view was that the companies affected would be those directly exposed to China as a source of customers or product manufacture. During that time, we were comforted by the low risk assessments of the World Health Organisation and the USA’s Centers for Disease Control and Prevention (CDC).

Then, on the 26^th of February, the CDC made a telling adjustment to their advice. “However, it’s important to note that current global circumstances suggest it is likely that this virus will cause a pandemic. In that case, the risk assessment would be different.”

We saw that as a clear signal of likely developments, and we acted on it. Our initial response was to sell/short businesses exposed to travel and tourism and those that have logistics chains into China. We also targeted our short positions to stocks with higher liquidity which enabled us to rapidly respond to signs of a market recovery. Overall, we reduced our exposure to the market so that our cash weight, which had been about 20%, finished February at about 40%.

Did the portfolio perform as you would expect in the sell off?

As the news got worse in the first two weeks of March, the portfolio fell about 9%, while the ASX200 fell 13% and the Small Ords declined 16%. So, the cash and our short positions really helped. But on a pro rata basis, we were more or less in line with the market. That was okay considering our stock holdings comprise businesses that we expect to perform very well over time, and they tend to trade on higher multiples. It was the higher multiple stocks that tended to fall the most.

What changes did you make to portfolio positioning over the past month and why did you make these changes?

Despite bad news momentum building, the market held up for the first few days of March, so we did a bit more selling on the 5^th of March. The cash weight increased to 50% through shorting exposures to education and aged care sectors.

Only one week later the market was down 18% for the month and we started to see bargains in a number of quality growth stocks, with very little, if any, exposure to the consumer or logistical effects of COVID-19. We had previously avoided buying a few of these because of their excessively high price multiples. This buying reduced our cash level back to 40%.

That didn’t seem so clever only another week later. At which time the market was down a total of 29% for the month to date, which with hindsight was its low point on the 23^rd of March.

On the one hand, we knew it was unquestionable that the market was oversold. The pandemic would play out, one way or another. In time, the market would recover strongly as it looked beyond the short term loss of earnings and the equity dilutions from capital raisings.

Covid 19 is a health care crisis, specifically the ability of the hospital system to treat patients. The solution has been social distancing that has resulted massive disruption to the economy. The economy is not weak due to cyclical factors such as high corporate debt levels, underlying over supply or demand destruction. It is weak due to forced closures and once these are lifted, economic activity will return.

On the other hand, we didn’t feel it wise to try and catch a falling knife. This tempered our desire to take advantage of the “bargains.” We bought modestly, and at the end of March our cash weighting was 34%.

Are you bullish / bearish on the outlook for equities right now? What are some of the factors supporting your view?

We are bullish.

The market incorporates future expectations very quickly. So quickly, that there is often not much time to react. At the same time, the future is always uncertain, and never more so when there is a crisis, making it even harder to act promptly. The temptation is always to wait for more information. By then it is usually too late.

Here are the main reasons why we are bullish:

1. The value of a company is the discounted cashflow of its earnings over time. And when times are uncertain price discounts for risk are greater. So right now, stocks are being hit with a double-whammy. On an even conservative view, in six months’ time we will be sufficiently progressed through this health crisis that the market will be pricing a much more normal set of company earnings forecasts and uncertainty will have reduced.
2. It’s not “too soon” to buy. We don’t need the crisis to be resolved. We just need to be able to see when the worst will be behind us and have a feel for how bad that “worst” will be. Now that new infection rates are falling globally, and the demonstrable success of social distancing measures, we are well past that point.
3. The catastrophists were wrong. After only about a month of lockdowns, countries are already planning a staged unwinding of restrictions. Infection resurgence remains a risk we watch closely, however, the efficacy of social distancing, widespread testing and contact tracing is now proven.
4. It’s likely there will be a drug found that will reduce the symptoms or inoculate us against COVID-19 at some point. There are many companies urgently working on such drugs and trials are already taking place. While not a certainty, news of success is a risk to the upside.
5. Low interest rates will continue. Technology, demographics and central bank dovishness have been placing downward pressure on interest rates for the last 30 years. Low rates will be needed now more than prior to COVID-19, to support the economy and help governments pay down debt. This will be one of the key long lasting impacts of Covid-19, as interest rates will need to stay low for a very long time to allow Government to replay the enormous deficits / debt that are being incurred.

How is this outlook reflected in your current positioning?

Since the end of March, we have continued to buy stocks and unwind our shorts. We are currently fully invested. As always, we continuously monitor emerging developments and factor these into our portfolio positioning with agility.

Are there stocks / sectors that you owned pre COVID-19 that you no longer want to own due to a materially changed outlook? 

Stock prices have moved so fast. There are sectors and stocks we were selling/shorting because they were negatively exposed to COVID-19, which we have now turned around and bought back or covered because they have been oversold, or because the crisis will not be that bad for them.

For example, IDP Education Limited (ASX:IEL) is a co-owner of IELTS, the world’s most popular English language test for tertiary institutions. While the provision of services to overseas students has taken a hit this year, demand for Western universities will recover over time with appropriate infection testing and immigration safeguards. Initially we shorted IEL, we since covered and went long at a lower price. We have made money from our short and have also made money (so far) from our long.

Is there a stock / sector that you believe is set to emerge stronger from the COVID-19 crisis?

Kogan (ASX:KGN) has been a beneficiary. Australia’s largest internet only retailer. With so many people needing to work from home, demand for computers and their peripherals has climbed. People are also doing jobs around the house, or buying things for it now that they have some extra time on their hands. With Kogan, they can organise their purchases and deliveries while sitting at home.

This has really accelerated Kogan’s share of the retail market in Australia. They are not just selling more to existing customers but also picking up new customers. During March 2020, Kogan’s active customer base enjoyed the largest monthly increase since its IPO. This gives Kogan a bigger database for the marketing of their other verticals, such as mobiles, insurance and utilities.

You’ve been an investor in Afterpay over the past 12 months. Do you currently hold the stock and what is the rationale behind your positioning?

We rebuilt our position in Afterpay (ASX:APT) following its price fall. We did this only once it became clear that their transaction losses would continue to be low.

While their sales from bricks and mortar retailers have hit a wall in the short term because of the shutdown, their online sales are still growing strongly. However, the company has increased its risk hurdles for new customers, which has acted to slow its growth a little.

APT recently gave a market update. Overall, the first two weeks of April were a bit above the first two weeks of March, and 10% above the last 2 weeks of March. This is very solid given that March was APT’s 3^rd biggest month on record (after Nov/Dec of 2019).

We see the APT investment thesis as unchanged, and its growth trajectory will be re-established in the next year or so. Our price target has dropped a little because of the near term sales slowing from our previous expectations, and after providing for an increase in transaction losses. However, rebuilding our position after the price fall has meant that we expect a greater pay-off to investors now than before COVID-19.

I note your portfolio is outpacing the market in the current bounce. Is there a part of your investment process that has helped or worked well?

We are doing well in the bounce (so far). We reported as of Friday 17 April that our portfolio was up 15% for the month to date after fees while the ASX200 was up 8% and the Small Ordinaries up 11%.

The flexibility of our mandate has been an important contributor. We can vary our cash levels, go short, as well as long, and can disregard the composition of the market indices when investing.

But the flexibility counts for nothing if we don’t make good investment decisions. We only invest in stocks that meet our high pay-off hurdles, using discounted cashflows as the main valuation tool. If a stock hits our price target we sell out and hold cash, as we did in January and February this year. We are happy to hold cash if we can’t find stocks to buy.

We do our own research and modelling. When assessing a company’s future sales, profitability, balance sheet and cashflow, we look to rely on recurring business situations or patterns of behaviour we have seen before to give us some confidence in our forecasts.

Shane Fitzgerald and I have been in the investments markets since around the time of the 1987 crash. Over that time we have seen many situations that crop up from time to time.

All these things have come together in this latest market dislocation.

We never stop learning. What is one lesson that the team at Monash picked up over the past few months?

This crisis has reinforced the importance of short term business liquidity to a stock’s value. It doesn’t matter that the balance sheet is strong, if they run out of cash. This has forced a number of highly discounted and dilutive equity raisings recently. It is possible to make educated guesses as to which companies are at risk and to act accordingly.

Benefit at every stage of a cycle

Monash invest in a small number of compelling stocks that offer considerable upside and short expensive stocks that are at risk of falling. Want to learn more? Hit the 'contact' button to get in touch or visit their website for further information.