Compelling opportunities amid the sell-off
This is the biggest economic shock of our lifetimes and we have already seen a fair share of records broken: the fastest crash ever, the biggest stimulus, and the largest job market losses.
Markets went into this crash with a full head of steam, trading on some very high valuations. Only in three periods have valuations been so high: 1929, 2000 and 2020.
But importantly, in all these crises, there's always a domino effect. So, in this crisis, we must think what are the second, third and fourth-round effects?
Just as housing debt was the problem heading into the GFC, corporate debt was the outstanding problem heading into this crisis.
This is particularly coupled with companies that have listed recently that are yet to post profits. We think the implications of this have a long way to play out.
These sort of shocks bring a lot of opportunities and the key thing is you have to be in a position to grab them. This is why we like to have a portfolio with a large toolbox able to snap up the best value in Australia, or globally, but also have the flexibility to hold some cash to defend the portfolio.
Long-term value investing has shown a propensity to add value over the long term. Like the GFC, value stocks in the financials, energy and resources sector were the most sensitive to the crash. But once markets bottomed in March 2009, value stocks strongly outperformed. This was the result of their strong recovery from beaten-down levels and benefits from the cyclical recovery.
We share the same outlook and taking a long-term view, we believe the new positions we have taken and existing positions we have increased have all been in high quality companies trading at discounted valuations. Our quality and value approach plus the flexibility in our investment strategy means that we were able to outperform not only as markets fell, but also as they rose, while still maintaining a value-orientated portfolio throughout.
Balance sheet strength is paramount
The balance sheet of companies is critical in times of market stress. This was evident in the companies we own as their strong balance sheets provided some downside protection during the initial part of the sell-off.
As the markets fell in March, we identified and assessed the companies exposed to risks as a result of COVID-19 and either removed them from the portfolio or significantly reduced the exposure. For example, Norwegian Cruise Line Holdings which was immediately impacted by COVID-19 given its travel and leisure operations. We largely consider there to be a high correlation between macroeconomic events and the impact on banks and therefore reduced our exposure to Lloyds Banking Group and exited our position in NAB.
Opportunities presented during market volatility have been rewarded
The large toolbox in our portfolio included substantial cash prior to the market crash. This allowed us to deploy cash into the companies trading at discounted valuations as a result of the market volatility. Some even trading at 40% - 50% discounts. These companies are high quality businesses with conservative debt levels, solid management and recurring earnings and were previously trading at valuations we considered too high. The market volatility meant we were able to take advantage of these companies we had our eye on.
For example, Persimmon Plc which is a leading UK home builder with a net cash balance sheet. Persimmon’s share price fell discount 50% during the crash and is an asset rich cyclical which we believe is poised to recover. If we focus on mid-cycle returns, looking past the next 6 to 12 months, we do not believe that the market has priced in any recovery for Persimmon.
The crash also gave us an opportunity to top up our existing holdings at discounted values. For example, AUB Group, Flutter Entertainment and La Francaise Des Jeux SAEM. In particular, Flutter which we have held almost a year. During the market crash, we doubled our position in Flutter as it was trading around £55 and has since rebounded strongly with the share price at £97.50 on 30 April 2020.
During the days of maximum fear, even the best companies were subject to indiscriminate panic selling like Crown Resorts. We've always said this was a great quality company that was trading at a very low valuation given its world class assets and virtually no debt. Private equity firm, The Blackstone Group recently agreed with us, and took a 9.99% stake in the closing days of April, validating our position.
The impact of COVID-19 on the share market has forced certain companies to compress structural changes likely to have occurred in the next five to seven years, in just two months.
This is a case in point for Flight Centre as they restructured their business to consider shifts to online business and changes to travel following the easing of self-isolation. Flight Centre have a prudent management team who have experience in managing crises previously and their entry price of $7.20 is not only attractive but well under their true underlying value. As we have followed Flight Centre over time, we were able to take advantage of this opportunity quickly and participate in their capital raising.
It is times like these that our active management style with a focus on value and quality that gives our investors an edge. We are still seeing value opportunities out there, as volatility will persist for the next several months. Our flexible investment strategy enables us to proactively and quickly take advantage of opportunities as they arise, and we are focused on our style and stock selection adding to value over the next few years.
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Vince is the Deputy Head of Equities at Perpetual Asset Management Australia and is the Portfolio Manager for Australian Share, Geared Australian Share and the Perpetual Equity Investment Company Limited (ASX:PIC).