So how is this going to play out?
Without trying to sound like an expert the issue at hand for most economies is not so much the sickness and deaths associated with the virus itself, it is the government and corporate policies put in place to try and restrict the virus from spreading. While this reaction is understandable, the aggregate impact of bans on international and domestic travel, enforced working from home and a sudden drop in consumer confidence is going to have an impact on the economy. Clearly this is going to have a more acute impact on some industries (travel, entertainment, hospitality, retail) than others.
This sudden demand shock in certain industries is going to provide liquidity pressures, especially for some small to medium companies. The other area where it will continue to cause problems is supply chains. Given the integrated nature of international trade, when China shuts down, it negatively impacts everything from car parts to hospital supplies. All this culminates in lack of consumer confidence.
When this happens suddenly on a global basis, it is extremely hard for corporates both big and small to be prepared.
All of the above is pretty well known, so let’s play this out over the next three to six months.
Initially we will see a heap of casual employees lose their jobs and there will likely be hiring freezes in the most acute hit industries mentioned above. There will likely be a pick-up in small business bankruptcies. This will probably have an outsized impact on smaller companies which were probably already struggling but this liquidity crunch pushes them over the edge.
I envisage there will be hiring freezes across the board as we saw in the Qantas announcement followed by redundancies as corporate try and reduce their fixed base to negate the impact on margins. The longer the shutdowns, the more intense the impact on employment in aggregate.
The next question is whether or not this feeds into a credit cycle. Clearly the longer the demand shock the bigger the impact. The canary in the coal mine will be the payday lenders and Buy Now Pay Later providers given their exposure to a demographic who are probably more heavily weighted to casual employment. Some Buy Now Pay Later operators do little in the way of credit checks and hence will have a book full of people close to the edge already.
Where are we looking and where are we still cautious?
Remain Cautious on some of the financials
- Investment Platforms/Financial Planners/Fund Managers: Investment platforms generate a large proportion of their earnings from the interest rate spread between the interest they pay clients and the interest they can get from the bank. This will collapse in a zero-interest rate environment. All three of these businesses are leveraged to equity markets. With the recent equity market falls, there will be earnings headwinds.
Financial Asset Volatility: It is extremely hard as an outsider looking in to know what financial companies have on their balance sheet and understanding that some business models require an open securitization market as part of their business model. With such massive volatility in FX, commodities and bond/equity markets it is extremely difficult to understand what investment banks globally are exposed to and whether they are on the right side of this volatility or not. The concern is that by and large a lot of investment banks tend to be short volatility but that is not always the case.
Watch the Balance Sheet, Cashflow and Operating Leverage
During bull markets, it doesn’t pay to focus on balance sheets, however, it is at times like this that the equity market participants stop becoming virus experts and start to try and become credit experts. An intense focus on companies’ cashflow and balance sheets is essential. Clearly the absolute level of debt is a focus but also understanding the terms of the debt and the covenants is something we spend a lot of time on. There also needs to be an understanding the asset side of the balance sheet. Is the company asset rich or does it lease all of its properties and only have goodwill on the asset side of the balance sheet? Companies like Harvey Norman, Bingo Industries and AP Eagers all have a lot of property on their balance sheets which puts them in good stead in any downturn. It is no co-incidence that these companies still have founding majority shareholders. We view these principal owned and operated businesses favourably. They tend to think long term and are asset rich rather than get seduced into short term sugar hits like sale and lease backs. Understanding the operating leverage is extremely important as well.
Companies with high fixed costs and low margins are more prone to generating negative cashflow in a demand shock rather than companies with high margins and low fixed costs.
For a company like TABCORP, most of its costs are variable costs (tax and racing industry fees) which makes us a little more comfortable than most retailers which have high fixed cost leverage. These are things we spend an enormous amount of time analysing whether or not we are in a bull or a bear market.
So, what are some of our observations about balance sheets across the companies we look at?
- A demand shock will result in a liquidity crunch for a lot of companies. Understanding how strong a balance sheet is going into this liquidity crunch will give us a good feel for whether a company will survive and whether or not this company will have to come to market with an emergency capital raising and permanently impair long term value.
A strong balance sheet will put a company in a great position to acquire other companies at depressed prices. Amcor buying Alcan from Rio is the best example of that in 2009 but more recently AP Eagers bought its larger competitor Auto Holdings during its downturn.
Watch out for Contractors with problem projects. At the interim results we observed that the construction contractors Lend Lease, Cimic and Downer all had extremely poor cashflows. With Cimic and Lend Lease the cash is unlikely to improve in the short term due to completion of problem projects. In a market environment where asset sales and equity raisings are more difficult one needs to watch out for these companies.
Both airlines and travel agencies have a negative working capital business where customers give them cash before they travel and hence this cash is used to operate the business. In the event that there is a demand shock, this could create a liquidity crunch for both airlines and travel agencies.
Concept Stocks: A lot of the highflyers over the last few years have been concept stocks. These are companies which are loss making all the way up the profit and loss statement and don’t even generate much revenue. However, they have sold a dream of being the next Amazon or disrupting a market with a trillion-dollar TAM. They are serial capital raisers so are an investment bankers’ best friend (and hence generally have positive recommendations from sell side analysts). When markets become volatile like this, equity raisings become more difficult. Any company whose business model is reliant on raising outside capital could be at risk as well.
Its not all bad news!
- Shock should be transitory: While it may not feel like it looking at the red on the screens on a daily basis, or listening to news reports every night talking about the spread of Coronavirus and the impact its having on different economies, one way or another this will end and things will get back to normal. Some things may take a long time to get back to normal (like air travel) but at the end of the day we are already seeing massive improvements in infection rates in China.
- Shares are 30% cheaper: As a value investor, I am seeing more opportunities now in this panic than I did when we were making new all-time highs every day. Now, just because a share price has fallen a long way doesn’t mean it is cheap.
If a stock is 200% too expensive and it falls 20%, it doesn’t make it cheap. However, there are starting to be some very good opportunities.
Low Interest Rates: As mentioned above the probability of low interest rates for longer will likely mean that when the dust settles the yield investors are prepared to accept would be lower or for equities the P/E they are will to pay will be higher all other things being equal. The point being, we have seen a big drop in equity prices at the same time equities have become relatively much cheaper than bonds. Asset prices should go up when the dust settles, and growth normalizes.
Fiscal Stimulus: The Australian government has a strong balance sheet and after a year of austerity have the mandate to spend big. This should provide an offset to the demand shock.
Australia - What Better Place to be Stuck: We live in the best country in the world. With international travel at best severely curtailed, what better place to be stuck. Not only do we live in a beautiful country, but we also have a growing population because everyone else in the world wants to live here too.
Cash to invest: In both long/short funds we have plenty of cash to invest at a time when we are beginning to see bargains. We looked stupid in the bull market but feel like we are in a good position now while we are seeing massive deleveraging from other funds both domestically and globally.
Embrace the Volatility: Volatility creates opportunity. The key is not to be scared to buy something just because the share price could be lower in a day, or a week or a month. I believe more than half of the companies on the ASX will downgrade their earnings forecast over the next few months. I believe that is a mistake to wait for the downgrade to buy shares. That is what everyone else is doing. Does that mean you should be scared to buy? Absolutely Not. If you can buy a good business with a strong balance sheet, good management team and a potential to grow in more normal times at a cheap price than take advantage of this opportunity. We are happy to look through short term downgrades but the one word of warning. Everyone always underestimates operating leverage. Given the speed of the demand shock a lot of the revenue shortfall will fall to the bottom line.
Good and Bad News for Value Investors (mostly good)!
While I would love to say that it is all good news for value investors, I believe that there is a bit of balance here. As mentioned above, as the dust settles, we are going to see the market’s expectations of interest rates to stay lower for longer. Hence, I believe when this happens there will be a mad rush for companies with stable dividend yields (or at least perceived stability). Therefore bond-proxies are likely to get bid up. The other aspect you may see is that anything which can deliver earnings growth is going to get a P/E re-rating. The spread between low P/E companies and high P/E companies could blow out again as market participants chase companies which can grow earnings which will be few and far between. Neither of these are great environments for value investors in isolation.
However, the good news is that due to this market sell-off, we are able to buy some high-quality growth companies at a pretty good price.
The other piece of good news for fundamental value investors is that in the next twelve months life should get pretty tough for passive/quant/momentum investors alike. Momentum has been the best performing strategy over the last five years. Momentum has come in two forms. The first is purely passive and that is buying shares which are going up and selling shares which are going down (irrespective of value). The popular strategy which has worked very well for some active fund managers is buying a company which will likely have an earnings beat and selling a company which is going to miss earnings (irrespective of value).
In a market environment where more than half the companies on the ASX are going to downgrade in the next few months and probably a dozen are going to need emergency capital injections, which way is the momentum. I suspect that passive/momentum/ETF etc. etc. are just going to keep selling (irrespective of value).
To put it in perspective, three weeks ago, momentum was buying up market darlings post their interim result because “they didn’t downgrade their guidance”. Some of these companies were trading at 50x P/E or higher but they were still bought because momentum is value agnostic. However, even the market darlings are going to downgrade in the next few months. Given the share price momentum has turned negative AND the earnings momentum will likely reverse. We suspect that momentum and passive are going to continue to sell these market darlings.
Momentum works fantastically well in an upward sloping market but in a choppy market can be disastrous.
A few things get me excited as a fundamental value investor.
Momentum works both ways.
While I was pulling my hair out as the market was making new highs because I couldn’t understand how anyone could justify the valuations people were paying for different companies, the simple explanation was that momentum does not care about valuation. They just care about earnings and share price momentum. Well, the problem now is that momentum works both ways. Now, with the likelihood of earnings downgrades and negative share price momentum, these investors are going to continue to sell these companies (irrespective of value). This is a dream situation for a fundamental value manager as we try and buy companies at below intrinsic value and the seller is non-fundamental.
Emergency Capital Raisings.
During the GFC, an enormous amount of money was made by participating in recapitalizing companies which met with some liquidity issues. The core business was fine, but with a credit crunch they were over-stretched and needed an equity injection which was usually done at a depressed price. As a fund manager it was like shooting fish in a barrel. If as I predict this is going to happen again in the next few months, it is going to be much tougher in 2020 than it was in 2009. Why? Because the make-up of the market has changed dramatically. There is a lot less money in the hands of fundamental value managers. This money has transitioned to quant, passive and momentum. Quant and passive will not participate in these capital raisings unless there is index inclusion (yawn) and momentum only ever participate in equity raisings if is combined with an EPS accretive acquisition. The point here is that the simple demand/supply dynamics mean that there are much fewer participants looking to provide capital for these recapitalisations which means we can be very picky on price and quality. This is great news for value investors.
So, what are some of the things we have been buying in this pull back?
Some Old Favourites
TABCORP: Having fallen 20% in the last month, TABCORP is looking extremely attractive at current levels. We believe that the lotteries business justifies the current valuation if you were to put lotteries on a free cashflow yield of 5%. You are therefore getting the wagering and gaming businesses which will generate around $480m EBITDA in FY20 for free.
Incitec Pivot: The share price has been under pressure because urea and DAP prices have been weak globally. Also, due to drought conditions in Australia over two years and some unscheduled plant shutdowns, earnings have been weak. However, the company generates most of its earnings from selling ammonium nitrate to miners and construction materials companies both in Australia and the US. It is a great market structure with only two main players in Australia and three in the US. Also, with breaking rains at the right time, the fertilizer distribution business should bounce back this year. Two years ago, the company generated EPS of $0.25/share it is currently trading at a 35% discount to book value and 7.2x mid cycle earnings, this is a good opportunity.
Some new additions
Adelaide Brighton: one of the biggest construction materials and lime producer in the country. Earnings have been under pressure over the last few years due to import competition, a drop off in multi-residential construction and lower infrastructure projects spend. The share price over the last two years has fallen from $7/share to $2.56/share. The EPS over the last ten years has oscillated between $0.10/share and $0.35/share. At mid-cycle Adelaide Brighton is probably trading on 9x P/E with a strong balance sheet to take advantage of distressed opportunities and a 30% discount to book value.
MacMillan Shakespeare: There are two main businesses. A fleet leasing business and a novated leasing/salary packaging company. The company administers salary packaging for mostly non for-profit organisations but also makes money through selling novated leases to their customers. While the weak car market and slightly lower commission from finance providers has created and may still create a headwind, if you strip out the fleet business at book, you are buying the core business at an ungeared P/E of 7.5x P/E. The stock price has literally halved in four months and we are buying this on a fully franked dividend yield of 8.1%. This may sound like a boring business, but I like the way they have grown their business organically and have spent a lot of capital recently automating their back-end tech stack and digitizing the front end. Shareholders have yet to see the benefit of this.
As you can see there are some eye-watering opportunities available currently. Having cash to deploy when the passive investors, ETFs, momentum investors and leveraged hedge funds are all selling at the same time is pretty exciting. We are not complacent about the massive issues facing the global economy in these unprecedented times. We are still excited about our short book. However, one needs to be really careful about getting too confident about putting on new shorts. We need to continue to re-test our theses on our core short positions. We are in unique times and as mentioned above, we believe that more than half the companies in the ASX will downgrade over the coming months and probably a dozen or so will need to conduct emergency capital raisings.
This is going to be very hard for passive, quants and momentum investors to know what to do.
The trick for us is to remain patient, have some cash available and not be too scared to buy shares even if we expect a downgrade. This should be a great time for those with cash on hand to capitalize on great opportunities. We intend to do this. However, we need to be careful. While the demand shock should be transitory, we need to be forensic on the balance sheet, business model and cash generation. We definitely won’t get them all right, and we won’t buy the shares at the exact bottom, but as long as we find companies with quality management, good business model, pristine balance sheet at dirt cheap prices, it doesn’t matter if we get the bottom, we will more than likely make a good return from that investment over the medium term.
Make the most of market inefficiencies
The Perpetual Share-Plus Long-Short Fund invests in companies we believe will rise in value and takes short positions in companies we believe will fall in value. Stay up to date with our latest insights by hitting the follow button below.
In addition, I was also a guest on Livewire's Rules of Investing podcast last month where I discussed two companies that I’d love to buy the next time stocks go on sale and what I look for in a compelling short candidate. You can listen to that episode here
13 stocks mentioned
Anthony is the Portfolio Manager - Industrial Shares, Pure Equity Alpha (50%), SHARE-PLUS Long-Short and an Analyst. He has 13 years experience outside of Perpetual, most recently at Ellerston Capital. Anthony is a CFA charterholder.