Disruption. This year, it has moved from the conceptual, a long slow burn of profit dislocation within and between industries, into a full-blown commercial war, spurned from a virus with nebulous beginnings but a vicious commercial and humanitarian reach. Of course, in Australia, thankfully, the humanitarian impact has to date been relatively limited thanks to luck, isolated geography and adroit public policy and the fiscal capacity to provide assistance when it was needed. Others can better judge what proportion each factor contributed, but no doubt each has played a role.

What started as a health care storm quickly morphed into a lockdown in physical presence and profits, only for market prices to aggressively bounce back such that now we are close to being back to where we started at an overall index level in many markets.

But not in Australia, where notwithstanding some bifurcation reflecting global trends – healthcare and technology, media and telecom to the left, energy, REITs and banks to the right – the relative overweighting of laggard sectors relative to global indices has seen the ASX200 still well off its highs.

The limits of stimulus

Within this context, there are two sources of ongoing debate with respect to portfolio composition within the ASX.

Firstly, at a market level, it is of course correct to say that globally, fiscal and monetary stimulus has promoted the market rally. The bigger question is what, if any, are the limits to such stimulus, and how is it known when such limits are being approached? Is it simply a flow issue (i.e. more stimulus therefore higher markets) or is it also a stock issue (i.e. at some point finance to allow stimulus is denied or costed at an uneconomic level, perhaps because of finite government supply of funding, forcing resource allocation choices). As Jeff Gundlach noted, 

“Why bother with any taxes at all if Chair Powell is correct that there is no limit to expanding the Fed’s balance sheet? Implicit in his declaration is the assertion that the whole tax collection system is a royal waste of resources”.

And, of course, to some extent as a shareholder, this doesn’t matter, until it does; in the past decade, for example, public policy changes saw Telstra shareholders wake up and realise they no longer owned a national network they had been sold in a privatisation a decade earlier; Star Entertainment Group shareholders had a competing license for a casino issued for premises across a waterway from them; many entities in the healthcare sector endured policy changes that depressed their economics (or worse; ask shareholders in aged care operators), and bank and resource company shareholders were confronted with super profit taxes for little public policy basis other than they were making a large amount and can afford it. Far fewer sectors have not seen public policy changes effect returns to equity than have experienced its wrath because of changes in public policy (there are none we can think of where benefits have flowed to shareholders from reduced taxes).

Our position remains that increasing levels of public spending will see increasing levels of regulatory intervention in profit pools, and in that context those that benefit from regulatory settings are also most vulnerable to ongoing, and new, claims from policy intervention.

A final observation on this point is that the biggest source of stimulus to the equity market has indeed been monetary policy, and common parlance has it that it has been the rocket fuel for multiples through the past two decades. Credit Suisse has recently noted, however, that through the past fifty years, across countries, there is a break point to this relationship; once bond yields fall below a threshold level (circa 5%), the longer run line of best fit sees multiples fall as well, increasingly as bond yields fall further below the threshold. Following the policy induced rally of the past quarter, multiples are now placed well above an expected level given this relationship.

We do not expect upgrades to ensue following company profit results for the June period when released in August, which means the recent rally could quite easily reverse once earnings and more importantly, lowered outlooks for FY21, are released at this time.

Behavioural biases versus fundamentals

Secondly, at a stock level, to what extent are behavioral biases overwhelming fundamentals? If, as is the case with our Australian equity Funds, opportunities were not captured by purchasing growth stocks on the ASX in the market sell off, when if at all would such companies be purchased?

Simply put, our process is looking to arbitrage the difference between price and value; not arbitrage the difference between price and a perceived likely price in the future (the definition of trading). 

Value, in our eyes, is undivorceable from cashflows. 

The problem with many of the ASX growth names is not as much that they produce low cashflows as that they produce no free cashflow at all. We are happy to invest at a good multiple where there is a clear pathway where that may happen, however are at a loss when this pathway is absent.

A good example was in the case of one raising, when we asked management; as no free cashflow had been produced through the prior five years, was that likely to be rectified in the event the recapitalisation proceeded? The answer was simple; we expect our competitors to go broke. Management did not believe they could put prices up, however, even in this scenario, and barriers to entry are low such that new competitors have and would be likely to continue to emerge should they do so.

We also asked whether formal clearance had been received from banks such that any funds raised were to be available for general corporate purposes, without the banks’ explicit approval. The answer was no. That stock has done exceptionally well since listing, and hence, objectively, we made the wrong call in not participating. The risk attaching to such participation, however, we believe to be very high; as, indeed, to be fair, have been the subsequent returns.

It can be seen that our process, as with any process, has limitations; it is perhaps just for the best to be clear though, in the face of much market noise as prices move in extreme ways, as to what the process is and what opportunities it allows to be exploited, and to be equally aware of what potential opportunities it inhibits. 

On balance, we do not believe now to be the right time to be loosening the reins on risk, even though that has clearly been the wrong call through the past quarter.

Portfolio Outlook

Risks can come from different sources. We would never have envisaged a global pandemic being the prompt for a market dislocation at the beginning of 2020. But what we did envisage was that there is a large variance in companies within our universe in how they have armed themselves to prepare for a risk of any type.

Those heavily geared, for example, paid a heavy penalty for six weeks; all has been forgiven in the more recent six weeks. Divergences, however, have emerged; some commodities (Gold, iron ore) are well above our long run assumptions, just as others (almost everything else) is well below. Banks are no longer operating in a paradigm of no bad debts, and they remain concerned much more is to come through FY21, although to date evidence for this is scant, as is the case for retailers (and their landlords) concerned sales are to collapse.

What is clear, however, is two things; firstly, interest rates in Australia are at an extreme, just as multiples have reverted to for anything growth related, and hence the growth expectations built into the better performing stocks in the market through the past quarter have never been higher.

Secondly, that growth is not coming through this year, and within two months expectations for next year will be more transparent. With few exceptions, we think the clear risk is that those earnings expectations are also likely to prove optimistic.

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