The morning after the night before

Fourth quarter 2018 saw the market essentially pricing in a recession via a strong risk-off sell down; economically sensitive (cyclical and financial) stocks were hit hard. In the case of financials, there were additional concerns due to negative sentiment associated with the Financial Services Royal Commission. Not surprising, expectations from the cyclical and value end of the market going into reporting season were low.

Fast forward to February: the S&P200 Accumulation Index produced a strong return of 5.98% during the month, and the S&P Value index did even better delivering a total return of 6.16%. The month also saw a strong partial rebound in performance for some of the economically sensitive stocks, including IOOF, Viva Energy, QBE, James Hardie, ANZ, Westpac and Woodside Petroleum – all stocks that we hold. It appears the market pricing of some stocks was too pessimistic and when the reality of the situation was presented, these stocks rallied and delivered significant outperformance.

A case or two in point

IOOF Holdings

IOOF had been aggressively sold off following APRA action to remove the Chairman and four executives. Whilst it was disappointing that the company had allowed the relationship with its regulator to deteriorate to that point, the market extrapolated that the impact of losing the executives would deliver negative outcomes for the operational performance of the company.

Whilst the company reported one of its weakest results in a number of years, the disaster scenarios of client and FUA loss have not been apparent. Moreover, the company is working diligently to restore its relationship and eliminate the poor governance practices, which were not unique to IOOF. The result: IOOF outperformed the ASX200 by c30% over the February reporting season as the market recognised that too much negativity was priced in.

Viva Energy

Viva Energy had been a poor performer since listing. This was on the back of:

• a decline in regional refining margins, and
• declining volumes in its Coles Alliance, which markets fuel through the Coles Express network.

The market was pricing Viva Energy at c$1.80 through January (compared to the issue price of $2.50). At this level, the market was, in our estimation, factoring in refining margins remaining weak indefinitely and that the issues with the Coles relationship would not be resolved. Again, we believe this was too negative.

Refining margins are inherently volatile but are highly mean reverting, as low margins see capacity withdrawal. Low margins won’t be sustained indefinitely. Further, both Coles and Viva were motivated to see the volume recovery and a resolution was more likely than not, particularly given new management at Coles was not anchored to historic profit levels.

Whilst we had no insight into the structure or timing of the outcome, we were confident a resolution would occur and that the market was not pricing this into the share price. After the restructured Alliance arrangements were revealed in February, the share price improved to $2.48 at the time of writing and outperformed the market by 25% in February.

Other value names that had similar experiences were Janus Henderson Group, Ardent Leisure and QBE Insurance.

Let’s be frank about capital management

There has been plenty of column inches dedicated to Labor’s plans to tweak franking credits and the impact on companies’ capital management policies. Reporting season presented a chance to see how much of that was hype vs reality.

What we found was that releasing franking credits to address a change that will affect only a small percentage of investors, and which may not happen, was not the main driver for capital management decisions. The main driver was cash from asset sales.

Only Woodside called out the franking credit change as a reason for an increased dividend, which they may have felt necessary given they only raised capital six months earlier. Wesfarmers and Rio Tinto didn’t hold back given their undergeared balance sheets.

Perhaps the most interesting observation was what didn’t happen. Woolworths and CBA didn’t rush to pay out the proceeds from asset sales that hadn’t closed. And companies like Harvey Norman, with huge franking balances, didn’t suddenly decide to return them to shareholders before they are lost.

It would appear that company boards have shown, and rightly so, that they are more worried about being over geared in uncertain times than they are about gaming a taxation tweak

Sticking to what you know

Our approach to value investing is focused on long-term earnings and cash generation of individual stocks. This reporting season confirmed once again that the market is often too short-term focused and unable (or, more likely, unwilling) to properly price risk. It also showed that the market was acting more sensibly compared to the panic we saw in the fourth quarter 2018.

Our process frequently identifies value in stocks where the market is too impatient to wait for an earnings recovery or where there is a large amount of uncertainty over future outcomes. In the latter case, we often find stocks where the market is pricing in a large discount to even a reasonable ‘worst case’ scenario — as was the case for Viva Energy and IOOF Holdings.

On the flipside, we were reminded of the loss potential of holding stocks with unrealistically high expectations. One such stock that experienced this dynamic in February was Cochlear. While we admire this company and recognise it to be high quality with tremendous future growth, the market was pricing in much more upside than is likely to be delivered. A soft result saw the stock underperform the market by 18%.

Having experienced significant underperformance in 2H18, as the market moved into panic mode and indiscriminately sold stocks with no hint of risk or cyclicality, this reporting season re-affirmed that short-term price moves are often excessive on both the upside and downside and, moreover, that share prices will ultimately revert to fundamentals.

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