Investment Matters

Is the market mad?

The market continued to stage a comeback early this week, strongly finishing a shocking March quarter.

However, it remains down over 23% for the quarter, in what has universally been a difficult time for investors.

IM1april3Source: IRESS: First Samuel

True to the volatility we have seen, the market subsequently fell later in the week.

Although volatility overall is lessening, we continue to see significant inter and intra days swings in the market.

Which begs the question….

Is there a method to this madness? Or, is this indiscriminate selling?

It is useless opining as to what drives the day-to-day moves of the market. Our focus is on the longer term.

However, there appears to be some method to this market madness when viewing the relative price performance of companies over this period (which we discuss below).

Yet, as we have seen, there have also been elements of just plain madness, when it comes to the price performance of some companies. Of course with this has also come opportunity.

Recap: The Virus and its impact

Isolation and containment measures have resulted in an abrupt halt to economic activity globally (or a “hard stop”).  This has significantly reduced, or in many cases completely stopped cash flows for companies. 

Initially:

  1. Many financial institutions were caught off guard by sudden price falls and the increase in volatility
  2. These institutions had to quickly sell their positions in an environment where there were few buyers
  3. Much of this initial shock has resolved, with central banks stepping in as a buyer, which has helped reduce some of the friction and volatility in markets

Subsequently: 

  1. Investors have been cautious when re-entering the market.
  2. This generally has resulted in the avoidance of companies:
    -  with a high proportion of fixed costs (or operating leverage), debt or significant financial obligations in the near term
    -  directly and significantly impacted by the virus (travel stocks, airlines etc.)

Investors have therefore seemingly divided the market into two categories:

Resilient:

  • Less directly impacted by the virus
  • Little to no debt
  • Few short-term cash commitments
  • High gross margins
  • An ability to quickly and easily vary their costs (minimal fixed costs)

These companies’ share prices have fallen less and recovered more.

An example of such a company in your Australian Equities sub-portfolio is Appen (APX) and Pushpay (PPH). 

Vulnerable: 

  • Directly impacted by the virus
  • High degree of fixed costs
  • Many short-term financial obligations (such as debt that is maturing or significant payables)
  • Moderate to high levels of debt

These companies have fallen more and recovered less well. This includes some companies in your portfolio such as Emeco (EHL) and Boral (BLD). 

Has this been rational? Yes and no. 

In an environment where there is uncertainty as to the length of time the economy will effectively be at a standstill, this reaction is on face value, prudent.  However, there are several examples of where companies have been sold based on this face value categorisation, but are, in fact, relatively resilient.

The selling of these companies has been less rational.

This has provided opportunities for those who are willing to more carefully examine these companies.

Theory versus practice: Emeco

Emeco, one of the companies in your Australian Equities sub-portfolio, provides a good example of a company that has been mis-categorised.

On face value, Emeco fits into the category of stocks that may be seen as “vulnerable”.

Yes, it has:

  • A high degree of fixed costs: including running, maintenance and repair of its equipment.
  • Moderate levels of debt: the company is moderately leveraged with a portion of this debt due to expire in 2021. Furthermore, this debt is denominated in US dollars, which may be problematic given the Australian dollar has subsequently declined.

However: 

  • Activity for the company has been minimally impacted. Its customers (Tier 1 and Tier 2 miners) remain in production and demand remains high for their commodities. Ironically, Emeco is one of few companies on the ASX which has not withdrawn its guidance for expected profits in 2020. Thus, its fixed costs are less of a problem.
  • It has significantly reduced its debt over the past 3 years to what is now a sustainable level (to an expected 1.5x at the end of FY-20 from 5.5x operating profit). 

As a testament to this, it has recently had the rating of its debt upgraded by both Moody’s and Fitch. Furthermore, its USD denominated debt is fully hedged to Australian dollars.

Despite this, its share price has been slow to recover and continues to trade at far below its fundamental value.

Takeaway

Uncertainty is high and investors are cautious. The market has become more discerning, particularly about companies’ ability to meet short term obligations and their balance sheets.

While in theory, this reaction has been prudent, this has led to some “catch-all” selling or avoidance of companies with certain characteristics (high fixed costs, debt levels, low gross margins, amongst others).

There have been instances in which companies have been unnecessarily lumped into the “vulnerable” category and now trade at a considerable discount.

This has provided us with an opportunity to purchase and hold these companies through this period, to a time when market caution eases and these companies are re-examined.

We remain comfortable with how the majority of companies in your Australian Equities Portfolio are positioned to weather this period.