What matters now?
The market this week continued on its road to recovery. Since its recent bottom (on the 23rd of March) the market (as represented by the All Ordinaries Accumulation index) is now up by more than 15%.
It is now a little more than 18% off its highs in late February, after being down almost 30% at one stage.
As the market has recovered, we are beginning to see some of the value we were able to capture during the correction being realised.
During this period, your Australian Equities sub-portfolio (excluding recent price adjustments and cash held in reserve) has outperformed the market by almost 2%.
Bucking the trend
Our underlying outperformance is particularly pleasing when viewed within the context of the correction we have witnessed.
Clients will remember the discussion around recent trends in the market, the disparity between the performance of value versus growth stocks.
The recent sell-off led to a continuation in these trends. The preference for expensive growth has increased, despite the market correction. That is, the premium paid has been higher than that prior to the correction (as seen below).
Above: P/E Dispersion of ASX100 ex Resources (80th percentile P/E divided by 20th percentile P/E)
Source: UBS Research
However, as the market begins to look through the impact of the virus, the rotation towards value positions is likely to occur.
Just as our market likely “bottomed” on March 23rd, it is likely that the global preference for expensive growth stocks, which also peaked on the same day, will now begin the path of reversal that we have seen in previous cycles, including in the period in which First Samuel dramatically outperformed.
Discounted rights issues and equity raises
Over the week, we also saw several companies come to market for additional funds to help weather them over this period.
This has included companies such as Megaport, Oil Search and G8 Education.
We have held cash in reserve for this reason and have looked closely at many of these offerings. Over the coming period, we will use the remaining cash holdings to participate where we see value.
Volatility and opportunity
Once again, Emeco provides an example of some of the dynamics we have seen play out in the market recently. The table below outlines the huge variance in Emeco’s share price we have seen over the past year.
Emeco’s Share Price
This volatility has been seen in spite of (in our assessment) Emeco remaining much the same (if not improved) business that it was since the year began.
The range and volatility of its share price highlight a concept we have spoken about previously: with volatility comes opportunity.
We have looked to capitalise on the volatility in Emeco’s share price and the fundamental disconnect between its share price and value. The same applies to other investments made over this period.
What matters now?
COVID-19 has thrown up several questions for investors:
- Will [insert company name] have sufficient liquidity (be able to pay its bills) during this time?
- Will [insert company name] be able to meet its debt obligations and stay within its debt covenants?
- What will this year’s earnings look like?
- What will next year’s earnings look like?
Ultimately, these questions are asked to determine what companies will be worth in a post-virus world.
Valuation is based on the fundamental concept: A business is worth the cash flows it can generate in the future, discounted at an appropriate rate of return.
With this in mind, which of these questions matter and why?
Weathering the storm
Arriving at an answer to the first two questions has been paramount.
Referring to “the fundamental concept” – the answer to these questions defines how long the “future” for these businesses will be.
During this period, companies have had to weather the considerable demand shock that has come about. They have acted, so they can continue to pay their bills.
Given there is little companies can do to support their revenue line at this time, support has generally come from three areas:
- Cost reduction
- Overheads: Reduction in overheads/operating expenses (store closures, furloughing of non-essential staff etc)
- Spending: Deferring of non-essential or growth capital expenditure
- Balance sheets and capital markets
- Balance sheet: the use of existing cash on a company’s balance sheet.
- Shareholders: the raising of funds from existing or new shareholders
- Lenders (including landlords): extension of existing credit facilities, waving of covenants, refinancing of existing debt, rent abatement.
- Central banks and the government: wage subsidies, reduction in the interest rate on debt through stabilisation of government debt, accelerated depreciation.
Of course, given that many companies are looking to access this form of support all at once, the cost of doing so during this time in some instances has been elevated.
This refers to the “rate of return” element of valuation. Investors are demanding a higher rate of return during these difficult times, or simply, asking for a bigger discount.
This provides an opportunity for those with cash at their disposal.
Ultimately a majority of companies have and will receive support.
Why? Because stakeholders and investors alike can see through the fog of the short term and recognise the value in these businesses over the long.
We have already seen this, with several companies successfully raising capital recently.
Which leads us to the next two questions...
This year’s earnings? Next year’s earnings? Do they matter?
Financial commentators over this period can also be heard asking: What will this year’s earnings be? Or next year’s?
The question they should be asking is: are these numbers relevant?
During more normal times and under normal conditions, the answer would be: very!
Near term earnings, margins, revenue growth are an important input in determining a company’s future performance and the cash flows it can produce over the long term.
However, we have experienced a large, exogenous shock to the economy during this period.
Life as we knew it, has come to a sudden stop.
This will impact all companies, and the numbers that they will report will, frankly, look terrible across the board.
There is potential that structural change to arise as a result of this period of confinement. This period may have accelerated underlying structural changes and trends (for instance, increased penetration of online sales). The impact these changes have on long term value, of course, must be taken into consideration.
Business models that were precarious pre-COVID, won’t be under less stress today than before. They will, are less likely to be supported and may fail. We look to avoid these.
Investors in the near term will have to forego some of the cash flows businesses were expected to generate. This amount is important and must, of course, be quantified.
However, performance over the coming months or year will by no means be representative of the cash flows companies can earn over the long term.
Sensibly, no one extrapolated pre-COVID economic data as indicative of how our economies would fare over the coming months.
There was a clear recognition that COVID-19 created an unexpected and unique shock to the economy.
We need to view near term earnings numbers with this same clarity.
A shock has occurred to the economy and this will be reflected in the numbers.
These numbers are less relevant in determining the ability for companies to generate cash once conditions normalise.
The concept of value
Ultimately, value comes back to that very simple concept:
A business is worth the future cash flows it can generate, discounted at an appropriate rate of return.
The recent shock has had a marked impact on economies around the world.
There will be a large impact on cash flows over the coming year or more.
However, what is most relevant during this time is relevant is a company’s ability to weather this period.
This is in turn dependent on the level of support they receive, which is ultimately reflective of their long-term value.