Where to invest in a post-lockdown world
Now that governments are talking about re-opening the economy, investors can start thinking about the businesses that might provide the best returns as we emerge from economic hibernation. Here, I give a quick appraisal of the investment landscape, and identify the key attributes of businesses that I think will rebound the hardest.
Many are comparing the Australian economy’s current predicament to the Great Depression. During the Great Depression however unemployment in Australia rose to 30 per cent. Nobody is currently predicting such a crisis – unemployment is forecast to rise to between 7.5 per cent and 10 per cent. And as each state gains control over the spread of the virus, relaxes social distancing rules and reopens commerce, the unemployment rate will likely lean towards the lower end of that range or, if it spikes higher, is unlikely to remain at the peak level for long. That is even more likely if lockdowns are unlocked sooner.
Wages however have plunged as those that remain employed are forced to take pay cuts. Meanwhile, the official response has been enormous. Government stimulus of $220 billion represents 11 per cent of GDP, which is much greater than the average globally and the RBA has been buying bonds, supporting banks and ensuring rates on business and household lending remain low.
While economic conditions are rapidly evolving and highly uncertain, the economic outlook has deteriorated. The questions for many investors is how deep will the recession be, what sectors are expected to see the largest declines, and what are the key data points to monitor?
As ‘bottom-up’ equity investors however, we are interested in the experience of individual companies, as well as an understanding of the dynamics in each sector, which can vary greatly. While we expect earnings and dividends to fall by as a much as a third in aggregate, it’s not all bad. A friend of mine, Peter, owns a large bike shop and his revenue is up more than a third year-on-year. Bike stores across the country are reporting a huge spike in sales and servicing as families ride together to escape boredom and get fit.
Not everyone is using home isolation to get fit though. Another friend owns a boutique wine distribution business and he tells me volumes are double to triple what they were this time last year. Another bonus for him is that with restaurants shuttered he’s suddenly a wine grower’s best friend. Labels that might not have spoken to him previously are now clamouring for him to buy their stock and he can help in their crisis, establishing enduring relationships.
Collating our own and sell-side analyst thinking we note the following.
Market overall
After rallying slightly more than 25 per cent from the low on March 23, market valuations appear stretched again, which could limit further upside. Putting the rally in perspective, the ASX 200’s PE ratio is more than one standard deviation above its recent average. Ex materials, property and banks the market appears to be on a FY20 PE of over 25 times. Obviously the market is looking beyond the short term impacts of COVID-19.
Mining
Lower global demand for raw materials and steel. China accounts for 70 per cent of seaborne iron ore demand and economic activity there is reviving. Lower production to date due to disruptions but production from South America, South Africa and South East Asia is coming back too.
Banks
We have been negative on banks for a few years now, believing credit growth would moderate and net interest margins would come under pressure. Our significant underweight position reflects those views. And while credit conditions have now collapsed, we mustn’t forget the banks are high quality oligopolists. Several banks are now trading below book value for the first time in many years and therefore offer much better value. Capital raisings below book however are dilutionary and impact adversely on valuation per share. On balance a more neutral (rather than negative) perspective is required.
During the bank reporting season which has commenced this week, investors will probably focus on outlook statements and the extent to which expected cuts in dividends are realised. Earning reports will be from the past, with late March and April likely to better reflect the downturn and therefore immediate future conditions. But it will still take some time for arrears to flow through, so bad debt provisions will help us to understand how a bank’s management is balancing actual first half conditions versus expectations for the full year.
In terms of valuation, they are cheaper than they have been for some time, but we believe better value is necessary given the substantial erosion of profitability over many years and more recently.
REITs
Difficult to summarise all in one paragraph as they have different exposures. There will be negative impacts from short term rental abatements and from retailers negotiating with greater legislated power. Deferrals and incentives will ensure landlords share some of the burden of the economic lockdowns. In turn, there will be an impact on loan to value ratios, which may result in capital raisings. In the residential space, turnover has collapsed. The extent to which job losses extend beyond part-time and casual staff will pressure volumes as will the rapidly rising level of rental stock.
Infrastructure
Lockdowns have significantly restricted mobility, which in turn has impacted cash flows and dividends for the major players in this hitherto reliable sector. Essential infrastructure status (airports and roads – Transurban, ALX, Sydney Airport) however will ensure the long-term investment merits of the sector, and even a gradual or staged return to economic activity may limit the downside from here for investors. Dividend cuts/suspensions may remain for 12 months ensuring there are no questions relating to liquidity or credit market access. Sell side analysts are anticipating traffic to return to pre-COVID19 levels by 2021 – not too long to wait for investors with a longer-term horizon. Essentially, near-term volume impacts are being seen by professional investors as having a limited impact on longer term valuation.
Retail
Probably the most challenging to correctly anticipate. Revenue impact from declining foot traffic partially offset by staff reductions, store closures and rental negotiations. Revenue has been hit much harder than the cost of doing business. For some, a surge in online sales has increased the number of ‘members’ who will stick to the brand. This is aprticularly true for supermarket owner Woolworths, which has picked up almost a million Rewards memebers and online customers. We note, grocery (Woolworths, Coles, Metcash), electronics (Kogan, Harvey Norman, JB Hi-Fi) and hardware sales (Wesfarmers, Metcash) have been very strong – never seen so many people buying “essential” items at hardware stores during the lockdown. Analysts are assuming discretionary earnings return to past levels in FY22.
Prior to the sell-off, the key was to be in defensive, large cap, high quality businesses to reduce risk. Investors now need to think about leverage to the recovery. Another wave of price weakness is possible as markets re-calibrate their recent optimism, in light of the depth and length of the economic fallout. The possibility of another sell-off should be seen a positive for long term investors. Being prepared will ensure the lower the price paid, the higher the return.
The best businesses will be those with sound balance sheets but whose share prices have not recovered. One way to assess this might be to think about which companies have done a good job of their online offerings, are leveraged to a recovery because they sell categories that respond quickly (think fashion, homewares, fastfood for example), while comparing current price multiples to historical averages. Investors need to also ask whether strong recent sales have brought forward demand from later in the calendar year.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Arthur Smith
:
Illustrating my point about digitalisation I note the NASDAQ last night was within 1.4% of its all time high. This compares to a S & P 500 about 7 per cent below all time highs. I know, I know there could be many other reasons explaining this differential but I think the market is seeing just how much this virus has promoted the digitalisation cause. By the way, I think all would agree the NASDAQ has experienced a V shaped recovery, even if it later turns out to be a W, the V has been achieved, that is up 41% since 23 March and broadly back to where it was before virus concerns.
Kent
:
Mathew,
Thankyou for your astute comments, time will tell, I hope we both win but in Mr Market when someone wins someone loses.
Good Luck
Roger could you please email me a copy of the new tables or advise me where I can access them from when you have updated them.
Thankyou
Kent
Matthew Tate
:
Kent, to your comments earlier. You are forgetting one thing and that is the effect of global interests rates and treasury yeilds on equity valuations.
As long as we continue to see ‘yield curve control’ from the U.S Federal Reserve (and others such as the EU) creating negative ‘real yields’ investors will continue to bid up equity valuations regardless of your opinion on how non-sensical this may seem.
T.I.N.A (there is no alternative) is the trade right now, eventually as you say there will be a day of reckoning (likely when we see inflationary and near term yield pressures).
I just fear that like minded investors such as yourself sitting on the sidelines will underperform and miss a large portion of the gains we are seeing, despite the fact your opinions are quite correct!
Roger Montgomery
:
Matthew and Kent, These differences in views are what makes a market, and typically (and historically) the differences become more extreme at turning points.
Kent Bermingham
:
There has never been a time when Mr Market is doing what it does best, talking itself up and down by Analysts who have a conflicted interest in Mr Market.
There is no fundamental basis for recovering 25% since the 23rd March as future economic indicators and Annual reports will support.
It has no connection to the REAL World.
Corporate reporting season will expose Management,
Global GDP, Debt, Unemployment, Capital Movements will expose Analysts.
Using Rogers invaluable valuation tables there are only a handful of companies that score a margin of safety on past performance let alone short term future performance basedon unreliable conflicted analysts forecasts.
We must be patient, hold plenty of cash, wait for a cure to be announced,
wait for the withdrawl of Job Keeoer and a reduction of Seeker and then consider buying beaten up stocks where analysts have got it wrong again.
Look for professional Managers and Solid Balance Sheets especially strong Cashflows.
Not even Global Tensions between China and the rest of the world or Social disorder in many countries has an impact on Mr Market these days it tells me that Mr Market is more run by artificial Intelligence and Algorithms rather by how companies are actually performing and as for Analyst forecasts one would be better off putting your money on red at the Casino!
Rogers principle of buying great companies is well supported by his book and timing is everything and consistency is a must.
Where can I get a copy of the latest valuation tables updated for the latest ROE, Interest Rates, Required Return etc as I cannot find them anywhere that is current?
Rogers book has benefited me greatly and I appreciate his insights
Happy Investing everyone and keep up the good work Roger and team
Regards
Kent
Roger Montgomery
:
Hey Kent, I will try and publish those tables this week.
Darrell
:
Roger in one of the recent Montgomery funds webinars I noticed CSL as a significant holding. It wasn’t that long ago (maybe 12-18 months?) that I listened to a podcast where you stated that CSL was being priced at possibly 2-3 times your valuation. Since then the CSL price has risen considerably. What changed your mind?
Roger Montgomery
:
The price is back to were it was nine months ago. What we pointed out was that people were paying for two or three CSL’s to acquire one CSL with growth. What has changed now are the market’s growth expectations. The required return has also been lowered thanks to Trump’s record breaking deficits, which will result in huge volumes of US Treasury bonds being issued, and which the US Fed will be forced to buy, almost ensuring QE infinity. Having said all that CSLs quality remains something we are attracted to relative to other opportunities and given the prospect of more volatility.
Arthur Smith
:
The ‘digitalised world’ has been greatly enhanced by the virus. Stages of adoption that were going to take consumers years have occurred almost overnight. Look no further than video conferencing and the fortunes of the company known as Zoom Video Communications (I would not be an investor in it now but it would have been good to own at the start of the year). Faster digitalisation will offer the community huge benefits such as greater productivity and lower costs. In turn, getting digitalisation onto a faster track will mean the quicker death of other companies.
Roger Montgomery
:
Agree with that Arthur. I for one plan to conduct a lot more meetings online. Many more. And now that our business partners are also accustomed to the format, it will face less resistance and be greeted with greater understanding and acceptance.
Robert
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It seems that most people are assuming that eventually the total economy will return to something similar to that existing before the Virus. This may not be valid. The previous emphasis on tourism, including local, country wide and international, has been shown to be ‘fragile’. Should it return? Is the totals system ‘deterministic chaos’, and/or is there a ‘tipping’ point (or region)? If so has a shift occurred. Similarly should we return to an economy with emphasis on population growth, pollution including carbon dioxxide. Should we aim for one where the distribution of wealth is more equal?
Roger Montgomery
:
Wow. Big questions. Sadly I don’t think even a pandemic will stimulate such tectonic shifts and the status quo will be maintained. Always bet on self interest and the path of least resistance. Only when those gaols are achieved through the path of least resistance, are they achieved.
JEFF TRUDGIAN
:
With the economic carnage going on right now Gold, the traditional store of value, is actively on the rise and appears to be heading higher for longer.Does that thinking make sense?
Roger Montgomery
:
It can be self reinforcing; like being right for the wrong reasons.
Julian Watt
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REITs – If working from home increases or becomes rostered will this impact REITs?
Adam
:
Hi Roger I listen to your podcast etc on regular basis.. but I cant see the rational behind your enthusiasm on business like Transurban and sydney airports given they carry so much debt
How do you reconcile these quality companies that have such high levels of debt.. and are they likely to do a capital raising soon, if so shares will also be diluted.
Roger Montgomery
:
Yes the debt question is the one that often arises when infrastructure entities are being discussed. The reliability of the cash flows and the ability to pull various levers (such as suspending dividends), combined with a high interest coverage ratio helps answer the question as to the level of debt being manageable.
Stuart Almy
:
What are your thoughts on the travel sector long term? Think Flight Centre etc.
Roger Montgomery
:
Hey Stuart,
It is reasonable to assume that there will be a surge in travel as lockdowns are removed, and beyond that, when (if) a vaccine or effective treatment is developed. The question is really which companies can survive and what shape will they be in when demand returns. That’s it in a nutshell.
Karlis
:
Hi
I have seen that bike shops are almost running out of stock, bikes are on pricy part 3-5k AUD. Same is at shops if I go to get some little trinket like the cable I notice ppl buying Xboxes, TVs and so on.
I have not seen this side of human nature, could you please comment on what is chain reaction here. For example, everyone is so upbeat with optimism that I get government money and I can spend it all and by august its all done or dusted.
OR
A month or two from now on cahs has run out and then its, well, unpleasant?
Roger Montgomery
:
The bike riding and bike servicing boom is one of the positives of the lockdowns – families spending time together. Record household debt already exists – what’s a little more? The result is probably a pull-forward of demand. Fewer bikes to be sold this coming Christmas.