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Why we are reducing risk by focusing on quality and size

22062020_quality companies

Why we are reducing risk by focusing on quality and size

Since the COVID-19 induced market low, our fund has put a substantial proportion of our cash to work.  But we’ve been very selective about the companies we bought.

We added to our holdings in Macquarie Financial Group, Westpac, Commonwealth Bank, and Scentre Group.  And we are building additional positions in undisclosed stocks. In the process, our cash has fallen from more than 30 per cent to below 20 per cent, the lowest for some time.

It might be reasonable to interpret our moves as implying a bullish view of markets. That however is not the case.

Our most recent analysis suggests market prices are broadly at their most extreme valuations since The Montgonery Fund’s inception. And keep in mind that our analysis excludes further potential earnings downgrades amid an information vacuum inspired by hundreds of companies pulling their earning guidance, as well as stale sell-side forecasts for earnings and balance sheets.

Additionally, it is fair to say neither in my lifetime, nor in my reading of history, have I ever seen a human-inspired economic calamity such as the world is now experiencing. Here, I am not talking about the virus itself but the hard-stopping of the global economy at a time when elevated debt levels suggest the world can least afford such a hit to aggregate cash flows. In recent years, global debt has soared to a level unprecedented in history thanks to consumers, corporate share buybacks and governments.

While markets laud, and rally on the back of, central bank counter-measures to buy individual corporate bonds, it should be noted that such action only has the effect of maintaining low rates for companies that would otherwise already be bankrupt.  It does not generate revenue or customers for those companies being ‘supported.’

Of course, all of this bond buying support must be funded by the printing of money, something markets are currently cheering.

But the US printing of money with gay abandon and without limit, under the auspices of Modern Monetary Theory, is not helping to finance military or economic domination, which in the current geopolitical environment is probably wise. Instead, the money being printed is merely being used to buy the bonds of, and support low interest rates for, rubbish, Triple C-rated, junk companies. It suggests something undesirable will probably emerge.

The unanswered multi-trillion-dollar question

Whether the current economic disaster can be repaired through the printing of money remains an unanswered multi-trillion-dollar question. The same goes for whether it leads to inflation, or possibly hyperinflation after excess productive capacity is soaked up.

Returning to the more immediate question of domestic equity valuations, even by extending valuation metrics to include earnings two years out, valuations aren’t all too compelling. And we would argue the level of uncertainty and volatility in the economy, means forecasting earnings even for the next quarter remains a complete guess.

With that in mind it is reasonable to conclude that much of the support in the stock market is inspired by gambling rather than solidly supported fundamental analysis.

One only needs to look at the 1,500 per cent rise in the price of Hertz after it declared bankruptcy on May 22, and the support for its billion US dollar capital raising after telling investors the shares could ultimately be worthless, that a material level of speculation is evident.

A return to “normal” levels of economic activity could take much longer than the “return to normal” implied by current aggregate share prices. A slow and halting recovery, rather than the quick and easy one implied by market prices, puts shares at a significant risk of disappointment. This risk must be assessed as minimal for any position investors now add to their portfolios.

Rather than chasing the highly speculative growth stories that are currently rallying the most, it may be prudent to reduce the volatility of one’s portfolio and concentrate investments on liquid, high-quality businesses.

Zero interest rates, treasury money printing and central bank bond buying is definitely supporting the speculative activity currently evident in markets but longer term investors already know that such dislocations between prices and real business activity do not last.

If something can’t last forever, it must stop. Stocks with the highest prices, and therefore the highest bars set for earnings, will be those that fall the hardest.

Assessing risks and potential rewards

Our recent purchase of relatively boring Woolworths (ASX:WOW) reflects a positive outcome from an assessment of the risks and potential rewards. Woolworths enjoys a defensive earnings stream with a solid and growing yield, the loss of competitors such as Target, leverage to a recovery through the ALH pubs business, a hedge against any food inflation, and a significant lead to Coles in data-driven cross-selling to an additional one-million online and ‘Rewards’ customers signed up during the pandemic lockdowns. Indeed, Woolworths may be re-rated on the back of a change of status to ‘growth.’

Equally boring, our increased weighting towards banks when they were trading at a rare discount to NTA, and despite a challenged short to medium term operating environment, also reflects an assessment of the balance between risk and reward.

Our lower levels of cash today are therefore less a reflection of any increased conviction in a bright future for broader equity markets, but rather the product of assessing prevailing value and stock-specific risks and rewards.

Investors would be wise to understand whether rational assumptions of growth justify the inflated prices being paid for growth stocks. In many cases we believe investors have suspended reality and that’s why we have kept investing but reduced risk by focusing on quality and size.

The Montgomery Fund and Montgomery [Private] Fund owns shares in Macquarie, Westpac, Commonwealth Bank, Scentre Group and Woolworths. This article was prepared 23 June with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.


Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. 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.

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  1. Trent Russell

    Hi Roger,
    Thank you so much for your detailed explanation, I really appreciate it.

    Thank you

  2. Trent Russell

    Hi Roger,
    I understand this question is not related, but Im hoping you can answer it for me. I bought Avita Medical shares sometime ago now., which I think you also mentioned its a company you hold. Can you explain what happened today to this company? The share price soared but the number of shares I hold reduced to balance against the share price so the overall value remained the same?


    • Hi Trent, check out the Scheme of Arrangement Booklet here: https://www.asx.com.au/asxpdf/20200624/pdf/44jws4hn6d2gg1.pdf
      “Under the proposed scheme of arrangement:
      o a newly-formed company, Avita US, recently incorporated in the United States, will
      become the new holding company of the Company;
      o shareholders will effectively exchange their shares in the Company for equivalent
      securities in Avita US; and
      o the existing listing of the Company on the ASX (as its primary listing) and on NASDAQ (as
      its secondary listing) will be replaced with a new listing of Avita US on NASDAQ (as its primary listing) and on the ASX (as its secondary listing).”

      Avita US will acquire all of the Company’s ordinary shares, and in exchange:
      o Eligible Shareholders who hold Shares (other than the ADS Depositary) will receive 5
      Avita US CDIs for every 100 Shares held by them on the Record Date;
      o the ADS Depositary (who holds Shares for the benefit of ADS Holders) will receive one Avita US Share for every 100 Shares held by it on the Record Date and will distribute those Avita US Shares to ADS Holders who will receive one Avita US Share for every 5 Company ADSs held by them on the Record Date upon surrender by them of their Company ADSs and payment of the ADS Depositary’s fee for that surrender; and
      o the entitlements of Ineligible Shareholders and Fractional Shareholder Interests will be sold in accordance with the Sale Facility outlined in section 11.5 of this Scheme Booklet and the relevant net proceeds of that sale will be remitted to the relevant Shareholders.
      Therefore, Eligible Shareholders, on receiving the Scheme Consideration, will hold an equivalent proportional interest in Avita US as they held in the Company prior to the implementation of the Proposed Transaction (subject to the Sale Facility aspect of the Proposed Transaction dealing with Fractional Shareholder Interests, discussed at section 2.8 and section 11.5 of this Scheme Booklet).

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