The first half of 2020 has been a tumultuous period for the world and no less for the economy and financial markets. For many investors and market participants, this period has been described as a ‘once-in-a-generation’ black swan event.
From its peak in late February to its trough in late March, the S&P / ASX 200 (a preferred measurement of the equity markets by many Australian investors) fell over 35%. At VP Capital, we had been expecting this for some time. Valuations had been stretched on many levels and financial metrics suggested many parts of the equity markets were trading at lofty highs not seen since the period leading up to the dotcom crash in 2001 and GFC in 2008. Combined with political uncertainty, particularly between the US and China, as well as the initial Covid-19 outbreak during the December 2019 and January 2020 periods, our analysis indicated the market was vulnerable to trade down on bad news. With this in mind, we entered February 2020 with a significant percentage of our holdings in cash which proved to be conservative, thereby protecting our fund. Despite the broader market returning one of the steepest declines in modern history, we were able to minimise the first quarter impact to single digits, protecting most of the +36% gain we achieved in 2019.
Explaining the recent “recovery”
The share market downturn was not unexpected given the unprecedented disruption to businesses caused by Covid-19 and the economic shocks that reverberated throughout the economy, but what took many – including professional investors – by surprise was the subsequent 30%+ recovery from the index’s bottom on 23 March 2020. During the next three months, investors had to make hard decisions about how to position their portfolios. On the one hand, a strong monetary policy response including yield curve targeting in countries like Australia to the promise of “unlimited QE” by the US Federal Reserve as well as fiscal stimulus (such as JobKeeper in Australia, for example) lured capital back into the equities market, perhaps by the promise of ever- lower-interest rates and ample liquidity. On the other hand, there was no doubt that it would take months – if not years – for some sectors such as hotels, airlines, dine-in restaurants to return to 2019 trading conditions. Productivity – ultimately what each country is measured on when we talk about GDP – was (at least temporarily) significantly reduced, which would ultimately lead to falling earnings and falling asset prices.
The GFC playbook in the past taught us that one should never bet against what became known as the “Fed put” (ie where the US Federal Reserve underwrites liquidity and asset prices through monetary policy stimulus), but there was also no doubt that the Covid-19 pandemic is in many ways very different to the GFC. The 2008 crisis was concerned about liquidity, especially at an institutional level, but the 2020 pandemic is one that directly affected consumer facing businesses and disrupted jobs (and that’s not to downplay the even more important health consequences of the virus). The 2020 pandemic was also more disruptive for the individual. For a start, there were border closures, inhibiting travel around the world, effectively shutting down the tourism and overseas education sectors so critical for a country like Australia. Eventually many countries and cities progressively went into some form of government-mandated lockdown, effectively inhibiting business operations altogether. Long-term contractual obligations such as supplier relationships or rental agreements, as a result, were either renegotiated or in some cases blatantly dishonoured. While all these factors were playing out, health authorities were trying to supress the spread of the virus to avoid a second wave, something that some countries and cities are now starting to contend with.
So how do we explain the rise and rise of the share market since late March 2020 against all this negative news? And what should we expect from here? While some of this article’s earlier discussion would offer clues on what may motivate market participants (eg monetary policy easing, fiscal stimulus, or perhaps things just looked ‘cheap’), there probably isn’t one single deciding factor about why share prices have skyrocketed since the lockdowns started. Since the recovery started gaining momentum, there has been substantial retail interest in buying shares. A simple search on Google Trends showed that people around the world searching for the words ‘buy shares’ was the highest ever in over 10 years. Popular market platforms such as CommSec, not to mention the low/no- fees likes of Robinhood, also reported significant spikes in new account openings and previously inactive accounts trading. Observing that there has been no immediate- disastrous economic result, we think the recovery has been driven by a false sense of security, and a flawed assumption that the current benign economic environment will continue. We think the equity market took this narrative and morphed it into a broad-based momentum trade. And of course, the quant funds working on algorithms to detect the start of such momentum trades would not have been far behind. Typically, as the momentum gains traction, the market goes up even more and even faster. This was what we saw not just in Australia, but around the globe’s leading financial markets such as the Nasdaq, China ADRs and other major exchanges in London and Tokyo. Fast-moving momentum trades that draw large retail crowds though, like cryptocurrencies in the past, tend to reverse just as quickly as they went up. But for now, it would seem investors are happy to go along for the ride and hope they’re not the last ones stuck holding overpriced shares in a reversal of the trend.
Winners and Losers
More importantly, going forward we would expect the market and ultimately the economy to start moving towards a two-tiered, two-speed market – an idea reminiscent of the ‘two-speed economy’ terminology that was commonly used during the laggard days in the mining industry, while east coast Australian domestic economies seemed to reach new heights year-on-year. And this time, the two-tiered, two-speed market is probably here to stay. The Covid-19 pandemic has accelerated certain trends such as the rise of online retail (the likes of Kogan, Temple & Webster), a greater reliance on amalgamated logistics hubs (the likes of Qube Holdings, Goodman Group ), a move away from cash and hence the rise of the prolific buy-now-pay-later sector (Afterpay, Sezzle), payments businesses (Pushpay, EML), and even the near-return to normal trading conditions for EFTPOS terminal businesses (Smartpay). At a global level we see the same happening around the world, as more businesses or individuals adopt technologies such as Shopify and Zoom for e-commerce or business meetings or consumers rely on web-based service providers such as Meituan Dianping in China. We believe there is still a lot of value in such businesses and these business models will most likely come out stronger after this pandemic, as people are essentially forced to learn and adopt these technologies during this period. Once familiarity with such technologies is established, it is hard to see businesses or consumers reversing their habits.
On the other hand, it is questionable why some businesses have risen to the extent they have in this equity markets recovery. There is no discernible pathway in 2020 and we would expect for most of 2021 for tourism- exposed industries (such as airports, airlines, cruise ships operators, hotel operators), REITs (many of which have publicly announced devaluations driven by defaults and rental renegotiations), overseas education exposed sectors and so forth to return to the trading conditions of pre- Covid-19. With lockdowns around the world looking increasingly likely to stay longer and potential second waves of outbreaks occurring in many countries or cities that have started relaxing the rules, we would expect such businesses to face substantial cash drains in the foreseeable future. Similarly, the Australian Government has forecasted immigration to decrease materially in the next 18 months, which will potentially drive a near- term imbalance between housing supply and demand. This affects not just developers and the like, but also construction companies, materials suppliers, to name a few. Ultimately, this all leads to jobs losses and these are starting to emerge, as we saw with Qantas’ decision to make redundant 6,000 employees at the end of June.
For now, there are many companies relying on fiscal stimulus (such as JobKeeper payments) and renegotiating terms with creditors such as landlords and suppliers. But the end result is that the pie gets smaller, especially when the government initiatives finish and someone (whether it’s the government and ultimately taxpayers, or a landlord or a supplier) has to cover the bill. In fact, everyone will have to share in the cost of the bill. Governments cannot indefinitely borrow against the future nor can they indefinitely print money without either creating a significant tax burden in the future or potentially debasing their currencies.
Presently, economic conditions are not as dire as what was initially expected. Investors always expected, for example, electronic sales companies such as the likes of JB Hi-Fi and Harvey Norman to do well (and indeed they posted like-for-like sales growth during the lockdown period). And probably rightly so. But even some sectors such as household furniture (eg Nick Scali and Adairs), car repairs (eg Super Cheap Retail Auto) all posted some growth during the Covid-19 period. Now that we are some months into the pandemic, it is starting to become clearer who or which sectors will do well and which sectors may face greater financial constraints moving forward. We think there will be an opportunity to take long term positions in the sectors and companies that survive on a second retreat in the market, especially as some countries and cities flirt with the idea of re-entering a lockdown and unemployment figures potentially become more concerning as government subsidies are wound back.
Positioning for the future
At VP Capital, we have these discussions almost on a daily basis and have positioned our portfolio to reflect such a view. There is no point making strong returns on the way up, if it means we are taking undue risks and only to give up those gains when market volatility heightens or when the market turns the opposite direction. An investor’s philosophy is hopefully – and we strive for this – all about constructing an investment portfolio that generates stronger-than-market returns during good times, while preserving capital during harder times. This has helped us capture the upside in 2019 when the market was strong, but weather the market volatility in February and March 2020. We achieve this by constructing what we believe is a relatively balanced and diversified portfolio. By the end of June 2020, we are holding around 20% of our funds under management in cash. This is backed up by 40% of our funds in about 15 to 20 companies that we believe will either come out of this pandemic even stronger or achieve greater heights irrespective of near-term market fluctuations. We hedge this position not only with our unusually high cash position, but also through a combination of strategic shorting and positions in gold stocks. The market is a fascinating place to be at the moment. There will be numerous opportunities to secure long-term positions in the near-future. The key is to avoid the pitfalls and not blindly follow the momentum.