The current crisis, stemming from the global spread of COVID-19, has seen us dust off the playbook that we first wrote down after successfully navigating the Global Financial Crisis, more than a decade ago.
The current crisis, stemming from the global spread of COVID-19, has seen us dust off the playbook that we first wrote down after successfully navigating the Global Financial Crisis, more than a decade ago. Whilst each crisis is different, there are common elements. Below we detail the common elements in our four-step plan for managing a share portfolio during a crisis, and also how we have adapted it to the current crisis.
Starting from around late-February when we first noticed the issues resulting from the virus were broadening from just supply chain disruption stemming from China, to more general demand destruction across advanced economies, we have been executing on this four-step plan to protect our portfolios. It is worth noting this plan is integrated into our investment process which already considers stock holdings in a stressed market environment, but acknowledges each recessionary environment is unique and must be adapted to.
The four-step plan encompasses:
1. Increase cash positions. This has seen cash positions in our Funds move from our typical 8-10% range up to around 13-15% during most of March, a little under the maximum of 20% we would generally see as our ceiling. This has provided some portfolio protection during March as we await further clarity ahead on the path of the virus and direction of markets, but just as importantly optionality to initiate positions in new companies or top up existing holdings should volatility reveal more attractive entry points. Our mandate with investors is we are first and foremost an equity fund, so we are never going to be moving cash around to 50-80% as an example. That type of wholesale market timing game is virtually an impossible game to play. We’d rather stick to the historical fact that equity markets are generally stacked in investors’ favour over time and that guessing their short-term direction is not the type of risk we wish to take with investors’ money.
2. Reduce exposure to those companies most vulnerable to the crisis. For COVID-19 this has generally focussed on three fronts:
a. Companies with the greatest earnings risk or uncertainty. For example, companies with exposure to industries such as travel, certain forms of out-of-home entertainment, discretionary retail and financials. For financials, in a downturn we are reminded of the old proverb “If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem”. Shareholders of financials are feeling this right now as “forbearance” becomes the word of the month and bad debts will no doubt rise significantly.
b. Companies with high fixed costs including debt. Generally, our investment process steers away from companies with high debt levels at any point in the business cycle, though we have found ourselves at the margin pairing back exposure to even modestly geared companies. Operating leverage works in reverse in a downturn. A once profitable business can easily become a loss maker when revenues dry up and fixed costs can’t be cut.
c. Companies with refinancing risk. Following on from point (b) above, even moderately geared businesses can find themselves in cash flow trouble if they have to refinance at higher interest rates during a downturn, possibly forcing them into a dilutive, and share price destructive, capital raising.
3. Redeploy capital to those companies less/neutrally/positively impacted by the crisis but oversold. Pairwise correlations between stocks in Australia has recently doubled and gone back to GFC levels indicating the relatively indiscriminate nature of selling that has been occurring. This type of market dynamic invariably provides opportunities during the market volatility to top up existing positions, and add new positions, in companies we believe have been unfairly sold during the downdraft, as investors seek liquidity. We have been happy to provide them with this liquidity, particularly in our favourite type of opportunity: those that we already like for their structural growth characteristics but that are also seeing a cyclical boost due to the crisis.
There are usually always some companies that will actually see an improvement in their business from some facet of the crisis. An example of this from the current crisis in our Global Opportunities Fund is Hello Fresh, the global food box delivery service. Hello Fresh has seen a cyclical boost in demand from more people self-isolating at home. We believe some of these new customers will likely become longer term customers when isolation measures are relaxed as they get used to the ease and convenience of meal delivery (and provided recipes) compared to going out to buy ingredients.
Another example in our High Conviction Fund is the Australian company NextDC, Australia’s leading Data Centre operator. The company is benefitting from the increasing use of online digital technologies including those that support working from home, and video streaming and gaming, that are seeing increased use at present. After initially being sold off like the rest of the market in early March, the company re-affirmed earnings guidance in the middle of the month and initiated a capital raising in early April to help fund its growth agenda. After dropping to $6.58 in the middle of the month during peak fear in the market, the share price is around $8.90 and around all-time highs in mid-April.
4. Allocate a portion to quality, “at risk” survivors. This sees us allocate a portion of our portfolio to oversold, but quality growth companies, that suffer from the issues in 3(a) above, when it’s clear they will make it through the economic downturn induced by the crisis. It is important to note we are not at this point yet and we fully expect this will only represent a relatively small portion (5-15%) of our portfolio as it did during the GFC. We know from experience though that this area is often where some significant value can be found given the benefits of operating leverage in what is likely to be a significant cyclical economic rebound this time around.
In this current crisis it seems the time ahead for the global economy is likely to be difficult over at least the next 3-6 months. Markets have already fallen a significant way (even taking into account the most recent rebound) in acknowledgement of this. We are continuing to find a large number of great secular growth ideas both in Australia and globally for our Funds. We are content to take a medium to longer term view with our core portfolio holdings, in recognition that no one can consistently pick the bottom of bear market downturns. We are seeing plenty of opportunities to incrementally invest ours and our investors’ capital in the expectation of a high probability of making attractive risk adjusted returns on a 3-5 year horizon.
We hope the above provides some insight into how we are managing ours and our fellow investors’ capital through this current period, informed by our “baptism of fire” as portfolio managers during the GFC. The experience was an incredibly valuable one, and one where we can bring its lessons to bear today, for the benefit of our Funds.