March 10, 2020
Letter to Investors – February

By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers

In our February 2020 letter to investors we discuss how the coronavirus has seen a correction in sharemarkets as well as takeaways from the February reporting season in Australia.

Dear Fellow Investors,

Welcome to the February 2020 Ophir Letter to Investors – thank you for investing alongside us for the long term.

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Dear Fellow Investors,

Welcome to the February 2020 Ophir Letter to Investors – thank you for investing alongside us for the long term.

Month in review

It was a month to remember as GFC type panic gripped markets during February as news the coronavirus was spreading faster outside of China panicked some investors. The number of infected cases of the virus globally jumped from 9,927 at the start of February to 86,013 by the end of the month, with over 4,000 deaths in early March at the time of writing. Whilst over 68% of cases and nearly 73% of deaths have been seen in China, investors are worried about:

1. Despite it appearing the growth rate of the virus has peaked in China, it’s accelerating rapidly elsewhere.
2. The economic impact is beginning to spread primarily through containment measures which is impacting both demand and supply for goods and services.

As expected, central banks have begun to move to assist the global economy which has included the US Federal Reserve announcing a 0.5% out of cycle policy rate cut and the Australian RBA a 0.25% Cash Rate reduction to help support demand and ease financial conditions. We expect more global monetary easing, supplemented by fiscal support from governments over the days and weeks ahead. Whilst it remains a fluid situation, and still much is unknown about exactly how it will unfold, the global economy has weathered many severe events in the past, going on to become stronger and more prosperous over time. The virus is unlikely to permanently dent the long term productive capacity of the global economy and the ability of individuals and companies to develop better and more efficient ways of delivering current and new goods and services. That is why we see this most recent pull back in the sharemarket as an opportunity to high grade our investment portfolios, increasing exposure to high quality companies at better prices, that we remain confident will be able to compound earnings at high rates over the long term.

For the month of February, global shares, as measured by the MSCI Developed Markets Index in local currency terms, fell a very heavy -8.1%, though perhaps somewhat surprisingly the MSCI Emerging Markets Index dropped only -3.8%, with the MSCI China index of the Chinese equity market up 1.3%! Clearly some investors are looking through the immediate impact in China to the slowing growth rate of the virus there and the stimulatory policies recently enacted by the government. Investors didn’t differentiate across the large developed economy sharemarkets with the US, Japan and European share markets down all very close to -8% for the month. On a sector basis globally, Energy (-14.3%), Materials (-9.8%) and Industrials (-9.5%) fell the most for the second month in a row, whilst Communication Services (-5.7%), REITS (-6.6%) and Healthcare (-6.8%) fell the least.

The local Australian sharemarket followed the lead of its global peers with the S&P/ASX200 index down -8.2% for the month. Small caps were hit a little harder down -8.7%. On a sector basis it was similar to that seen globally with Energy (-18.2%) down the most, followed by IT (-17.6%) for company specific reasons, with Materials (-11.9%) seeing the next biggest falls on virus impacts to the large domestic miners.

Ophir Fund Performance

The Ophir Opportunities Fund returned -9.8% for the month after fees, underperforming its benchmark by -1.1%. Since inception, the Fund has returned +24.5% per annum after fees, outperforming its benchmark by +17.8% per annum.

 

Growth of A$100,000 (after all fees) since Inception
Since Inception (p.a.) 5 Year (p.a.) 3 Year (p.a.) 1 Year 3 Month 1 Month
Ophir Opportunities Fund* 31.2% 22.3% 21.6% 25.7% -4.3% -10.1%
Benchmark* 6.7% 7.4% 8.3% 1.6% -5.9% -8.7%
Value Add (Gross) 24.5% 14.9% 13.3% 24.1% 1.5% -1.4%
Fund Return (Net) 24.5% 18.0% 18.6% 19.9% -4.9% -9.8%
* S&P/ASX Small Ordinaries Accumulation Index (XSOAI). Past performance is not a reliable indicator of future performance

The Ophir High Conviction Fund investment portfolio returned -5.6% for the month after fees, outperforming its benchmark by 3.6%. Since inception, the Fund’s investment portfolio has returned 18.9% per annum after fees, outperforming its benchmark by 9.0% per annum.  The Ophir High Conviction Fund’s ASX listing provided a total return of -11.8% for the month.

Growth of A$100,000 (after all fees) since Inception
Since Inception (p.a) 3 Year (p.a.) 1 Year 3 Month 1 Month
Ophir High Conviction Fund (Gross) 23.6% 20.8% 15.1% 1.4% -4.3%
Benchmark* 9.8% 8.5% 3.3% -6.4% -9.2%
Gross Value Add 13.8% 12.3% 11.8% 7.7% 4.9%
Ophir High Conviction Fund (Net) 18.9% 17.6% 11.3% -0.7% -5.6%
ASX:OPH Listing Total Return n/a n/a -6.3% -4.0% -11.8%
* 50% S&P/ASX Small Ordinaries Accumulation Index (XSOAI), 50% S&P/ASX Midcap 50 Accumulation Index (XMDAI). Past performance is not a reliable indicator of future performance

The Ophir Global Opportunities Fund was flat for the month after fees, outperforming its benchmark by +5.7%. Since inception, the Fund’s investment portfolio has returned +36.0% per annum after fees, outperforming its benchmark by 33.6% per annum.

 

Growth of A$100,000 (after all fees) since Inception
Since Inception (p.a) 1 Year  6 Month 3 Month 1 Month
Ophir Global Opportunities Fund (Gross) 47.7% 64.0% 15.2% 9.0% 1.7%
Benchmark* 2.4% 7.9% 2.9% -4.1% -5.7%
Gross Value Add 45.3% 56.1% 12.3% 13.1% 7.4%
Ophir Global Opportunities Fund (Net) 36.0% 49.6% 12.1% 5.9% 0.0%
* MSCI World SMID Index TR (Net) (AUD). Past performance is not a reliable indicator of future performance

Macroeconomic Highlights

It was virtually impossible to avoid news of the coronavirus and its spread during the month of February. Many seemed to see that initially it would largely be contained within China but have received a rude awakening as its spread has accelerated, particularly in South Korea, Iran and Italy, though it is likely the US, Japan and other parts of Europe will not escape a broader outbreak. This has come at a time when there is some hope the worst may be over in China (see chart below).

New Cases in and outside of China

Source: Various newswire, WHO, J.P. Morgan. Cases as of 27th Feb, 2020.

In response sharemarkets sold off strongly in the last week of February, with consecutive days of large falls seen in major sharemarkets. The speed and severity of the falls have shocked many investors who may have been lulled into complacency about risks given the strong rise in sharemarkets over 2019. The most recent falls at the end of February 2020 has taken the global sharemarket back to levels seen in March 2019 (see chart below).

MSCI World

Source: JP Morgan, Datastream

Other financial markets have responded in kind, with long term sovereign bond yields in the major markets plumbing all time lows, markets pricing in further interest rate cuts from major central banks, the USD appreciating (and AUD depreciating), as well as gold rising on safe haven flows and oil prices falling precipitously on global slowdown fears.

Looking across sharemarkets in February, none were spared, except maybe China, where there was some optimism at the end of the month that the virus spread has slowed and workers who were ordered to stay at home could begin coming back to work soon. It also gave some indication that markets there were buoyed by the news of government monetary and fiscal support. Another interesting feature of markets in February was how so many markets were consistently down around -8% for the month (see chart below). This is in spite of the fact that different countries can have very different supply chain links to China as well as different containment measures in their own countries, amongst other key differences. This gives you some idea of the opportunities that can become available at a country and company level when investors don’t differentiate during market downturns between countries and companies which can throw up opportunities for astute investors willing to do the work.

Global Sharemarket Performance in Febrary 2020

Source: JP Morgan, Bloomberg

Closer to home and the market pullback in February has seen the ASX200 index price-to-earnings ratio, one of the key valuation metrics of the Australian sharemarket, fall from over two standard deviations above its historical average, back to a little under 17. This though is still well above its average of 14.5 and its most recent trough of 13.7 during the market falls of the December 2018 quarter. This suggests that based on panic selling you could still see the market valuation fall further given the sharp run up we have seen over the last year or so (see chart below).

ASX200 –  P/E vs EPS (1yr forward)

Source: JP Morgan, Bloomberg

This is a similar story to what we have seen in other major sharemarkets during this most recent correction. A factor that may mitigate the likelihood or extent of further falls however is that bond yields have fallen to extreme levels at the same time. For example, at writing the 10 year US government bond yield, often considered the global risk free interest rate, dropped below 1% for the first time in history and the equivalent rate for lending money to the Australian government is around its all time low at 0.7%. This is scant reward for investors and after taking into account likely inflation over the next 10 years will probably result in a negative real return.

Lower government bond yields, all else equal, lower the discount rate that is used to value the cash flows of companies that we and other investors invest in. This increases the value of these cash flows today and hence the value of companies. Lower government bond yields do also suggest that there is likely to be lower inflation and lower growth ahead and this should also be taken into account when forecasting cash flows from companies.

Given that shares and sharemarkets are priced in a relative sense compared to bonds, another way to look at valuations for sharemarkets post the most recent falls is not just price-to-earnings ratios compared to their own history, but compared to bonds yields. The below chart shows the earnings yield (inverse of the price-to-earnings ratio) compared to the 10 yr government bond yield in the US. Given the recent increase in earnings yields (decrease in price-to-earnings ratio as sharemarket prices fell) and falls in bonds yields (on lower interest rate expectations, inflation and growth), the yield ‘premium’ shares are providing to bonds is at multi-year highs (see chart below).

S&P500 earnings yield minus bond yield

 

Source: JP Morgan, Datastream

This should help provide some support to sharemarkets given their relative attractiveness in light of the alternative yields on offer in most of the large bonds markets globally. Further interest rate support is likely to come from major central banks as the US in recent days was the first G7 economy to cut interest rates this year, though is unlikely to be the last (see chart below).

Policy Rates changes by central banks by country this year

 

Source: Bloomberg

February Reporting Season Highlights

Whilst the coronavirus was catching the headlines, many of our investment staff, us included, were busily seeing companies during reporting season in Australia for the first half of the 2020 financial year.

Overall for corporate Australia this reporting season was relatively ‘normal’. According to UBS, the beat-to-miss ratio for first half results was 0.9 (with slightly more misses than beats) which was a bit below the long term average of 1.2, but earnings guidance was better than expected for the second half with the upgrade-to-downgrade ratio at 1.2. Market earnings per share growth for FY20 has been revised down by 0.8% to a lackluster 1.7% by analysts. The downgrades are across the board across Resources, Financials and Industrials. The level of earnings downgrades is slightly better than the long term average (see chart below).

EPS revisions in February reporting seasons

Source: FactSet, UBS, only includes February reporting seasons

Perhaps unsurprisingly, those that upgraded earnings expectations tended to rise on average during the month, whilst those that downgraded fell. What was more interesting though is that downgrades were punished by more than upgrades were rewarded, and that high price-to-earnings companies had outsized reactions in either direction depending on their guidance direction (see chart below).

Relative capital return of low and high PE stocks (ex commodities)

Source: Company Data, FactSet, MST, Marquee

Key Stock News

In key stock news for our Australian equity strategies, A2 Milk, Cleanaway, Dominos Pizza and IDP Education all logged good results that were rewarded by the market.

In particular, A2 Milk (ASX:A2M) delivered a very strong result which was slightly ahead of expectations given guidance was only provided late last year. The company rose 6.3% over the month on the result. What was particularly impressive was the result included a large number of one off costs, so it was a very high quality set of accounts in our view. These costs include paying material amounts for carbon credits, discontinued UK operations (for which a small loss was realised) and likely a large amount for the ex-CEO payout.

A2 Milk is perceived by customers as a very high quality brand which has seen demand for its products be relatively inelastic, protecting its somewhat from cyclicality in consumer spending. We are not surprised that A2 Milk is seeing increasing demand due to the coronavirus, given it has the most flexible channels to market and is therefore positioned to take share from competitors who may rely on domestic manufacturing or single sales channels. Management have confirmed this, commenting they have seen switching into foreign brands as a result of the virus.

A2 Milk is now investing in its own manufacturing capacity and some have questioned whether we would like to see the group hand cash back to shareholders instead. We continue to see A2 as a growth company that earns exceptional returns and would like to see it continue to invest in growing its business ahead of dividends. Its capital light model has served it well to date however as it grows to a significant size, it also needs to balance the benefits of diversifying the risks of a concentrated supply base with any potential small increase in capital intensity.

IDP Education (ASX: IEL) was another company we own that posted good results and was rewarded by the market (+27.9%). It posted very strong first half growth and an improved underlying earnings outlook, assuaging investors concerns somewhat about outbound education business from China effected by the coronavirus.

Cleanaway (ASX:CWY) was a top contributor for February, rising 11.3% for the month, beating low market operating earnings expectations by 4%. Its Solid Waste Services division drove the result with revenue growing 5.4% and improved earnings guidance suggesting its ability to take market share it helping to protect it from general economic and commodity price weakness.

Afterpay (ASX:APT), which has historically been a volatility stock, fell -14.0% on the month, after what we saw was a solid result coming in the last week of February. Investors had already sold down the stock somewhat coming into the result. For us, we saw Afterpay’s global expansion momentum pleasingly continued with acceleration in both the US and UK markets. Consumers in these new markets are following a similar adoption curve as in Australia which provides strong guidance for the future of the business.

Customer purchasing frequency continues to grow as older cohorts of customers are using the platform more and more. This says to us that consumers are embracing this payment method and it has undoubtably changed consumer purchasing behaviour.

The maturing and highly cash generative nature of the Australian business is allowing Afterpay to invest significantly for the future. In big growth news Afterpay is going to launch instore in the USA in the second half of 2020 and the next regional expansion will be into Canada. This makes sense to us given the rapid growth seen in the neighbouring US where retail partners often operate in both countries and there is already some brand awareness.

The coronavirus and sharemarkets

Reporting season also saw a number of companies withdraw guidance over uncertainty relating to the coronavirus, and/or suggest they may be in for a tougher second half. The challenge for analysts will be to see whether any companies are using this as cover for deteriorating underlying momentum (ex-coronavirus) or not.

In Australia, and major sharemarkets more generally that we invest in, there is currently huge intraday volatility between stocks which throws up opportunities to high grade our investment portfolios. Lower liquidity smaller companies are being sold off much more aggressively than larger peers, sometimes when they have very little exposure to the virus. In times of high volatility, it is important to stay calm and differentiate between companies and be opportunistic. We haven’t increased our cash position but we have been selectively buying companies that are caught in the downdraft where we see little impact to their underlying business, and selling companies we have less conviction in.

Direct impacts are very roughly known, for example through travel companies and some retailers such as Webjet, Corporate Travel, Flight Centre, Sealink and Lovisa, but secondary impacts are yet to be fully determined. Much is unknown about the extent of transmission of the virus outside China now and supply and demand impacts on businesses more generally.

The market never likes uncertainty and we likely won’t know the full impact on businesses until a few months later. Investors should be focussed though on the rate of growth in transmission growth rates outside of China to get some idea of when the worst may be over and where the impacts are likely to be felt greatest.

On those companies likely to be more impacted we have been undertaking a detailed analysis of both supply side and demand side factors. For those most impacted, it is important to differentiate between those companies that are likely to permanently lose sales during this period due to either reduced demand or supply chain disruption, and those likely to see ‘catch up’ sales once it passes. It is also prudent to review the ability of companies most impacted to weather short term revenue storms to ensure they are can get through the ‘hump’.

For long term investors, the coronavirus needs to be put into the context that the value of a business is the discounted value of all its future cash flows. For companies that are long term holdings for investors, it is likely that for most it will only be a minor impact on the value of that total future stream of earnings.

The key point for us at present is that we don’t really need to change anything or manage any differently because we do our best to plan for corrections and downturns ahead of time in our portfolio construction. We always apply a lens of “how does this perform in a correction/downturn”, so we manage for corrections proactively, balancing exposures accordingly from a sector, style and geographic standpoint as well as a focus on the quality of earnings and its relative and absolute valuation. That way when corrections inevitably come, we have prepared and can add to positions we have the most conviction in that are unfairly sold down by the market when its in a state of panic.

Whilst it can be unsettling to see swift market falls, these are the times when the prepared can make some of their best investments that are likely to be rewarded by the market when conditions inevitably normalise.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Portfolio Managers

Ophir Asset Management

 

This document is issued by Ophir Asset Management Pty Ltd (ABN 88 156 146 717, AFSL 420 082) (Ophir) in relation to the Ophir Opportunities Fund, the Ophir High Conviction Fund and the Ophir Global Opportunities Fund (the Funds). Ophir is the trustee and investment manager for the Ophir Opportunities Fund and the Ophir Global Opportunities Fund. The Trust Company (RE Services) Limited ABN 45 003 278 831 AFSL 235150 (Perpetual) is the responsible entity of, and Ophir is the investment manager for, the Ophir High Conviction Fund. Ophir is authorised to provide financial services to wholesale clients only (as defined under s761G or s761GA of the Corporations Act 2001 (Cth)). This information is intended only for wholesale clients and must not be forwarded or otherwise made available to anyone who is not a wholesale client. Only investors who are wholesale clients may invest in the Ophir Opportunities Fund and the Ophir Global Opportunities Fund. The information provided in this document is general information only and does not constitute investment or other advice. The information is not intended to provide financial product advice to any person. No aspect of this information takes into account the objectives, financial situation or needs of any person. Before making an investment decision, you should read the offer document and (if appropriate) seek professional advice to determine whether the investment is suitable for you. The content of this document does not constitute an offer or solicitation to subscribe for units in the Funds. Ophir makes no representations or warranties, express or implied, as to the accuracy or completeness of the information it provides, or that it should be relied upon and to the maximum extent permitted by law, neither Ophir nor its directors, employees or agents accept any liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. This information is current as at the date specified and is subject to change. An investment may achieve a lower than expected return and investors risk losing some or all of their principal investment.  Ophir does not guarantee repayment of capital or any particular rate of return from the Funds. Past performance is no indication of future performance. Any investment decision in connection with the Funds should only be made based on the information contained in the relevant Information Memorandum or Product Disclosure Statement.

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