I. Market Recovery First Phase Completed
This blog coincides with the recovery of the Australian share market from a low of 4546 to 6148 on 10 June 2020, followed by a retracement and currently in the week ending Friday 19 June, trading around 6000. The rationale for the view that the first recovery phase is complete is because the first phase revolves around the market’s reaction to the COVID-19 health issue.
Australia has been well served by our government and public policy representatives in adopting the Singapore solution with its three limbs; a) COVID-19 cases quarantined at home or in a government arranged facility, b) serious cases in the hospital with drugs/ventilator and, c) testing continually to separate the sick from the well. To these three limbs set out in the third blog for March, can now be added d) social distancing.
The bottom of the Australian market coincided with the fall in the double derivative i.e. the rate of change of new COVID-19 cases. This appears to be on a country by country basis with China bottoming first as they brought their health pandemic under control, followed by countries such as Australia. From the high in January of just under 7200 to the low on the 23 March, the market fell by 36%. The S&P/ ASX 200 index was 6618 on 30 June 2019 and this is a more appropriate base to benchmark the 2019/20 financial year. The banks fell more than the market because of concerns about bad and doubtful debts, with the majors falling from $25 to $15 i.e. by 40%.
This base case for the banks was predicated on two arguments: a) that each $1 of share price was equal to $3B market capitalisation, so a $10 fall in bank share prices equated to $30B for each bank. This seemed excessive. b) On a valuation basis, the level of impairments looked overblown because we were considering a health event rather than a systemic credit crisis. Moreover, governments around the world had injected liquidity and fiscal support at unprecedented levels including the Jobseeker/Jobkeeper program in Australia, the PPP program in the USA, and like support programs in the UK, New Zealand, and other parts of the developed world. RBA lowered the cash rate to 0.25% and has anchored future cash rates to 0.25% through Quantitative Easing. These stimulus packages meant that the financial system was flooded with cash supported by central bank buying bonds and other securities. So here, we are with a market around 6000 and the first phase of the COVID-19 market recovery complete.
Let us consider some of the learnings to date. We have all been learning day by day of the health impacts of a pandemic such as COVID-19. Having avoided earlier viruses such as SARS, MERS, Ebola and been assured by the Chinese authorities that they had COVID-19 under control, Australians were justified in having as their base case that COVID-19 would not have a significant impact on Australia. How wrong we and the rest of the world were.
The shock of such a Black Swan event should not be underestimated. The mind tends to rationalise and simplify its response, with fear and running for cover as the normal human reactions to the lion appearing. With markets being leading indicators, the history is that one should not hideout for too long because markets adjust quickly and in this case bottomed three weeks later, an extraordinarily fast fall. “Up by the stairs and down by the elevator” is the old adage.
The Burrell approach as outlined in the blogs and broadcasts have so far born fruit. Firstly, as was the case during the March 2009 global financial crisis bottom, it was important not to run away from the market, but to hold ones’ positions and to take up placements, share purchase plans, rights, and other issues. Secondly, during such a correction, all stocks tend to fall at once as they run away from the black swan event. It is during the recovery period that the good businesses i.e. the cream rises to the surface. It was, therefore, appropriate to compile a list of stocks with defensive earnings in a Burrell Focus List and to consider other stocks which had fallen by about the same amount, but which would be much more impacted by COVID-19. A rotation from the latter stocks to the defensive focus stocks should enhance portfolio returns and has indeed done so. This may mean the same return for a lower level of risk, but there is no need to take any additional risks in the current environment.
Another core behavioural tenet during such periods is to value invest not sentiment invest. Such investment requires consideration of company announcements, research, and an experienced advisory firm that does not go astray. Another tenant is not to get too far ahead of the curve. Paul Taylor from Fidelity Australia made this point in one of his broadcasts. Stocks in heavily impacted industries such as tourism, education, and entertainment should be carefully analysed to see whether the real economy impacts going forward might be underestimated. It needs to be remembered that the profit in any business is in the last 10-15% of sales. Our base case is that all businesses will start with sales being 10-20% off. The economy and business are disrupted- disrupted businesses earn less revenue. Even companies that one might think are doing well such as those in the pathology industry have announced that during April, revenue was off 30% because whilst they were undertaking COVID-19 tests, few were attending their medical centre for regular pathology tests. Moreover, COVID-19 tests are expensive requiring isolation facilities and PPE (Person Protective Equipment), so that the profit on the COVID-19 tests is unlikely to make up for the fall in the pathology industry.
II. The Second Phase
This brings us to the second phase, which is to assess the impact on revenues and profits from COVID-19 on Australian listed companies.
Firstly, it needs to be understood that as a previous head of the Federal Reserve stated on Bloomberg this week, there is a great deal we do not know about how the world and the economy will respond to COVID-19. There is a tendency for many including analysts to underestimate the impact on businesses.
In many cases, there is a dearth of reliable information, because the companies themselves do not know as to what the impact will be. It seems likely that there will be a quarter of loss of production in June, which will never be recouped. Moreover, the September quarter will also be down a material amount before some more reasonable recovery towards the end of 2020 and into the beginning of 2021. Some businesses such as international air travel may not be viable if and until a vaccine or other effective medicines is trusted and available. Best to avoid those companies as the reality may lead to a loss of share price and value at any point when a company fails to meet expectations.
It is highly unlikely that we are looking at a v-shaped recovery in the economy, yet some overseas markets have been behaving as if there will be a V-shaped economic recovery. Rather the base case for economic recovery is shorter than a systemic event such as the GFC being 3-7 years so that economists are suggesting 12-18 months to recover towards a GDP employment level before COVID-19.
Within this broad pallet of economic recovery, different businesses including listed companies will recover at different rates. Management will be more critical and managers that were appropriate for the good times may well be found wanting during testing times during the recovery phase.
III. Australia Easier to Predict than overseas
Australia has had the dual benefits of good governance of the health issues during COVID-19 including low deaths due to one of the best health systems in the world and a culture of vaccination and common sense. On the economic front, China has acted responsibly and in its interest by reopening its economy and going to extraordinary lengths to restore the supply chains. There was initially a great concern about the interrupted supply chains as set out in the original March blogs. However, China has assured that the supply chains are open and goods have caught up reasonably quickly. This means that the Chinese demand for Australian iron ore has continued at record levels and likely to do so for a while, as customers not only make-up supply but decide to carry higher levels of stock rather than the just-in-time stocks which management accountants have suggested for many decades.
The Australian consumer will likely be tentative. Many of the Australian generations have not had an event to teach caution and even amongst those of us that have a few lashes of experience, COVID-19 ranks right up there in teaching the need for saving and keeping funds aside for a rainy day. While online sales in certain categories may be booming, many Australians will be rightly concerned about income levels going forward whether from their businesses, their employment, or as to what happens when government support is wound back or ceases. Against this backdrop, the decision by the Australian government to defer the Australian Federal Budget from May until September/ October was wise and spending on infrastructure was anticipated. In fact, the first major announcement on infrastructure that was made in the past fortnight has validated some stocks in the infrastructure chain being included on the Burrell focus list.
Whether the economic recovery via Nike tick, W, or one pessimistic banker was suggesting an L shape, only the optimists would see a snapback V. Your diarist sees an immediate small v recovering half of the fall and then a more gradual recovery over the next 6-9 months for the second half. Employment is a lagged economic indicator and will take longer.
IV. Overseas is more complicated
The USA is currently experiencing a second wave of COVID-19 cases. That has been obvious to the rest of the world for some weeks, but many in the US appear to be in denial. There is a strange thing that the USA with all its attributes has as its greatest strength that they are myopic, and as its greatest weakness that they are myopic. We saw this during the GFC, when those in New York could not understand the impact of the mortgages they were writing, and the rest of the world was misled because we thought those smart people in New York would have it under control. Again, we should be wary of assuming the USA has the second wave of COVID-19 under control. They may well have a flashback to March, which needs to be managed, and this could have an impact on the rose coloured view within the US market. At Burrell, we also remain concerned about the US November election. The 115,000 US deaths with some projecting 200,000 by September must surely provide the Democrats with a reasonable chance of taking not only the Senate but also the Presidency. Such a thought would have been unthinkable two months ago. Your diarist is not predicting this will happen, but even if the market thinks there is some probability of change, resulting in the corporate tax rate cuts being reversed such that the US corporate tax rate increased from 21% back to 28%, then the US market will suffer a material rethink. It is known globally that the US health system is one of haves and have-nots. Part of the reason for this is the US health system has at its base that employers arrange health cover for many in the population. With 20.5 million continuing US jobless claims increasing at around 1.5 million per week and now over 1 million per week for the thirteenth week in a row, there may not be a better time for Democrats to adopt an Australian Medicare style program.
Elsewhere overseas, the UK has suffered from the US mishandling of COVID-19, European growth remains weak, COVID-19 has spread to several emerging nations and those emerging nations do not have the ability to provide the stimulus programs of the western world.
Burrell has therefore been reluctant to place major positions overseas until there is greater clarity that overseas countries have more adeptly dealt with the first phase being the health crisis.
In summary, the first phase of the Australian market recovery is completed with the market recovering to 6000-6200 range. Stay the course, be engaged, value invest, be more defensive than growth-oriented. The second phase is to understand how the economic recovery will be experienced by different businesses. Look for a good margin of safety and question yourself and others when they say, “things will easily return to where they were”. Enjoy the challenge.
Disclaimer & Disclosure: Burrell Stockbroking Pty Ltd and its associates state that they and/or their families or companies or trusts may have an interest in the securities mentioned in this report and do receive commissions or fees from the sale or purchase of securities mentioned therein. Burrell Stockbroking and its associates also state that the comments are intended to provide information to our clients exclusively and reflects our view on the securities concerned and does not take account of the appropriateness of the recommendation for any particular client who should obtain specific professional advice from his or her Burrell Stockbroking Pty Ltd advisor on the suitability of the recommendation. Whilst we believe that the statements herein are based on accurate and reliable information, no warranty is given to its accuracy and completeness and Burrell Stockbroking Pty Ltd, its Directors and employees do not accept any liability for any loss arising as a result of a person acting thereon.
This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs ('relevant personal circumstances') of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor. If the advice relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.
Burrell Stockbroking Pty Ltd (ABN 82 088 958 481), a Participant of the ASX Group and the NSX.