Commentary & Performance
Following a very strong 6% (net) return for the month of January, the Collins St Value Fund followed the ASX lower during February and March resulting in a net return of -23% for the quarter. Late February and March brought with it a degree of volatility and a market correction, the likes of which have not been seen in a generation.
We hadn’t predicted the outbreak of a pandemic, nor the precise impact one would have on ASX listed stocks if it did occur. To be fair not many people did. What we did do however, was identify that the ASX was expensive quite some time ago and that at some point the market would pull back. In response to this view we did two things:
- Accumulated cash (currently 35% of the portfolio); and
- Invested in stocks not reliant upon the indebted Australian consumer or an over-heated property market to generate positive returns.
In retrospect this was the right decision on two fronts. Firstly, because 2018 and 2019 delivered outstanding real returns to our investors (ranking in the top decile of peers as measured by independent research houses in both years) and secondly because it is giving us the flexibility to take advantages of the current situation.
Whilst we are yet to ‘pull the trigger’ on any new opportunities as at the time of writing, we did participate in the recent Paradigm Biopharmaceuticals (PAR.ASX) capital raise which saw us increase our position at $1.30 per share. Post completion of the capital raise (which was heavily oversubscribed) and resumption of normal trading on the ASX Paradigm Biopharmaceuticals last closed at $1.59 per share.
Put simply, we remain fully confident in our existing portfolio companies (balance sheet strength is one of our key criteria for inclusion in the Fund) and have not sold any of our positions this calendar year. Importantly, we are not forced sellers of stock due to our strong cash position and the continued support of new and existing investors which have seen positive flows into the Fund and no COVID-19 related redemptions.
We view the current correction as one that is long overdue and look forward to allocating our capital to a number of wonderful businesses that had been too expensive for a long time.
COVID-19: Impact on ASX Listed Shares
As far back as 2017, we identified the market as expensive. Our expectation at the time was that the high level of household debt (particularly home ownership) would begin to unwind causing a correction to both the property market and the stock exchange.
Instead, Central Bank and Government intervention saw a relaxing of lending laws and a significant fall in interest rates, the confluence of which saw all asset values increase.
Nevertheless, no amount of intervention can be sustained indefinitely, and we remained confident that some sort of slowdown was on the horizon.
The following graph identifies just how expensive US markets had become as they reached their peak in January. This chart is based on data going back over 100 years. As such it will be impacted by the type of companies that make up the index. However, it is abundantly clear that at 31x earnings, US equities were enjoying a period of optimism that was unlikely to be maintained.
In Australia, the data is similar. In the run up to our recent correction the markets unadjusted P/E (based on Morningstar data) reached as high as 18x – significantly above the historical average of around 14x-15x, with the recent correction seeing the market multiple down to approximately 13.5x.
This puts the market in Australia at cheaper than average, but quite some distance from the <10 times earnings we saw during the GFC. To put it in context, the S&P ASX200 would have to fall to just 4000 to return to GFC levels, and that’s assuming that earnings don’t fall as a result of the current pandemic.
The Outlook from Here
The market in early 2020 was objectively expensive, and though it seems that multiples are now more reasonable, we maintain concerns that there may be an additional leg down as earnings downgrades impact share prices.
Additionally, an unwinding of debt could see a reduction in cheap borrowed money searching out a home and see a protracted period where the index continues to meander around current levels.
That said, we believe that we have seen ‘peak panic’ play out in mid March as markets fell faster than ever before on the back of general concerns about the pandemic, and a rapidly increasing death rate, before plateauing as the cities of Los Angeles and New York shut down. At the point that it seemed that the world couldn’t see the light at the end of the tunnel; that’s the point where it is safe to assume an over-reaction by the market.
This is not to say that we don’t think there will be challenges moving forward. In fact, between the cultural changes we expect to see from consumers, the impact of long term shutdowns of major economies and the unwinding of consumer debt, we think there could be a protracted bear market. But uncertainty provides opportunity, and this is precisely the type of market that value investors thrive in.
We anticipate that for the foreseeable future, investors will abandon the idea of investing in index funds. Afterall, in a time where there will be clear winners and losers, who wants to invest in the losers (other than the index funds by mandate). But before that occurs, we expect cheaper prices.
In terms of identifying the turning point for the markets, historically there have been a number of reliable indicators. These include:
- Capital raisings (that struggle to get filled);
- Business failures;
- Opportunistic takeovers of companies with no other options;
- Revised earnings (downgrades, not removal of guidance);
- Objectively low multiples; and
- Commentary suggesting the death of equity markets.
While the market is not quite cheap enough for us, there are several individual companies that are getting close. Businesses raising capital via institutional placements are a perfect starting point for us.
Once establishing that the business itself is sound, a heavily discounted capital raising will often resolve the issues that the company previously had, thereby providing us with the opportunity to invest in a good quality company with no near term concerns, at a price significantly lower than where it was just four weeks (or even four days) ago.
Underscored by a 35% cash weighting and positive flows the Collins St Value Fund approaches the situation from a position of strength.
Whilst we intend to be very opportunistic in acquiring good quality companies that have been sold off heavily, we are not rushing in as markets appear to be recovering.
Instead we are seeking to use our broad and flexible mandate to take advantage of capital raisings and special situations (such as convertible note opportunities or take-over arbitrage transactions), whilst continuing to tweak our existing weightings and generally remain patient into what we see as an index fund driven recovery.
We think the future is very bright for the right companies, but we don’t believe that the market has fully appreciated the challenges that the economy faces. To that end, beyond our participation in the Paradigm Biopharmaceuticals capital raise, we are yet to make any new purchases in the Fund.
Though we continue to view the ASX20 space with interest, we wonder how the big banks will grow earnings in a weaker economic environment, at a time where foreclosures are likely to increase (albeit 6 months later than it would have been if not for government intervention) and consumer appetite for debt is decreasing. We wonder how companies like QBE, Challenger, and Computershare will fare in a world where their substantial cash floats struggle to earn a risk-free return of better than 1%.
We are attracted to large businesses with low PE’s, but when the ‘E’ (earnings) are so uncertain, our approach is one of caution.
It is precisely these types of environments where it becomes important to have invested in companies with sound balance sheets, in businesses that will survive the coming difficulties, and in people that can make the most of these very rare opportunities.
About Collins St Asset Management
Collins St Asset Management seeks to preserve and grow the capital of high net worth investors over the long term through a high conviction value-based strategy that promotes a genuine alignment of interests between investors and the portfolio management team.
The Collins St Value Fund was Morningstar’s top performing Australian equities based value strategy in 2018. The Fund is underpinned by a unique fee structure that only sees fees charged when investors make a return greater than the 10 year Australian Government Bond yield.
Collins Street Asset Management is Melbourne based and specialises in long only listed securities. The Collins Street Value Fund is available to investors that are wholesale clients as set out in section 761G(7) of the Corporations Act.