The March quarter was probably the biggest contrast in fortunes and events we’ve seen since the global financial crisis. Positivity and robust markets in January and early February gave way to a rapid selloﬀ in March on the back of the spread, and attempted containment of the Coronavirus. While January and early February now seem like a distant memory, it’s worth recapping where the quarter started before we got to March.
January was actually a strong month, both in terms of economics and investment markets - with confidence high after at least a cease-fire in the US / China trade war, and finally a resolution of the ongoing Brexit debacle. Investor sentiment was also supported by central bank stimulus measures put in place towards the end of 2019, and the fact that Europe appeared likely to finally enact a fiscal stimulus package, after years of austerity following the GFC. In fact the only major risk remaining on the agenda for 2020 appeared to be the US Presidential election, with the major concern there being the possibility of a socialist-leaning Democratic candidate winning the race.
January also saw the emergence of the Novel (ie new) Coronavirus in China, but in the early days containment appeared likely and the virulent nature of the virus was less apparent. However, as evidence emerged of its rapid spread, the Chinese containment measures became far more serious, culminating in what was at that point the largest quarantine in human history, with 100 million Chinese citizens in full lockdown. With the Chinese province of Wuhan a vital link in many global supply chains, this led to something of a supply shock, which started to send modest shockwaves around the globe from what had previously been seen as a largely China-centric issue.
The spread of the virus outside of China, originally through Iran, South Korea, and Italy, then broader Europe and the US, resulted in unprecedented global containment policies to control the spread of the virus, prevent deaths, and try to prevent hospital systems from becoming overburdened. Those same containment policies then resulted in economic paralysis, a significant rise in unemployment, and left companies scrambling to find a way to survive until business conditions normalise, once the virus has been contained.
The result was carnage in asset prices - with equity markets falling at their fastest rate since the 1987 crash, bond markets grinding to a halt, and the Aussie dollar falling to US55c. Just to top things oﬀ, we also saw a collapse in oil prices, as a spat between oil producing nations Saudi Arabia and Russia led to an increase in supply at a time when demand for oil was rapidly falling due to virus containment measures.
What followed in response was the largest and most co-ordinated stimulus measures we’ve ever seen, with governments and central banks globally showing their willingness to do whatever it takes to get their economies to the other side of the virus induced shock. These actions provided some support to asset prices in the last week of March, where we saw a rebound in equity prices and some healing in bond markets.
The quarter ended with plenty of unknowns still to work through, including how long containment policies will be in place, what the exit policies from the containment are likely to look like, and whether governments and central banks have yet done enough to enable an economic recovery to take place once we’re through the worst of this virus.
From an asset return perspective, it was only the bond market that emerged from this chaos unscathed, with Australian bonds finishing up almost 3% for the quarter while currency hedged global bonds delivered a 1.3% return. Other growth assets that have historically been quite defensive such as property and infrastructure were actually some of the worst hit markets this time around. Australian listed property fell almost 35%, while currency hedged global listed property and listed infrastructure fell by around 30% and 28% respectively. Given the sharp fall in the Aussie dollar, the unhedged returns of these two asset classes fared much better. And of course equity markets also fell for the period, with Australian equities down just over 23%, while unhedged global equities fell 9%.
Portfolio Summary (performance charts can be found on the last page)
The Portfolios had a mixed March quarter relative to their peer groups, with elements of both asset allocation and investment selection contributing and detracting.
On the asset allocation side, our exposure to unhedged global listed property and infrastructure significantly contributed to performance on a relative basis, with the falling Australian dollar providing some cushioning, and avoiding the poor performance of domestic assets, which are heavily concentrated in harder hit assets such as shopping centres in the property space, and airports and toll roads for infrastructure. However our higher weighting to Australian equities compared with unhedged global equities detracted from performance, once again due to the significant fall in the Australian dollar that cushioned the falls for international shares and the greater sector diversification in global markets.
On the investment selection side, Quay Global Real Estate and 4D Global Infrastructure significantly outperformed their relevant benchmarks, as Quay moved swiftly to limit the fund’s exposure to shopping centres and oﬃce while 4D was carrying a relatively low weighting in the heavily hit areas of infrastructure. Our Bellmont Consolidated Equities portfolio underperformed mainly due to its focus on value relative to more expensive growth companies, and our holdings in travel companies. Flinders Emerging Companies also underperformed due to their exposure to travel and consumer-facing stocks as well as mining services. Within global equities, T. Rowe Price Global Equity significantly outperformed on a relative basis, helped by its significant portfolio diversification (over 100 stocks), its growth orientation, and its portfolio construction eﬀorts in reducing overall portfolio risk leading into March.
In contrast, both our bond managers detracted from performance on a relative basis, due to their exposure to corporate, rather than government bonds and AB’s exposure to emerging market currencies.
A more detailed review of the Bellmont Consolidated Equities Portfolio in the quarter is found below, with an in-depth video covering the quarter from an Australian Equities perspective available here.
Unsurprisingly, our Australian share portfolio was not immune to these falls. After reporting solid 15.5% pa returns since inception at the end of the December quarter, now at the end of this extraordinary March quarter we’re left with a 0.85% per annum loss - albeit still significantly better than the 2.8% per annum loss of the market over the same period, but obviously significantly below our longer term expectations. For the quarter our portfolio fell by 27.5%, slightly more than the 23.1% fall of the ASX200 Accumulation Index. While such falls are never enjoyable, we do enjoy what they produce - the opportunity to buy quality companies at bargain prices, and that’s something that we’ve been busy taking advantage of. But more on that later.
While it feels almost like ancient history now, we were pleased to see our portfolio holdings generally perform strongly in the February half year reporting season. With only a couple of notable exceptions (Blackmores and Cimic Group), our companies generally managed to increase both revenues and earnings at a solid clip. Easily the standout for the period though was our largest holding - Mineral Resources (MIN), which delivered an impressive 263% increase in underlying earnings, even after excluding a massive profit on the partial sale of their Wodgina lithium mine (reported profit was actually up 6,700%!!). The company’s forward guidance was also strong, with enormous growth opportunities in front of them, and the balance sheet to be able to fund those projects moving forward. Needless to say we remain delighted with our existing 9% weighting in this exceptionally well run business.
While strong business performance is undoubtedly the foundation of good long term investment returns, we also remain mindful of the importance of attractive valuations. Even the best businesses can be poor investments if they are excessively priced, so we remain reluctantly willing to sell even strongly performing businesses when their share prices have been pushed up to excessive levels that necessarily portend lower future returns. It should be no surprise then to see that in the buoyant market conditions in February we took the opportunity to reduce a couple of our holdings that had performed particularly well for us in the last couple of years. Carsales (CAR) is a business that we have owned in the portfolio since inception, during which time it has generated a very solid 20.5% per annum return. Its business performance during that period could be characterised as solid, although not spectacular, with earnings growing by around 5% per annum, and dividends plus franking credits of around 3% per annum on average. The sum of these two figures - earnings growth and dividends - is what we consider to be the ’sustainable’ return of an investment. The diﬀerence between our ’sustainable’ return of approximately 8% per annum, and the return we achieved of 20.5% per annum is derived from an increase in the P/E ratio that the market was willing to ascribe to the Carsales (CAR) business over this period. While such increases do serve to inflate our paper wealth (and massage our egos), they also by definition lead to lower future returns. In late February, with Carsales’ (CAR) P/E ratio reaching an all time high that we deemed excessive in the context of their future prospects, we chose to sell the last of our holdings, and look to deploy those funds elsewhere at more attractive levels.
In similar, but more spectacular fashion, Magellan Financial Group (MFG) has been an outstanding performer for us since inception. An average return of more than 54% per annum has been driven by exceptional 22% earnings growth, plus a very healthy 7% per annum contribution from dividends and franking credits on average. Still, with the company’s P/E ratio almostdoubling from our initial purchase, to stand at a record high P/E ratio in late February,underpinned as it was by a record high US stock market, we took the opportunity to sell half of our remaining holding. With our other sales of Magellan (MFG) in the last 12 months, we have sold almost 80% of the total shares we purchased in this business, but would be delighted to be able to buy more of this exceptional company once again, if there was an opportunity to do so at a reasonable price.
Importantly, while in hindsight these sales turned out to be ideally timed - just prior to the beginning of the March selloﬀ, this was certainly not due to any prescience on our part. Rather, they simply reflect the continued implementation of our fundamental philosophy of investing in high quality, reasonably priced businesses. Regardless of the reason though, this cash has certainly come in handy in the Coronavirus inspired sell-oﬀ, enabling us to purchase shares of some exceptionally high quality businesses at prices we could only have dreamed of just a couple of months ago.
Accent Group (AX1) is one such business that we have been following for many years, and could quite possibly lay
Coupled with their strong returns on capital, a conservative balance sheet, and an exceptionally capable management team that collectively owns almost a quarter of the business, it’s exactly the sort of business we look for. The company’s strong first half performance saw earnings grow by another 9.2%, sending the share price to an all time record level of $2.20 (which was not unreasonable given the quality of the business), and frustrating our attempts to acquire shares at what we deemed to be attractive prices. The coronavirus inspired selloﬀ in March gave us that opportunity in spades however, as the market indiscriminately sold oﬀ retail businesses at fire- sale prices, regardless of their quality. In the month of March we managed to pick up 3 tranches of shares in Accent Group (AX1), at successively lower prices, and all significantly below our estimate of the long term value of the business. While the business will no doubt experience weak results in FY20 as a result of an extended closure of their store network, and there is every chance the share price could fall further in the short term, we are confident that they have both the balance sheet and management smarts to navigate this crisis, and come out stronger on the other side.
NIB Holdings (NHF) is another business that we added to aggressively in the period. The company’s shares began to fall sharply in late January, after updating the market that their profits in FY20 were likely to be lower than previously anticipated, as a result of a significant increase in claims expense across all of their business lines. Interestingly, an increase in claims inflation was not unexpected, with management noting in numerous prior periods that they had been earning abnormally high profit margins in their core Australian Resident Health Insurance (ARHI) business in particular in the last couple of years as a result of lower than expected claims, which they expected (and in fact intended) to normalise through a combination of both pricing and claims growth. While the FY20 profit margin is now expected to be back within their target range (after spending the last couple of years well above it), this added to the negative narrative of declining participation in the private health system to send the shares down to bargain levels. While we don’t disagree that the private health system faces a number of challenges, we remain comforted that it is an essential component of our health system, and any sustained moves away from private health insurance participation are likely to be met by government intervention in the form of both the carrot and the stick. With one of the most impressive management teams we’ve come across, that have managed to grow profits every year since they floated back in 2007, at a compound annual rate of 18% per annum - we’re confident that our purchases at these attractive prices will be richly rewarded over time.
Two of our portfolio companies that have been right in the eye of the storm in this recent crisis have been Corporate Travel Management (CTD) and Flight Centre (FLT). With unprecedented domestic and international travel restrictions in place globally as a result of the Coronavirus pandemic, there has been nowhere to hide for businesses that service the travel industry. Almost overnight they have seen their revenues virtually switched oﬀ, turning the focus of investors away from growth and profitability, to solvency and sustainability. Despite coming into this crisis with strong track records and extremely conservative balance sheets (neither company had any net debt at the end of H1 2020), they have not escaped the carnage ravaging the sector. In order to survive this extended downturn, both companies have stood down a substantial portion of their workforce, with Flight Centre (FLT) also announcing around a 50% reduction in the size of its retail store network and conducting an emergency capital raising of circa $700m, to provide itwith the cash needed to see it through this period. While we won’t pretend to know how long it will be before there is any sort of normalisation of travel, what we are increasingly confident of is that both companies are now positioned well to survive this crisis, and come out stronger on the other side. Flight Centre (FLT) in particular will emerge from this crisis far leaner, with a smaller network of more profitable retail stores, a greater focus on more cost-eﬀective home-based consultants, and a higher percentage of their business focused on the more profitable and faster growing corporate travel market. Both companies will also likely benefit from a substantial reduction in competitors when this crisis inevitably ends, with few companies in this highly fragmented industry likely to have entered the downturn with the sort of balance sheet strength and access to capital that Corporate Travel Management (CTD) and Flight Centre (FLT) enjoy. At their lows in late March, the share prices of both companies had fallen by more than 75%since late February, substantially undervaluing their longer term prospects in our opinion, even despite the unquestioned diﬃculties they are bound to face in the short term. Although we haven’t added to our positions at these low levels, we do intend to participate in the FlightCentre (FLT) entitlement oﬀer, enabling us to add to our holdings at what we consider to be very attractive prices. While we continue to expect these businesses will face challenges in the coming periods, we are confident that they’re now both well positioned to deliver strong long term returns for us and other shareholders.
As usual, we have no idea where markets are likely to move in the short term. What we have seen in the last quarter however has been an exceptionally rapid transition in the market from strong positivity (and high prices) to extreme pessimism (and correspondingly low prices). While we have no illusions about being able to ‘pick the bottom’ of either a particular share price, or the market as a whole, we are confident that we can ascertain with a reasonable degree of certainty when share prices materially undervalue the longer term prospects of a quality business. When such a situation occurs, we will buy, and we are confident that on average, such contrarian actions will deliver strong returns over time to our investors.
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