As the world entered the uncharted territory of a global pandemic, so did the financial markets. Never before has there been an external shock that has been met with so much fiscal support from governments and monetary support from central banks.
There’s no doubt that this is providing a cushion at a macro level, and in Australia, a swift market downturn has been followed by a relatively strong upswing. But on closer inspection, there are still many variables that need to play out before we can draw conclusions about markets.
In the article below, we discuss three lessons learnt and what to expect in the unfolding reporting season.
1. The market doesn’t always reward performance
Many companies have been hit hard by the impacts of COVID-19, resulting in a rush to raise capital in an effort to create financial buffers to weather the crisis.
However, other companies appear to have resilient earnings and have not needed to undertake the discounted and sometimes heavily dilutive capital raisings that others have. Yet despite this comparative strength, some of these companies have not been rewarded by investors with a positive re-pricing, and in some cases have even experienced a sell-off.
An interesting example is IPH (ASX:IPH), a company that files patents and trademarks on a global basis. It has proven a relatively stable business over many years, has not commented on earnings during the last few months and has not raised equity.
With an expected 2021 EPS of 40c (pre-COVID, and essentially unchanged today), the stock has gone from 25x PE to around 18.5x PE. In volatile times, we would expect a higher rating for visible earnings, and while we do expect some weakness in patent filings going forward, we don’t believe that it would warrant such a downward price movement.
Furthermore, we believe the broader sectors of Mining and Mining Services should be given more recognition and higher ratings than they have been given over the past few months. Commodity prices have been strong for iron ore, gold and more recently base metals such as nickel and copper. Balance sheets in the sector remain strong and earnings visibility is as high as it’s been for many years.
As an example, NRW Holdings (ASX:NWH) will likely meet or exceed guidance and has a strong forward order book with exposure to sectors such as infrastructure, iron ore, gold and civil construction. It has a positive outlook that should make the market notice its resilience and visibility. The stock trades on a PE of 7.3x next year – we believe it could be as low as 10x if it meets its guidance and continues to have a positive outlook.
Similarly, Independence Group (ASX:IGO), which mines nickel and gold, will show a balance sheet with $500m+ of cash and investments and has beaten production forecasts. It pays a dividend and has growth options. It is on a 10% free cash flow yield. The company trades on an EBITDA multiple of around 5x. This appears cheap for a company exposed to the fast-growing electric vehicle sector which has significant demand for high quality nickel for its batteries.
We find that many strong cash generative businesses like these are simply not resonating in the current so called ‘melt-up’ in shares. Investors seem more focused on customer growth and revenue growth, as opposed to free cashflows and earnings.
2. Not all technology stocks are created equal
A big theme of the year has been the impact of technology stocks on the performance of the markets, both locally and in the US. While we don’t want to weigh in on whether there is a tech bubble in Australia, we do think there are pockets of investor mania in fintech and artificial intelligence, where the road to any meaningful cashflow or profit seems very far out.
The technology sector has been very strong, and we own a number of companies in this sector, but the key is to be selective. Many of these companies seem to be growing their shares on issue rather than their returns.
Subscriber numbers and Total Addressable Market (TAM) are interesting but we are wary about the 'me too' effect. Afterpay (ASX:APT) was the first significant, listed buy-now-pay-later provider and now there are seven listed providers, with more to come. There will be winners and losers in the fintech space and we focus on ensuring they have a pathway to sustainable profit and cashflow.
Another aspect to consider in the technology sector for Australia is that there are some big global peers with significant access to capital. By nature, the sector is fast moving, and as a result the barriers to entry can be quite low.
3. Institutional investors are important when times get tough
As a large institutional investor, we are often asked about the wisdom of discounted capital raises and their dilutive potential for smaller investors.
Generally, when there is a strong share price performance from a company and it is ‘hot’ among investors, a company will capitalise on this and raise equity. Smaller (retail) investors will flock to the raising as the share price is going up. The reverse seems to be the case when an otherwise solid company is struggling, due to external factors, and the share price is weak. Smaller investors are less inclined to participate.
Overall, by the time a company comes to raise money, a large proportion has been de-risked by institutions, hence there may in some cases be an advantage for smaller investors. When a company needs equity in a short timeframe, it is not that feasible for a company to seek retail demand: their boards want some certainty of demand and success in a matter of hours.
The recent round of capital raisings, undertaken to provide companies with a buffer in the face of the pandemic, demonstrated the important part that professional investors play in the economy.
Looking ahead: themes for coming results season
The majority of companies are maintaining or changing guidance, or completely withdrawing their outlook. Most market participants are aware that the earnings estimates are likely erroneous or simply stale.
Some sectors, such as travel and pockets of retail, remain very difficult to forecast. Companies like Flight Centre (ASX:FLT) and Webjet (ASX:WEB) face the near impossible task of predicting when international travel will resume and also when domestic travel returns to reasonable levels.
Many companies have either already strengthened their balance sheet or have stated that their capital position remains sound. The problem for both companies and investors is that balance sheets are a 'snapshot' and their level of soundness can be directly correlated to the ongoing duration of the pandemic.
It is likely that some companies raised capital with a view that the pandemic would be near over by now, and hence may be forced to come back to the market for additional debt or capital.
Some themes worth noting:
- Companies will remain cautious so don’t expect guidance or outlook statements from the majority of companies.
- Potential ending of some fiscal stimulus measures such as JobKeeper will be at the forefront for some companies and investors.
- Check how the company has adapted to potential longer-term implications of this crisis? Issues like supply chains, online capability, remote working arrangements, appropriate gearing levels, customer concentration, rental arrangements and travel to name a few.
So, we aren’t expecting that the reporting season will be a disaster, but we do expect there will be some confronting news when investors see the actual numbers and the outlook.
Tim Canham and Wik Farwerck are Senior Portfolio Managers at First Sentier Investors (Australia), a sponsor of Firstlinks. This material contains general information only. It is not intended to provide you with financial product advice and does not take into account your objectives, financial situation or needs.
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