Have share price falls overshot economic reality?

The Australian equity market at one stage fell nearly 35% from its all-time high in just over a month amid the COVID-19 crisis.

The challenge for investors is working out - against huge swathes of data and human emotion – whether shares are priced correctly against wartime stimulus measures, an impending recession and a pandemic with vague signs of subsiding.

In this interview, Ben McGarry of Totus Capital and Steve Johnson of Forager Funds join James Marlay to debate whether the market has priced in the economic situation efficiently. They also discuss whether investors are getting sucked in by “bear market bounces”, important things to check within your portfolio and the greatest opportunities in this environment.

Notes: You can access the video, podcast or edited transcript for this Buy Hold Sell episode below. This episode was filmed on 25 March 2020.

Edited Transcript

James Marlay: Hello, and welcome to this Livewire Thematic discussion brought to you by Livewire Markets. My name is James Marlay. I'm the co-founder at Livewire Markets and in this quite different and unique time, I'm joined by Ben McGarry from Totus Capital and Steve Johnson from Forager Funds and these two gentlemen join me via a hookup on Zoom. We're obviously respecting all of the health recommendations and keeping our distance, but we know for a lot of investors, it's a really difficult time. You’re probably looking at big losses in your portfolio and if our two guests today can help ease some of that anxiety around investing, well I think that's a good thing. So we're going to push on with the show. Ben and Steve, thanks very much for getting involved.

Steve Johnson: We might add to it James, who knows?

James Marlay: We might.

Steve Johnson: It's good to see you. Hi everyone.

Getting to know today’s market

James Marlay: Steve, let's just start from the top. What's your sense on the current situation? How have you been assessing? It's been obviously really dynamic, lots of new news flow. What's your current assessment on the state of play?

Steve Johnson: It's bad. The economic impacts of what's happening out there are going to be very, very significant and very extreme. I think from a finance and stock market perspective, we've gone from trying to incorporate that environment into forecast around profitability and what's going to happen to the business, to some fairly systemic cross the market selling, and a bit of dysfunction, not just in equity markets but across bond markets and derivatives, and all sorts of different places that you're seeing show up in fairly wild gyrations, that are becoming, I think less and less anchored to what's actually happening in the real economy.

James Marlay: That's the really hard parts to get a sense on. And conversations I've been having, have really been around trying to assess if the market pricing has any better sense on what the economic impact is going to be from this, and the 30 to 35% move that we've seen in equities, has it been efficient in pricing the disruption that's going to happen to businesses?

Steve Johnson: Well, I think if you take that question though and you actually turn it into the fundamental question, is the whole of corporate Australia worth 35% less than it was a month ago? Maybe you could argue that equity prices a month ago were wrong. But I think wiping 35% off all of the future profits that corporate Australia is going to make, because of something that is probably going to be a really bad six months, to a year, is extreme.

If you sat down and did a discounted cashflow model and said, "I'm going to take next year’s profit and dividends out of it," you're probably going to adjust your valuations by five to 10. Now there are long-term consequences here and there's some businesses affected a lot more than others. But I think saying that the whole corporate Australia is worth 35% less than it was a month ago, because of what we're seeing out there in the real world, is particularly extreme.

And I think people tend to over extrapolate at the top and they tend to over extrapolate at the bottom. We have some advantages in this country in terms of the disease's progression so far. We're an island so we can protect the borders better than most. We have a government that has the balance sheet capacity to do very, very significant things here to try and rescue it. It's not all doom and gloom from my perspective, and I feel like... I'm not saying that the 35 can't become 50. You know, we've seen plenty of market pullbacks that are 50%. But I think you will look back in a few years time and say 35% was an overreaction to the economic impact that this going to have.

James Marlay: Ben, I'll bring you in here. That assessment from Steve - bad short term, but we know markets pricing's will move very quickly and can overshoot. What's your assessment on where we stand today?

Ben McGarry: Yeah, 100% agree it’s bad. Don't necessarily agree that 35% is an overreaction short term. Because what we've got to do here is find the clearing price for equity investors to step up and recapitalise a good chunk of the Aussie equity market. And given the damage that's been done short term, you’ve really got to put attractive deals on the table for people to want to step up and recapitalise, and step into stocks that perhaps came into this with too much debt or large fixed cost bases. Nobody saw this coming. But you know, we're seeing today a raising from Cochlear, a company that pro forma or prior to this month, didn't have a lot of debt on the balance sheet, now having to rise at a 17% discount to the last traded price on a share price that had already been smashed.

So it tells you that other companies that are in a lot worse shape, are going to have to do some pretty drastic things to get through this period of turbulence. I think we've had a very short, sharp fall, but I don't think we've played out anywhere near enough in terms of time. So I think we're going to get volatility. And over time as these companies start to recapitalise, and people get more comfortable with what the stimulus and the positives are on the other side of the negatives, we'll see a base form over the next few months. So I also think it's a big opportunity over the next few years. There's big dislocations, but I'm unsure that 35% has it all priced in short term.

When to pick the bottom

James Marlay: Ben, just staying with you, there's been a few trading sessions where we've seen, after a couple of days of consecutive falls, we've seen the market try and rally, and there have been some sensational individual stock movements. I think last week we saw Civic rally 50 or 60% a day, Afterpay plus 50% in a day. So we're seeing that extreme volatility. Do you feel like, from that reaction we're seeing, that people are trying to step in and pick the bottom, and they're probably pulling the trigger a bit early from your perspective?

Ben McGarry: Almost the opposite. I mean, I think it's classic bear market behaviour and the stocks that are up most significantly on these bounce days, are some of the ones that were facing challenges, or not really profitable generating decent cashflow even prior to this virus environment we've found ourselves in.

I think you'd be very careful buying those companies that were using things like factoring and receivables and payables to flatter cash flows that have reasonable debt levels - that were having problems on projects. You know, even prior to this virus situation or something like an Afterpay, which we can talk about later, which has got challenges and is also very capital intensive in terms of its business model. It's one of the sharpest bounces today, but I'll caution people to just be careful about those bounces short term.

Steer clear of irrationality

James Marlay: Great, Steve, I'm going to pick up on a question that I kind of stole from you because I thought it was a great one that you gave me last week. When we interview investors, they often talk about moments or periods in time where they witness extreme behaviour and anecdotes. And I've asked you to both bring along a couple of the crazy things that you've seen take place in markets that you think suggest that this irrational behaviour is taking place. Steve, what's are some of the crazy things that you've seen taking place?

Steve Johnson: Yeah. It's not always irrational just because it's crazy. I think someone that is a forced seller is not being irrational about it. They're just in a situation where they have to sell stocks and you're seeing super funds across the board now, where people are jumping online, changing their asset allocation from balanced or aggressive to cash.

And that underlying super fund then has to go out and reallocate their portfolio. And really the only liquid assets that they've got that are in the aggressive strategy, are listed equity. So you're seeing that. You're seeing dysfunction in bond markets, but it's not necessarily that the person on the other side of that is stupid. They are often in these situations, in a situation where they're forced to sell.

I would say the most extreme things in my portfolio are the things that I think are largely unaffected by what's happening. We own McMahon, which is a mining contractor, you know Aussie fund portfolio, it's got five big contracts that are all long-term, really low-cost mines. Hasn't seen any disruption in terms of being able to operate those mines at the moment. And they're fairly remote. The ability to quarantine some of those sites is much easier than it is to quarantine a big city.

And I've seen the share price of that business half. It's profitable, it doesn't need cash or debt. It's a very conservatively geared balance sheet and the share price is down by half. So, I think there's extremities there. I feel like some of the stuff that is directly exposed, it's very directional, the behaviour, i.e. this thing is in tourism, I don't want to own it and I'm going to sell it irrespective of what the price is. I completely understand it. I think the argument is right that this business is going to struggle a lot.

And you might not want to own it, but there's very little discussion around what the right price is for that business. And I think to Ben's point, you're going to see a lot of recapitalisations. So why would you put money in it? $5 for Webjet if you're going to be able to put it into a recapitalisations here, whatever they're going to raise that money out over the next couple of days. I think you're saying some extremities. For me, there's not a lot of liquidity at some of the small end where we operate. So you see some crazy stuff, but we can't buy enough shares to make any difference.

And we've got something like Experience Co today that's up 60% on 10,000 or $15,000 worth or shares traded. The information is sort of irrelevant. It is a tiny number of people that are selling something to someone else. And the fact that they're selling it at the low price to start with, then the high price largely means nothing for me.

James Marlay: Ben, is there anything that's caught your eyes being kind of wild and wacky and out there in terms of the market transactions and the behaviour you've seen?

Yeah, look, I agree with Steve that there's some things that are getting carted out regardless of fundamentals and I think people are just using the playbook of 10 years ago and following that almost blindly. One thing we learned in the financial crisis was stay close to your companies because some things are going to get belted that are actually not impacted. And that creates some of the biggest opportunities coming out of things. So yeah, stocks like Credit Corp which were destroyed in the financial crisis, they came in with bad book of debts. They were trying to collect prior to the financial crisis, had a bad balance sheet as well leading into it. This is a company that raised money at $30, well ahead of any sign of turbulence in the market, and has got down into sub $10 level, and there's director buying.

So, there's some opportunities there. And NRW is one in the mining space that got absolutely destroyed in the financial crisis. It’s Is in the process of repeating history here. But you know, the iron ore space, iron ore prices holding in well. Aussie dollars come off a lot. The miners are still spending. So there's some opportunities there. The really crazy stuff I think has been at leadership level, from politicians and two of the people I think that have got the most to lose, were the most dismissive about this virus impact and they're Donald Trump and Elon Musk. Both dismissed the virus out of hand early on. Both have incredibly cyclical fixed cost businesses and stand to lose the most from the economic downturn. And so may well have had a head in the sand in terms of their reaction to this crisis.

James Marlay: Ben, I know you follow Elon quite closely. I believe he's working on a vaccine for Coronavirus too. Is that correct?

Ben McGarry: Yeah. I want to make sure we get the GM or Ford vaccine rather than the Tesla vaccine.

Steve Johnson: I don't know if this is the place for it James, but I do think that concept, that everyone replays the previous crisis. Everyone was I think on the way up, worried about exactly the same things that caused the previous crisis and that's why you get blindsided by something that's completely different. You've had the government and the reserve bank move very, very quickly here to provide funding through the banking system. You've got a bank sector that's much, much better capitalised than it was going into the financial crisis. And I don't think that there is a lot of logic in sending a robust, sustainable business bust because of something that is probably going to last three months or six months. So I'm probably more worried about working capital unwind and those cashflow situations than I am about access to bank funding, as long as that bank funding is a perfectly reasonable amount for the business in normal circumstances.

And I think you'll see that play out, say through the retail sector. I mean Unibail or Westfield, is not going to send all of its retailers bust because they can't pay their rent. Because if they open the shopping centre in six months time, there's going to be nobody there for the clients to go and shop at. So why would you send all of your clients bust? Their cost of funding is extremely low. Why would the banks want to pull the pin on a Unibail-Rodamco? And you can capitalise the interest here at something like 3% over the next 12 months and come out of the other side of it with a balance sheet that is manageable as well.

So I think you'll see more rational behaviour this time around than you saw through the financial crisis. Because in the financial crisis, the financial players were in no capacity to be lending money to anyone. They were trying to shrink their own balance sheets and trying to deal with their own very significant issues. And, and I do think it's a different set up this time around.

Signs of recovery

James Marlay: We're seeing overnight, the US market had a big 11% rally. Clearly participants over there think they saw something which was going to help them get to the other side. That rally hasn't flown through, or it's lost steam in the Australian markets today. We're recording on the Wednesday. Interested to hear from the two of you, are there any particular markers that you're looking for or watching, that would be an indication that there is a clear path to the other side of the situation we're in at the moment?

Ben McGarry: Yeah. The recapitalisations are the obvious one where they’re well supported and people are starting to make money out of the raisings from companies. I think that's the major one to look out for. But also, the ‘end of the buy’, the dip mentality, I think by the time this is through, there's not going to be many dip buyers left and you want to be the ones standing with the highest quality book of strong companies to come out of this at the end of it. So don't spend all your bullets. And we haven't really seen any mega corporate failures yet.

We're only just starting to see the start of these capital raisings. So I think we've got a way to go. You know, every cycle you'll see some of the poster child's blow up, the Enrons, the Worldcoms. In Australia we had Babcock, Allco, ABC Learning Lifecycle. We've yet to see those sort of play out this cycle. And I suspect we'll see them.

James Marlay: Ben, can I ask you on the capital raising front, is the phone ringing from the investment banks sounding you out to sense your appetite for participating in capital raisings?

Ben McGarry: No, and I don’t think they are. We're a long short fund. The long shorts tend to be towards the bottom of the list. So they're not desperate yet. So we haven't had our phone ringing off the hook. But I think there'll come a point. The companies that are further down the queue won't be able to be picky about who their investors are. And we've certainly got a lot of dry powder to invest in recapitalisations in real businesses with medium term tail winds. We very much plan to be active in the recapitalisations over the next few months.

Steve Johnson: The one thing that I know is, that by the time that you know this is over, you aren't going to be buying stocks super cheaply anymore. The way this plays out is, it goes up 10 and then it goes down 10 and you'll have five of these ‘dead cat bounces’. And then it goes up ten one day and everyone says, "Well that's another dead cat bounce." And then it goes up another 10 and by the time you have certainty here around what the future looks like, you're not going to be buying stocks at super cheap prices.

So I think you've got to be careful. I have nothing against the strategy that says, I'm conservative and I don't want to lose money and I'm going to sit and wait this out. But thinking you get to have your cake and eat it too, that you get to see certainty here and still buy stocks cheap, you're not going to get that opportunity.

I think on the economic side of things, the playbook is already in front of us. You have seen China, you've seen South Korea go through this. We own Yum China who owns all the KFC restaurants in China in our international portfolio and in an announcement out yesterday, they are back to 95% of their KFC stores open in China. They're roughly 20% down year on year in terms of sales. You're seeing traffic jams again in China. That economy is not anywhere near 100%, but crack down really, really hard and you can start getting back to work, in that six to eight week period is not out of the question.

And like I said before, we're on the cusp here of crazy exponential growth and person to person transmission of this disease, but I still think that there is some chance, I'm not running my portfolio assuming that it's the case, but there's some chance that in three and four weeks time, you've seen declining cases here in Australia. And people can see that there is an end to this. Again, I'm not betting the farm that that is happening, but I think you've got some playbooks in front of you in other countries that it works. I went out for a short run before this and the city is completely and utterly dead. The only person I went anywhere near, we tried to run around each other on the same side and almost ran straight into each other.

I think people have finally got the message. It has been incredibly frustrating. I think for those of us in financial markets that are reading the news overseas very regularly, it's been incredibly frustrating that people have not been taking this seriously. Because it is something that you can fix. It is something you can get on top of. And I think there's a huge economic incentive out there for cheaper, widespread testing for medical solutions that are going to help with this problem.

And I think you'll be surprised, three and four months down the track here, how much we've been able to adapt to a very different environment. It's going to be different for a very long period of time, but I think if we do it properly as a country, we can be starting to get back to work sooner than is being anticipated at the moment. Perhaps wildly optimistic, but we'll see.

Stock picks that can survive a crisis

James Marlay: Ben and Steve, I'm going to put one question that we'll wrap it up on and I'll get both of you to have a dip at it. So Ben, I'll give it to you first. Can you give me a sense of any particular changes you've made to the portfolio? So, how are you positioned today? And how you might expect that to change over the weeks and months ahead? Rationale for those changes, and maybe a couple of stock ideas. Maybe one or two you like, one or two that you want to avoid? Just give me a sense of how you're investing.

Ben McGarry: Yeah, look, we've pretty much been playing it to the financial crisis GFC playbook. So, be very careful about financial services, leveraged stocks, stocks with balance sheet leverage and operational leverage in this environment, I think we've steered clear of. There are some winners. I mean in our office, the dash to work from home, we've bought a bunch of Microsoft surfaces. People are using a lot more data. The cloud is an essential part of people's businesses.

So businesses like Microsoft, we've been adding to gradually on the fall. It's well held, but you know, a great business that I think will come out of this really well. Amazon, our largest stock, it's held in so well that we've actually started to sell some to roll into things that are done more. And then the likes of Visa and MasterCard, are getting smashed. They're well held, but this just accelerates that move away from cash to card and online spending, which I think they're big beneficiaries of in the long run. So there's definitely some winners and losers. But I would be very careful about leverage stocks. Buy now, pay later, I would be careful of. Companies that are very reliant on external capital to fund their business models.

James Marlay: Steve?

Steve Johnson: Yeah. I mean we are long only and in our Australian fund, it's a fairly concentrated fund of lots of small and illiquid businesses. So the market prices of those companies have been smashed pretty much across the board. There's less ability for us to do anything dramatic in terms of changing the portfolio because you're selling something that's halved to buy something else that's halved in most cases. And you know, we know those businesses pretty well and we're in touch with the management teams and are confident, in most cases, that they're going to come out of the other side of this and that the valuation hasn't changed dramatically. So you know, we've been trying to top up on those that we think are most attractively priced.

We've been taking money off the table on, almost similar to Ben's Amazon point there, some of the stuff that held up really well at least in the early days. You know McMahon was one for us, that two weeks into this was still trading near its highs and there was volume in the stock. It's one of my favourite ideas at these prices, but we took a fair bit of money off the table. We've done a lot more of that in our international fund. We've been fairly under weight in the US for most of the past two years really. And we're seeing some really high quality businesses in that market, that are probably exposed to this. But you know, lots of big net cash balances on the balance sheet, and businesses that you want to own over a long period of time that have been expensive for a long time that are trading at pretty attractive prices.

So I think the aim for us is, yes cheaper, but also better quality businesses in this environment. You buy something for 50 cents on the dollar and sell it for a dollar 12 months later, you pay tax, you've got to find something else to do with the money. If you can buy a high quality business at 50 cents on the dollar here and hold it for the next 10 years, they compound your wealth for you. You don't have to sell it and pay the tax. And I think you get better long-term outcomes out of thinking about what's the ideal portfolio for this rather than jumping at shadows and chasing every single opportunity that comes along.

James Marlay: So staying with the high quality.

Steve Johnson: I wouldn't say Aussie Fund started with high quality, so trying to make a bit of a shift there.

James Marlay: Yeah. Okay, great. Well listen gents, thanks very much for that. Appreciate you taking the time to talk through how you're investing in this environment, and we'll get you onto a few shows of Buy, Hold, Sell.

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• Access Steve and Ben's previous discussion on '5 cash earners for a crisis'
• For further ideas, it may be timely to revisit Steve's 'Recession proof, property proof' ASX portfolio that he designed for Livewire subscribers
• In Totus: ‘Cash Earners’ vs 'Cash Burners’, Ben discusses how you can find an investment style that can perform regardless of what is going on in the market