That's a wrap folks

This reporting season was always going to be one to remember as corporates reported on the peak period of dislocation caused by COVID-19 and earnings estimates within our market were relatively stale given the broad removal of guidance over this period. We saw 2H20 EPS growth fall 38% for the ASX200, which for context was larger than what we experienced during the weakest point of the GFC (-20%). Despite the local economy having re-opened faster than expected and most companies benefiting from fiscal stimulus one way or another, 40% of firms missed estimates, which is above the typical 30%. However, investors seem very prepared to look through both this and next year’s earnings in an unusual display of patience, as firms that missed were broadly flat versus the index.

Over the month, the ASX200 gained 2.2% but underperformed MSCI World by 4.3%. IT was the clear leader gaining +15.3% whilst defensive sectors such as Utilities (-5.9%) and Telecommunications (-5.2%) underperformed. These businesses, whilst resilient, were not as immune as investors first thought. A positive surprise from reporting season was strong cash flows, reflecting falling inventories and a rapid rise in bank deposits, whilst an area of weakness was on costs, with many companies reporting higher than expected COVID-19 expenses. Other key themes that were evident include:

• Capex: we saw caution around companies making longer term capital investment decisions, with many companies also taking a 1 year break from maintenance/refreshment expenditure.
• Labour force: most companies are downsizing headcount, many taking pay cuts (at an executive and Board level) and pausing near-term recruitment plans, together with active management of all discretionary expenditure.
  
• Lack of guidance: the vast majority of companies have refrained from giving guidance for FY21, but we have seen some willingness to give guidance for 1H21 (i.e. the 6 month period ending 31 December 2020). This has been a useful way to deal with stale and/or a large dispersion in current consensus estimates. Where guidance has been provided, it is subject to further government-imposed lockdowns and any material delays in supply chains affecting delivery of goods.
  

As we wrap up the August reporting season, the ASX200 is now trading on a 12MF PE of 20x, and the Industrials Ex-Financials on c.30x which by all accounts is arguably stretched. Looking ahead there are reasons for cautious optimism, with a number of COVID-19 vaccine development updates anticipated in the latter half of this year. In addition, domestically there is also an expectation that the upcoming October budget will result in further stimulus measures (albeit likely much smaller in quantum). Average dividend yields are now sitting at c.3% which given the regulatory pressures placed onto the banks and insurance sector, we view this as the trough, with any recovery from here being gradual. We continue to monitor the economy for signs of recovery, acknowledging that true stress points remain clouded by the various support measures that were put in place. Besides government’s spending in large scale infrastructure, an indicator that we hope to see recover would be corporate capital expenditure, as spending is most likely our ticket out of this COVID-19 induced economic crisis.

Given the continued uncertainty and the lack of company forward earnings guidance, wide dispersion of earnings estimates will remain, but we do expect companies to continue to provide rolling trading updates to help inform the market as best they can. When it comes to forecasting, one needs to remain humble given the various alternative paths the market can take from here.

That doesn’t mean, however, that you sit on your hands. We have positioned our portfolios such that there is a balanced mix of defensive companies offering recurring earnings, businesses that are positively leveraged to the re-opening of economies, as well as companies with long term structural tailwinds that enable compounding returns over our investment horizon of 3-5 years and beyond. We tilt into these 3 broad categories, depending on forward-looking views, with the aim of looking beyond current market volatility and displacement. We continue to accumulate positions in high quality companies with effective management teams, strong balance sheets and positive earnings prospects.

General result update by sectors:

Materials: Strong results given resilient commodity prices, but broadly in-line with expectations. The bulks BHP, Rio Tinto and Fortescue all benefited from elevated iron ore prices. This is a sector of the market which is delivering attractive returns; dividend yields are well above market average and the expectations that elevated returns will remain in the near term given the high iron ore price.

Healthcare: Broadly exceeded expectations and well positioned for future growth. There are some clear winners over the last few months, in particular those leveraged to respiratory masks and humidification products such as Fisher and Paykel and Resmed, however there have also been others that were negatively impacted by wide-spread shut downs, impacting surgical procedures as well as supply chains (e.g. Cochlear, CSL). From a reporting perspective, most of our Healthcare companies saw material share price gains on the days they reported.

Industrials: COVID-19 significantly impacted earnings. Industrial stocks recorded generally weaker results with an already softening economic backdrop further exacerbated by a COVID-19 induced recession. The transportation sector (Airports, Ports and Airlines) posted the sharpest decline in earnings particularly in the June quarter, off the back of rolling lock downs and travel restrictions. Mining service companies saw their margins severely impacted, although the broad expectation is for these to recover from here.

Consumer: Broadly exceeded expectations given stimulus support and migration to on-line. The consumer sector was a bright spot of the FY20 results season, with a number of our core holdings delivering strong results notwithstanding the tough macroeconomic backdrop. Several key themes were evident across much of the sector. Firstly, COVID-19 driven lockdowns have underpinned acceleration in the channel shift to online, a move we believe will be structural. Secondly, retailers generally saw consumer demand rebound sharply, supported by fiscal stimulus and a lack of other avenues for spending such as travel or out of home dining. As a result of these factors many retailers have reported strong sales growth in the early months of FY21. We view this as largely cyclical and are closely monitoring for any signs of stress as support measures such as JobKeeper and temporary mortgage deferrals are tapered.

Real Estate: The divergence in performance across sub-sectors were more pronounced than ever, as COVID-19 had varying effects across retail, office and industrial. Retail undoubtedly was the hardest hit, with rent collection <50% for discretionary malls. As mentioned, the pandemic accelerated the pace of e-commerce penetration. The impact of this is rising rent incentives and falling asset values as brick and mortar retailers give back excess space. On the commercial properties front, office and industrial names saw limited impact at the income line as corporate tenants continued to service rent. For office, the unabated construction of pre-committed supply in the face of flexible working has the market questioning future rental growth. Industrial demonstrated resilience as it was the clear beneficiary from COVID-19, with strong demand in prime warehouse assets. In an environment where interest rates continue to be lower for longer, property players that have well-structured long term leases will continue to be well supported.

Financials: Mixed, dependent on the underlying segments. Commercial banks continued to report a challenging outlook. The absolute loss rates through time are yet to be determined as a result of COVID-19. What we do know though is that we continue to see loan deferrals in the economy, with loan losses so far supported by government support to consumers as well as business. There has also been regulatory relief provided to the banks on how deferred loans are treated.

Moving forward, we expect FY21 to be a tough year operationally for the banks with net interest margin pressure, low lending growth and pressure on loan loss rates. However, valuations are now reflective of this challenged outlook.

Exchanges did well in this environment, reporting resilient and growing earnings in an environment of increased volatility demonstrating the defensive characteristics of their platform.

For the insurance sector, FY20 was largely a year to be forgotten with underwriting profits crunched by the trifecta of climate perils, COVID impacts and lower investment yields. While the hardening rate cycle is expected to elongate as insurers recover lost margins, we are conscious of the health of the economy and rising affordability concerns.

Wealth platforms reported strong growth in assets and brushed off the initial COVID-19 fund transition delays, and were also aided by a strong equity market recovery from the depths of the selloff in March. We continue to monitor margin compression and cash spread risk within the sector, and caution that valuations are beginning to look full.

It would be remiss not to mention the Buy Now Pay Later space given the exciting first six months to the year, with exceptionally strong numbers being printed by these operators. The sector ended up as net beneficiaries of the accelerated shift in consumer behaviour towards ecommerce. We were initially cautious on the space given the lack of track record of performance through a credit cycle. However, we have been encouraged by the ability of Afterpay and Zip to react quickly in adjusting their credit settings and the resilience of the loss rates despite being exposed to consumer unsecured credit risk. We expect these trends to continue, albeit the steep run up in volumes and stock prices may need to take a breather over the next few months.

Technology: A stand-out in the market for top line growth. Australia’s comparatively small IT sector (relative to the US) has gained an astonishing 142% since market lows on the 23 of March 2020. As such, there were high expectations going into the reporting season for many of these stocks and some disappointed the lofty market expectations, while others continued on their stellar run. Valuations in this part of the market are looking increasingly stretched, and as such we take a discerning view on which companies we own. We back those we expect to be long term winners in their respective markets, and can get there, generally, on an organic basis.

Communication Services: A challenging period. It was a difficult reporting season for Telcos as COVID-19 caused high margin mobile roaming revenues to evaporate, while enterprise contracts were delayed. This has caused an impact to free cash flows which has placed pressure on forward-looking dividend expectations. The launch of Apple’s 5G mobile devices later in 2020 are expected to be a positive catalyst for the industry, while weaker economic conditions may cause competitive conditions to be unfavourable.

Utilities: Whilst proved its resilience to COVID-19 was not entirely immune and this in general was a slight disappointment to investors.

Energy: Results were impacted by the spectacular collapse in oil and gas prices, weighing heavily on revenue and driving asset impairments as management re-set long term oil price assumptions. We expect that the next half will remain challenging for profitability given the oil and gas prices have remained low and there is a lag in terms of prices realisation. But the set up in the medium term is more constructive due to the significant cuts in near term capex (slower supply growth) and expected return of demand lifting prices.

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