This time it really is different

The easy premise is that the scourge of COVID-19 will change societies, economies and company profits forever. The harder forecast is where, and to what extent. Just as there was really only one call to be made exiting the GFC, which has dominated societies, economies, company profits and multiples ever since.

QE, which started as an emergency measure initiated by one economy to save its financial system, morphed into a standard operating procedure across the western world, influencing politics and elections, wealth distribution and the relative performance of sectors and stocks more than any other structural change that may have been spawned by that epoch.

In contrast, the obvious structural change that may have resulted from the GFC – a restriction on financial entities using leverage for personal gain with socialised losses – has not occurred, with groups like Schwab and AON having close to double the leverage (debt to assets) today they had then, and larger institutions that were at the epicentre of the GFC (such as Bank of America, JP Morgan and AIG), levered at barely lower multiples today.

Like the GFC, COVID-19 will provoke many changes which will have a marked effect upon societies, economies, industries and companies – but discerning the form those changes will take in the long term is not obvious.

Our guiding principles

In navigating the current landscape in the short to medium term, we have a few guiding principles. First, fiscal stimulus is dedicated to job preservation, especially for those in full-time employment (Ken Henry has powerfully outlined the economic case for this policy). Consequently, scope for government support for other claimants, such as landlords, equity owners (even foreign owners of a listed airline), and the NRL and AFL is not likely to be plentiful.

Second, the duration of the pandemic is unknown, with our healthcare analyst Dr Sally Warneford not optimistic a vaccine will be available for public use within 18 months, and the general view being the judgment that the social cost of Australia pursuing the herd immunity policy of the UK appears to be too great. 

In turn, it is hard for us to envisage a V-shaped recovery in economic activity and company profits.

Third, equity markets remain vulnerable because the sensitivity of earnings to this downturn is obviously high, but the capacity for them to bounce back just as strongly where earnings are linked to the consumer, in particular, is limited.

Finally, there is a further cause of equity market vulnerability: Shiller multiples suggest valuations on mid-cycle earnings remain well off lows seen in prior market corrections, even though the dispersion in multiples across the market on this basis is also wider than ever, with healthcare two standard deviations more expensive than the rest of the market.

The cost of past excesses

In the longer term, COVID-19 will drive significant changes to society, economies and company profits, governments and citizens as they adjust to the new and very different circumstances they find themselves in.

For the first time in several generations, the Australian government will be heavily indebted. The great excesses of the past generation are now an obvious vulnerability – especially in Australia, where consumer indebtedness has reached record highs, funnelled into housing stock.

As Shayne Elliott of ANZ has suggested, the resulting fall in house prices is likely to be “material, not 3% or 4%”, changing the way Australians view technology, debt, employment, the capitalist system and even democracy. It’s quite a list, and the role of government debt and the equity of its distribution and amortisation is also likely to become a topic for social debate, having been ignored in Australia for the better part of a generation. Moderating that debate will be harder than in the past, where concentrated media channels made the transmission of a message more controllable, and foreign influence was barely discernible.

While these structural changes remain important when assessing how company profits will shift in the medium term, the obvious has prevailed when it comes to near-term market performance. Sectors whose earnings are intact have performed strongly, including supermarkets, health insurers, healthcare more broadly (especially foreign earners), rural and food stocks, and selected industrials (especially those earning foreign currencies, as the dollar sunk to the mid–US50 cent level). Major miners exposed to iron ore with little debt have also performed well, given that all commodities other than oil had a reasonably stable month as market tumult raged around them. In commodities, gold was the standout, with prices hitting a record high in AUD terms.

Conversely, sectors exposed to households and consumption sectors have had a rugged time as markets have fallen, particularly specialty retailers and their landlords, while the energy sector has been hit by the oil price collapse which presaged much of the COVID-19 wreckage, albeit by just weeks.

The valuation conundrum

What does this matter for company profits and investment? Actually, everything. Even for those that are relatively easy to value.

Consider Sydney Airport, whose revenue was highly predictable, with little variation even through the GFC, and whose costs have and always will be minimal. Until COVID-19, all there was left to argue about in valuing the security was the right multiple in a 5%, then 4%, then 3%, now 1% bond world.

Now it’s suddenly a different ball game. What will be the cash burn while passenger growth is muted? How long will it last? Given that in the past decade both passenger growth and (just as importantly) passenger spend have been dominated by the rise in Chinese tourism, what structural change should we should anticipate, if any, once a vaccine for COVID-19 is discovered and available? Given that any revenue decline flows straight through to profitability, and that net debt in Sydney Airport has more than doubled since the GFC to now be more than $9.5bn, the $10bn swing in market capitalisation through the past several months is clearly not due just to whether or not this and next year’s liquidity is fine (which it is).

Auckland Airport, which has raised NZ$1bn, provides a prudent template in a world where passenger numbers are in secular decline. In halving its debt to less than NZ$1bn relative to a market capitalisation of NZ$6.5bn, for an airport hosting 21m passengers per annum Auckland presents a stark difference in financial leverage to Sydney Airport, which has debt of $9.5bn against a market capitalisation of $11.7bn, for an airport hosting 44m passengers. The de-geared Auckland Airport has an enterprise value per passenger around 25% below Sydney Airport’s level.

Secular changes, whatever they may be, arising from COVID-19 would seem to impact patronage equally, so any changes to long run passenger assumptions will have a magnified effect on the equity value of Sydney Airport, given its higher gearing and starting multiple.

Healthcare’s star is brighter than ever

However, while they may have affected Sydney Airport, starting multiples have generally mattered far less than we thought they might have through the past month. Our supposition was that from a starting point of high market multiples, with a wider dispersion between the highest and lowest multiples within the ASX200 than had been seen for almost 20 years, any correction would see multiples converge and those stocks on the highest multiples underperform.

Specifically, we thought healthcare would suffer, given multiples that have been a standard deviation higher any other sector on the ASX over the past year – higher even than technology, media, and telecom (TMT) stocks. Then Cochlear announced both a profit warning and an unexpected and large equity raising (at $140, a price above our valuation) – and even amid that perfect storm, Cochlear still outperformed, immediately trading back up to a price 25% above the placement price.

Healthcare has been a stunning performer through recent years, largely driven by rerating as the market rose, and it has continued to outperform through the market sell-off.

The vaccine pricing dilemma

The multiple matters less, it would seem, when earnings certainty is on offer (putting aside the Cochlear downgrade). Or so the narrative goes. The dilemma is this, and we are about to face it. If a private entity discovers an approved vaccine for COVID-19, what is the fair price for it to charge for it? Is it fair to charge the same amount as CSL charges for Immunoglobulin (IG), given both are seen as life-saving and will most likely be paid for by governments in the most part, not directly by end users? For context, in the US, the annual cost per patient for IG is between $50,000 and $100,000. Conversely, Dr Sally Warneford highlights that the most expensive vaccines in the world cost US$300 per dose.

On the one hand, little wonder there are 60 clinical trials underway for a COVID-19 vaccine. On the other hand, based on the CSL example, the potential cost of a vaccine in an unregulated market is between one and two years of Australia’s GDP. Of course, in other countries where there is centralised purchasing of IG (such as Australia, UK, Canada, etc), prices are lower.

So how do you price the product if you discover the COVID-19 vaccine? 

Do you sell it at a higher price to the US than elsewhere, because, well, that’s the way the industry rolls? Or do you deny it to other countries until the US has exhausted demand at the premium price? It is difficult to see how either of these scenarios is viable, which is why we also believe the current pricing paradigm for CSL in the US is fragile.

Bank net tangible assets are a ceiling, not a floor

Finally, Australian banks are roughly twice as well capitalised now than they were through the GFC, thanks largely to the wisdom of the final report of the Financial Systems Inquiry, which recognised the structural weakness of the Australian economy and banking system as a capital importer, and consequently the need for “unquestionably strong” levels of capital.

Net tangible assets (NTA) have proven a floor for bank valuations in Australia through the past 20 years, as loan growth has been strong (and by far the major driver of earnings growth). If Shayne Elliott is right, there will be a secular reduction in the appetite for debt as a result of the COVID-19 recession we are about to endure. 

If asset growth for Australian banks continues to decline from the low levels it reached after the Royal Commission, it is hard to see how underlying profit grows at all, before bad debts rise materially and structurally as the elongated era of house price appreciation also wanes.

In the same environment in other markets, net tangible assets NTA has proved to be a ceiling, not a floor, for bank valuations, even in cases where underlying returns have been higher than those produced by Australian banks last year. Finally, it is worth remembering that the sector is still the largest profit earner on the ASX, even after these pressures. This will prove tempting for governments needing to find new and large sources of tax revenue. In the next few years, the sector is about to face what manufacturing in Australia has gone through in the past cycle.

Outlook

Multiples are now at reasonable to cheap levels across the board, but the bifurcation within the market is wider than ever, even after the correction. Earnings growth expectations are still wildly optimistic, and we expect an ongoing drag through not just FY2021 but also into FY2022.

We remain very wary of consumer facing names – for example, we assume long run turnover through shopping centres will be around 20% below last year’s levels. Indirect exposures to the consumer (retail banks and landlords) may also see ongoing earnings pressure. The inevitable broadening of supply lines outside China ostensibly supports manufacturing, however there is little listed exposure to that trend. Changes in our portfolio structure are minimal following the recent ructions as our portfolio biases – towards lower levels of gearing, and away from exposures to the consumer, especially the domestic consumer– have been reinforced by what we believe are the likely longer term impacts. Having said that, we are ever mindful of the wisdom of Obi-Wan Kenobi: “You’re going to find that many of the truths we cling to depend greatly on our own point of view.”

Learn more

For more on how the coronavirus is impacting Australian Equities and markets, click here.