The COVID-19 global pandemic is unfolding quite differently to all other major market events seen through history. Governments globally are facing a delicate balancing act between trying to minimise the health impact of the virus, whilst managing the severe disruption to their economies. The sudden and sharp shock facing the global economy appears without precedence.
DNR Capital, a leading Australian equities investment manager, notes:
Many comparisons are being made to the Global Financial Crisis (GFC), however the COVID-19 outbreak is a very different type of crisis. The GFC was caused by a major breakdown in the functioning of the financial system. The COVID-19 crisis is evolving into an unexpected and far-reaching shutdown of large parts of the global economy, sharply reducing short-term demand for goods and services, as well as disrupting manufacturing and supply chains. Governments and central banks are already providing significant fiscal and monetary support to cushion the short-term impact on households and businesses. This expansionary policy is likely to stay for the foreseeable future, especially sustained lower interest rates.
Sam Twidale, Portfolio Manager at DNR Capital, on assessing the impact on Australian small caps equities notes the following:
Certainly the impact on large parts of the Australian small cap equity market will be significant in the short-term. These companies are often less diversified with more focused business models, or have greater sensitivity to the economic cycle. Many rely on equity markets to fund their business models, with reduced risk appetite now likely to restrict expansion plans. The S&P/ASX Small Ordinaries Index has experienced a brutal correction, falling more than 30% since the start of the calendar year. The sell-off has been painful across a range of sectors, in particular impacting the more cyclical areas of the equity market. Retailers, consumer products, travel and tourism, commodities and financials exposed businesses have all fallen heavily. There’s only been a select number of gold, consumer staples, healthcare and software companies, which have demonstrated any defensive qualities. As liquidity has been pulled from the small cap market, even many of the more defensive or higher quality businesses have seen material share price falls. The sell-off has certainly been very indiscriminate in nature.
The duration and severity of the business disruption is unclear
Given the lack of visibility, many companies have already downgraded or stepped away completely from providing future earnings guidance. The challenge is that there’s still considerable uncertainty in assessing the duration and severity of the COVID-19 outbreak. This uncertainty adds to the sense of fear and panic in the market, with investors having to consider various types of worst-case scenarios. For example, whether the containment measures and disruption to business lasts for 3, 6 or 12 months. Many companies with high levels of operational gearing (high fixed costs which are difficult to reduce) or significant financial gearing (high levels of debt) could see a material impact on their profitability and/or solvency position. This means that the impact of the disruption will vary widely across the small cap index, with many lower quality companies with stretched balance sheets placed in a more precarious position. Having a resilient business model and strong balance sheet will certainly be a key advantage in the coming months as the extent of the downturn becomes clearer.
Significant uncertainty increases the likelihood of share price overreactions
With the probability of downside scenarios for earnings and balance sheets still unclear, this only adds to the significant share price volatility seen on a daily basis. The fear and panic now rampant in the market increases the likelihood of short-term share price overreactions. Just as the market has overreacted to positive news in recent years, the short-term focus of many investors suggests the reverse will also be true. During periods of market stress such as this, we believe opportunities for long-term investors will be at their greatest.
Staying committed to the investment process
As long-term investors, our focus is to ensure we take advantage of the significant dislocations arising between shares prices and fair values. Poor investment decisions are likely to be made when investors neglect their process, especially in times of elevated market stress (i.e. don’t panic). This means focusing on factors we can control, rather than the uncontrollable such as the extent and duration of the virus outbreak. Central to our investment process is to identify the highest quality smaller companies, especially those that are significantly undervalued by the market.
Focus on the highest quality companies – leaders in the industry
Focusing on quality means looking for companies that are leaders in their industry, or where we have conviction in their potential to become so in the future. Examples of these currently held in the Fund include:
Nanosonics – a global leader in ultrasound disinfection technology.
Breville – a leading designer and manufacturer of consumer appliances.
Bravura Solutions – provides mission critical software to the financial services industry.
Tyro Payments – a provider of merchant acquirer technologies disrupting the Australian payments industry.
Quality companies benefit from strong pricing power, generate high returns, are led by disciplined management and have strong balance sheets.
What have we been up to?
Over the past few weeks we have focused on reviewing the investment cases for all our holdings in the DNR Capital Australian Emerging Companies Fund. This includes revisiting our valuation models and detailed stress-testing of all assumptions. We have also been speaking directly with company management to understand how they are dealing with the current crisis, reviewing balance sheets, and the likely impact on long-term cash flows. Whilst management and the market can attempt to estimate the short-term impact of the COVID-19 disruption, we believe there is more value in understanding the potential longer-term impact.
What should drive the valuation? Long-term cash flows!
Ultimately the main driver of value is the sustainability of long-term cash flows, as opposed to the cash flows over the next 6-12 months. This often gets forgotten when share prices are falling sharply and panic selling is in full force. It is never comfortable seeing shares of high quality businesses collapsing even further than we imagined. However, for long-term investors with the ability to look through the volatility, this is the kind of market where outstanding opportunities will arise. It’s essential to keep revisiting valuations, as this provides conviction to buy companies when share prices are falling sharply.
Portfolio Changes – Improving the quality of our holdings
Given the indiscriminate nature of the sell-off, we have taken advantage of the significant share price falls by further increasing the quality of the Fund’s holdings. Although the coming months are likely to remain volatile, we believe the current opportunities will prove to be extremely attractive for investors prepared to look through the short-term market uncertainty.
Key recent changes have included:
Positions we have added to:
- Bravura Solutions (BVS)—Bravura provides essential software to the financial services with customers in the superannuation, life insurance and platform industries. The company has $100m of cash on its balance sheet, providing it with significant downside protection. Although the current market uncertainty may delay new customer signings, the company has a long sales cycle with customers agreeing long-term contracts. Bravura’s software also improves automation, digitalising manual processes and replaces expensive legacy software. We believe this will be a key structural theme in the coming years as the focus on digital transformation increases.
- Tyro Payments (TYR)—Tyro is certainly facing a short-term disruption given its payment terminals are used across the hospitality, retail and health industries, many of the hardest hit areas of the economy. This will reduce transaction volumes being processed through Tyro terminals in the short-term. However, management have significant financial flexibility with $170m of cash on its balance sheet. The long-term opportunity for Tyro hasn’t changed, and we expect the company to continue taking share from the major banks.
Positions we have exited:
- Monadelphous (MND) and Karoon Energy (KAR)—We now see a longer lasting impact of lower oil prices for both these companies. Monadelphous is facing lower construction activity in its energy segment, reducing our long-term cash flow forecasts and expected valuation upside. In the case of Karoon Energy, oil prices are likely to remain substantially lower than forecasted for a sustained period, reducing our expected upside. We see more attractive upside in the higher quality names we have been buying.
Alignment – Investing alongside our clients:
Both of the Fund’s Portfolio Managers have added to their personal holdings in the Emerging Companies Fund over the past week, with 100% of their exposure to equities invested in this Fund.