Rudi’s View: Now That We Had That Rally…

This story features CSL LIMITED, and other companies. For more info SHARE ANALYSIS: CSL

Dear time-poor reader: what does the future look like and why are so many cheap stocks still looking so… cheap?

Now That We Had That Rally…

By Rudi Filapek-Vandyck, Editor FNArena

The official mantra says financial markets are forward-looking.

The heavy sell-off that pulled the ASX200 some -38% from its all-time record high in February has thus been swiftly followed up by a 25% rally. This doesn't necessarily tell us anything about what follows next.

I note a number of financial market analysts and commentators who had been bullish in recent weeks have now turned a tad more cautious, taking profits while recommending their clientele does the same.

In simple terms, global equities have clawed back more than half of all the damage that was done upon the break-out of the covid-19 pandemic and the general realisation that a deep global recession is now taking place.

The driver behind this claw-back was a V-shaped recovery in investor optimism, but economies and corporate profits won't be bouncing equally as quickly.

Not in most cases.

Hence while in theory this market bounce is all about investors looking beyond the immediate impact, in practice most money flowing into equities has favoured the solid defensives, the few beneficiaries, the High Quality sustainable growth stocks, and the least vulnerable business models of the future.

Add iron ore and gold and you can pretty much identify the basket of "winners" in the local share market up until this point in 2020.

They say that major crises change trends and trajectories, but thus far the Great Economic Recession of 2020 isn't changing much; if anything it is emphasising and confirming trends that were already in place.

Coming into the February sell-off, many a professional asset manager could be heard complaining about exuberant valuations for Growth stocks while a majority of cheap Value stocks was attracting the attention of none, but, as equally highlighted by strategists at JP Morgan recently, the gap between the two polar opposites in terms of investment styles has simply blown out further in the two months since.

Previously, the relative gap between, say, a2 Milk ((a2M)), CSL ((CSL)), Woolworths ((WOW)), and TechnologyOne ((TNE)) on the "expensive" side and Westpac ((WBC)), Ardent Leisure ((ALG)), Scentre Group ((SCG)), and Adelaide Brighton ((ABC)) on the cheaper side had constantly been pushing boundaries, to great frustration of many.

Two months later and the relative gap between "Expensive" and "Cheap", "Growth" versus "Value" has blown out to proportions that may have never been witnessed, certainly not over the past two decades.

At first glance, this makes perfect sense. When separating the share market in two opposing baskets, analysts standard add "Quality" to the "Growth" basket and most Quality stocks in Australia are once again proving their resilience when corporate profits across the board are taking giant hits.

Thus while forecasts for global corporate profits have been falling off the cliff recently, quite literally, any changes affecting the outlook for TechnologyOne, a2 Milk and the like have been rather benign.

The other side of the coin reveals very much a devastating blow to forecasts for companies like Scentre Group and Westpac. There is an argument to be made this pandemic has hit a number of sectors incredibly hard -think tourism, casinos, airlines, pubs and retailers- and such direct impact supersedes any notion of "Quality" and resilience under normal conditions.

This is true, beyond discussion. But this does not negate the fact that many of the "cheaper" valued companies were already seriously struggling because of shifting industry dynamics on the back of aging demographics, changing spending patterns and technological disruption.

When looked upon from a bird's eye perspective, there is an equally valid argument to be made that this year's pandemic and recession are accelerating already existing trends and changes in societies, with even more negative impact for already struggling companies and sectors.

One observation that supports this narrative is the fact that in Australia forecasts for dividends are falling harder than forecasts for profits. This indicates many can no longer afford the elevated pay-out ratios from the past. More cash is needed to sustain the business, to repair the balance sheet, and to invest in growth (if not "survival").

As many self-managing investors and retirees in Australia have become dependent on income derived from equities, many will be in for a serious shock to the household budget this year. Many SMSF portfolios are equally exposed to property markets where tenants failing, declining values and temporary rent relief accumulate blow upon blow.

If there is one forecast I am confidently putting forward for the post covid-19 recovery world it is that household spending in Australia will not quickly bounce back to pre-February trends. I think investors should prepare for a more benign trajectory, with overall growth to remain at lower trend level for years to come.

On top of this, many an economist is predicting we will all remain cautious for longer, which essentially means more frugal, more savings, more spending on non-discretionary items.

Retailers might enjoy rent relief during this lockdown period, but they likely face higher rent later in compensation, or fewer customers, or accelerated investments in online.

Many will find themselves in Struggle Street even after surviving this year's lockdown.

The most obvious second derivative of this negative outcome are the landlords of these retailers. Not only do they have to bridge rent relief during lockdown, lower trend spending later negatively impacts on income and asset valuations.

In similar fashion, tough times for SMEs and larger businesses will impact on owners and managers of office spaces.

Intertwined with all these debt-and-income related challenges are, of course, the Australian banks. Too many investors (and market commentators) casually assume that whatever happens to the banks will be temporary in nature and under worst case scenarios only.

In reality, Australian banks have struggled since 2015, when sector share prices peaked, to keep the operational momentum positive and margins, profits and dividends have all remained under pressure since, as did share prices that as a direct result could not keep up with the broader market over that period.

Many an investor (and market commentator) too casually assumes that a cheaper share price means "opportunity", but a cheaper share price does not alleviate the operational challenges that are yet to show up for the banks.

Rent relief during lockdown means there are no bankruptcies to deal with. Those corporate failings will follow once the economy is ready to pick itself up again.

As I pointed out recently, the banks did not cut their dividends during the GFC; they did so in 2010 after the global recession had become a feature of the past.

This time around APRA, the bank regulator, has already put a lid on shareholders' expectations regarding bank dividends.

Another observation to note is that analysts updating their forecasts for the sector are now assuming total dividends paid out in FY19 (last year) won't be seen again until in four years from now. Of course, those estimates might prove too downbeat, but they also might not be.

It is probably no coincidence that banks have struggled during times of exceptionally low interest rates and bond yields, and both have been at historically low levels in many countries around the world. This year Australia has joined in.

Yet another trend that has been further solidified in 2020: interest rates and bond yields are near zero and not going anywhere in a hurry.

Lower for longer. The trend reversal for bonds and interest rates has been forecast too often by too many over the years past. If anything, the trend has progressed further in the opposite direction.

Will we ever see inflation announcing itself ever again? Possibly and potentially, but not anytime soon because major economic crises are deflationary, and their affect lasts for years into the future.

One final observation (for now) that I believe has received virtually no attention thus far concerns the capital destruction that is taking place among beaten-down share prices of vulnerable companies in need of extra capital.

When the likes of Webjet ((WEB)), Flight Centre ((FLT)), oOh!media ((OML)) and Southern Cross Media ((SXL)) raise extra capital at a significant discount from an already heavily sold-down share price, they are essentially locking in a permanently lower base from which the respective management teams can (hopefully) start building again.

At first glance, these capital raising are excellent news for institutional investors with plenty of cash to allocate and it is from this perspective that most commentary and research is being conducted. Share prices rallied after successful capital expansion.

What is seldom explained is that because the existing capital is often enlarged by 60%, 80% or even 100% (and more), loyal shareholders who bought their shares at much higher level, and are likely not granted the same opportunity as their institutional counterparts, have instantly been condemned to eternal losses on their capital. And I am talking serious and significant losses.

Probably the best way to illustrate this is through the updates that are occurring for respective companies. From Stock Analysis on the FNArena website:

-UBS has the only updated target price for Southern Cross Media post capital raising but that target has now fallen to 20c. Only last year the consensus target sat at $1.20. Meanwhile the share price has settled around 14c, down from $1.40 last year;

-Updated target prices for oOh!media are within the range $1.15-$1.25 compared with $4.50-plus one year ago. The share price is now at 81c. Up from 50c prior to the raising, but down from $4.50 last year;

-The newly updated consensus price target for Flight Centre of $13.44 compares with $49 twelve months ago;

-The newly updated consensus price target for Webjet has settled at $3.76. Last year it stood at $17.

Those retail investors who can never sell out of a stock unless it rallies back to the level of entry are now faced with the prospect of having been turned into a lifelong shareholder.

This is not to say these companies cannot by definition grow in years to come, but everyone who knows a few things about maths will agree with me on the prior statement.

Note not all capital raisings are of the same nature. When NextDC ((NXT)) opportunistically raised additional capital, the valuation for the business went up, not down. This is because the additional funds will be used to fund and accelerate the company's growth through building and fitting out more data centres.

In summary, it's easy to look at today's share price graphs and think: oh my, there must be so many opportunities out there. In reality investors will be best off by thinking very hard what a world post recession and post covid-19 pandemic might look like.

Not all questions can be answered right away, but then you don't have to take on board the risk of the great unknown either. Stay patient, level-headed and risk-averse. Try not to be hoodwinked by a "cheap" looking valuation.

That's what I intend to do myself.

****

FNArena subscribers have access to a dedicated section on the website on my research into All-Weather Performers (in many cases probably best referred to as High Quality sustainable growers).

See also my writings from the weeks past:

-No Time For Over-Confidence https://www.fnarena.com/index.php/2020/04/16/rudis-view-no-time-for-over-confidence/

-Cheap Quality & Conviction Calls (Must read for everyone looking to upgrade his/her portfolio) https://www.fnarena.com/index.php/2020/04/10/rudis-view-cheap-quality-conviction-calls/

-How Deep, How Long, How Far? https://www.fnarena.com/index.php/2020/04/09/how-deep-how-long-how-far/

-Bear Market Observations https://www.fnarena.com/index.php/2020/04/03/rudis-view-bear-market-observations/

-How To Survive The 2020 Bear Market https://www.fnarena.com/index.php/2020/04/02/how-to-survive-the-2020-bear-market/

-Global Recession Is Next https://www.fnarena.com/index.php/2020/03/27/rudis-view-global-recession-is-next/

-Things To Watch, Expect, And Avoid https://www.fnarena.com/index.php/2020/03/26/rudis-view-things-to-watch-expect-and-avoid/

-All-Weather Stocks & Cash https://www.fnarena.com/index.php/2020/03/19/rudis-view-all-weather-stocks-cash/

-The Bear Market That Changes The World https://www.fnarena.com/index.php/2020/03/17/rudis-view-the-bear-market-that-changes-the-world/

(This story was written on Monday 20th April, 2020. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

****

BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $440 (incl GST) for twelve months or $245 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index2.cfm?type=dsp_signup

Click to view our Glossary of Financial Terms