Weekly update on the impact of COVID-19 on the financial markets

Roger Montgomery - Montgomery Investment Management - Tuesday 14 April 2020

In this episode, Roger Montgomery from Montgomery Investment Management joins us to discuss the current state of the Australian economy, including the impacts of a potential recession and Government stimulus-response, the present value of Australian equities and the winners and losers from a falling Australian dollar.

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Paul O'Connor (POC): Welcome to the Netwealth Investment Podcast series. My name is Paul O'Connor and I'm the Head of Investment Management and Research at Netwealth Investments. In my role, I manage and govern the investments that are made available to you through the Netwealth investment platforms. Today we have Roger Montgomery, the Founder and Chief Investment Officer of Montgomery Investment Management. Welcome back, Roger Montgomery.

Roger Montgomery (RM): Great to be with you, Paul.

POC: Montgomery have a number of funds both across Australian and international equities available on the investment platforms. So, really, I think we're fortunate to have Roger as a guest on our portfolio construction series. And I think we had you on in February recently providing insights into the market. But, gee, February feels like a long time ago given all that's happened over the last eight weeks.

Given Roger's expertise and focus in managing Australian equities portfolios, I've thought we'd focus today on the discussion on the Australian economy and the market. However, starting with the global economy, Roger, what are your thoughts on the impact that COVID-19 is having on global GDP and do you think a global recession is inevitable?

RM: Well, I think we're already in a recession, Paul, I don't think there's any doubt. We know that GDP has fallen off a cliff. We know that productivity has disappeared. We know that output is gone. We know that incomes are decimated. We know that jobs are decimated. So we're in a recession. The question is, how long does it last and how do we come out of it?

POC: It's interesting that I'm hearing more and more discussion and debate around trying to understand the duration of the impact of the economic slow down. And I think it's very pertinent, the points you make there that there is no doubt the global economy has slowed significantly.

RM: Yeah, well it's gone backwards by definition, and it's gone backwards so deeply that even if in the next quarter we had less negativity, we'd still be negative over the two quarters. And so the question's not whether we're in a recession.

I think it's really important to understand that the economy wasn't going that well before COVID-19 hit or before the coronavirus outbreak. And we had Europe teetering on the brink of recession anyway. We had the U.S. slowing according to some measures. And Australia, you might remember, this is before Christmas, we had a retailing recession, we had housing approvals falling off a cliff, housing approvals or residential approvals were down about 40% over the year. And so, we were already quite weak in Australia, in Europe, the United States, Japan, even before this hit.

So when we come out of this, it's important to remember that what we emerge into was not all that appealing anyway. It was still quite weak.

POC: Do you think the recession, then, will have somewhat of a cleansing effect on the economy? I.e. some of these business models and sectors that you've had some concerns about for some time now, that they may not even exist or they'll exist in a very different structure going forward?

RM: Well, yeah. I think that's right. I think, you might remember when we last spoke, I talked about some of the warning signs that were... Might not have been the last time we spoke but the time before that. But we talked about a bubble in private equity, for example. And I demonstrated that there was an enormous amount of growth in the number of private equity funds around the world and that they were growing at a much faster rate than the population. And, consequently, there were more deals being done and those deals were more competitive and so they were being done at higher prices.

And then I made the point that you've got all these people being employed in all of these startup businesses that have their jobs purely because of the altruism of private equity investors. And as soon as you have a risk-off event, and I remember saying, I don't know what is going to cause investors to go risk-off and why they'll want to take money out of the market, but if and when they do, that money to support all of those jobs will be pulled and you'll see large job losses.

And that's exactly what's happened. And so in the private equity space, there's the change in terms of the workforces, money isn't limitless, or there's a realisation that money isn't limitless, and so you've got a lot more people on the dole queue all around the world.

POC: Yeah, it is interesting, the comments on private equity. And I guess we've always seen a changing nature of the investors and buyers of private equity over the last decade even, where it appears to be the domain of the investment banks trying to restructure and refinance companies there, which I'm with you, has led to, I guess, some scepticism and, I guess, some question marks over the purpose of what they're trying to achieve.

Moving to the Australian economy. I'm assuming, then, based on the comments you've made already, you think that Australia is in a recession as we speak?

RM: Look, yes. I think so. I actually don't think it matters what the number is. We all know that when you basically put an economy into a hard stop, it's going backwards from the year before and the quarter before. Therefore, we're in a recession. So given we have not had a recession since the early 1990s, what areas of our economy are particularly vulnerable that are really worrying you at the moment?

Look, I'm an investor, so I'm looking at any weakness as an opportunity rather than as a risk. So as we're recording this, the coronavirus itself and the shock of that, that's yesterday's news. So the narrative now is about returning to work and governments plotting and planning ways to get the economy going again. So rather than thinking about things that I'm worried about, I'm thinking about things that I see as being the highest leveraged opportunities or the opportunities with the greatest leverage to the recovery.

And those happen to be the things that have done the worst, I think. So travel, for example. I think travel will bounce back because people have been cooped up in their homes, unable to go on holidays, unable to visit their relatives, unable to take up the various discounts and deals that they took when they booked their holidays. And so there'll be enormous pent up demand to go away again.

And one anecdote I can give you to support that thesis is, we're aware of a person who works for one of the big cruise lines in Europe, and they sent an offer out to their passengers whose cruises were cancelled. They gave them two choices, they offered them a full cash refund immediately or a 200% credit for a future cruise. Our intel informed us, or our informant, told us that there was something like a 99% take-up rate in the offer of a 200% credit.

So people want to travel, that's not been killed. People will travel again. How long that takes before we can travel freely and normally again without masks and without temperature checks, I don't know the answer to that. But I do know that some of the pricing for travel companies and travel-related companies basically assumed that there would be no revenue growth ever again. And that's just nonsense.

POC: So, I guess, from that comment, do companies like Flight Centre or even Virgin have any interest?

RM: Well, yes they do have interest, but you've got to just look at their balance sheets and their cash burn. And what you've got to realise is that you're an equity holder. So assets minus liabilities equals equity and if you don't participate in a future capital raising, then you could be diluted. And so the share price for you might not recover to the levels the shares have previously been at.

And so it's important to understand that while the companies that you mentioned, Flight Centre and Virgin are interesting, we've got to look at the balance sheet. And number one, ask the question, will these businesses survive? That's the first thing. And then if they are going to survive, how much capital-If they are going to survive, how much capital do they need to do it? Then they've raised ... In the case of Flight Centre, they've raised money, about $700 million. But what form do they take once they've raised that money? In the case of Flight Centre, they've closed 50% of their stores [inaudible 00:10:19]. They're closing 800 stores so their ability to generate the level of revenue that they generated before is obviously changed. It's a smaller business now, growing off a lower base. That's the first thing to consider. And then if you think about the impact of a capital raising, when you raise money at a deeply discounted price, you can dilute the equity per share on a per share basis and then if you use that money to pay off debt, for example, which is important in this environment, then the return on equity from the capital, or the return on the equity that you raise, if you only use it to pay down debt, is the interest rate on the debt that you've paid off.

And so, you dilute your return on equity as well. A business that might've had $10 of equity per share earning 20%, might now only have $5 of equity per share earning 10%, and so its intrinsic value is a lot lower now than it was before. And so, while the business might survive, its value, its intrinsic value, what it's really worth, is a lot lower than what it was worth before. And so, you could still make money on that, but you've got all those risks to think about. You've got survivor risk, you've got the dilution of returns and profitability, and you've got the dilution of your stake in the business. And so the share price might initially bounce off the fact that the capital raising's been successful, but it might drift back down again once everyone realises that the intrinsic value is lower than it was before and the share price won't recover to where it was before for potentially a decade, maybe more.

POC: Yeah, I guess those comments, Roger, certainly highlight to me that you really need to undertake that research on the company. You've got to really understand the company and understand that balance sheet before considering participating in any of these capital raisings that we're starting to see on the market.

RM: Yeah, it's basic stock analysis 101.

POC: Yeah, active management, I guess, inaction there really. Moving on to, I guess, the Australian government, in terms of the fiscal response, it appears to have been extraordinary and certainly the RBA wasted no time in supporting from the monetary policy perspective by dropping the cash rate to 25 bips, or 4.25%. What are your views on the response? And do you think it's been sufficient? I guess there's been a fair bit of debate in the markets and the press around the fiscal spend and whether the government will need to do more. Does Montgomery have a view, as a house, on the fiscal and the monetary responses in Australia?

RM: Well, we're not macro managers so we don't have a house view on that. We all have, I guess, individual views. I think that the consensus is that, basically, the response has been rapid, it's been more than sufficient, and it surprised the market by, I guess, its magnitude. And so, unlike the GFC, where there was a lot of naval gazing before anything was done and, consequently, the depth of that crisis didn't occur for some months after it began, the central banks have really cut this off at the pass very quickly and so the RBA, the US Federal Reserve ... They announced just a few days ago that they're now going to buy junk bonds. They're going to support, not just investment grade bonds, but even lower than investment grade bonds or sub investment grade bonds.

And so, that really is a massive response. That's bringing out the big artillery to send a signal to the market that it will do everything, the Central Bank, will do everything that it can to ensure that liquidity exists, to ensure that what everything that they can do is being done. That gives the market some confidence. Now, whether it's enough to save the economy from a protracted recession, I don't know. What we do know is that, and this is something we've discussed in our investment committee meetings, but sacking a thousand people is a lot easier to do than hiring a thousand people. Just the process of re employing people, presuming all the businesses that have shut down survive and they won't, that's a big ask, will all those people get a job? Yes, eventually. How long will that take? It'll be longer than we expect. Then that circles back to what the government's doing, is it enough to get people back in a job in a months time or two months time? Well, probably not, but at some point, the government has to say, "We've done all that we can and it's now up to capitalism to work its magic."

POC: For the free market to takeover.

RM: Indeed.

POC: But I certainly think the monitoring fiscal response has sort of flown under the radar in recent weeks due to the real human impact that COVID-19's having on our society and our country and the world at the moment there but it does seem extraordinary, the actions that were announced and we certainly saw an improvement in conditions in the bottom market, globally, post the actions of the central banks when they all came together and it certainly improved liquidity and trading in the fixed interest markets that I've seen.


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RM: And what the RBA'ss done there is terrific. Not only have they cut rates to 0.25, but they've bought three year bonds, which has supported a low interest rate in three year bonds, which in turn provides liquidity and low rates for fixed household loans and fixed business loans. And so, there's a lot that the RBA has done that I don't think people appreciate. But I think they've done everything that they need to do to ensure that markets operate effectively and markets don't panic and that's what we've seen.

POC: Now with Australia's unemployment rate heading to 10%, but given this is really being caused by just complete industry shutting down, such as the hospitality sector, and I guess also given your past comments about starting to focus on post COVID-19 and how the economies will start to reopen, do you believe that unemployment can really reduce quickly when the lockdown rules are relaxed?

RM: No, I don't because, as I said a moment ago, I think hiring takes a lot longer than firing and consequently it will be some time before we see unemployment back to where it was. Yeah, it's just going to take longer, just the practical, logistical, mechanical process of hiring people, it takes longer and that's just a fact. Anyone who thinks that it's all going to come back quite quickly are kidding themselves.

POC: Okay. Moving onto the Australian market, you've been concerned for some time now that valuations were overstretched and as a result of held defensive positions in your portfolios and you sort of touched on this earlier in the podcast, where do you think valuations are at the moment? Do you really have a handle on whether their cheap, reasonable or expensive across the Australian equity market?

RM: Yeah, it's a good question. It's a difficult question to answer because normally what we do when we're calculating intrinsic values, which we knew were completely out of step with reality before Christmas, and you might remember when we last met, I was explaining why we had so much cash in the Montgomery fund, in the Montgomery private fund, we were sitting between 20 and 30% cash. The reason was, it was obvious that earnings estimates were declining at the same time that prices were going up. And so, prices were just out of step with reality, as I mentioned. But now, it's not so easy to work out whether they're cheap or expensive because the earnings has vaporised so we don't know what the earnings are going to be and we talked a moment ago about Flight Centre closing 800 stores.

Any attempt to kind of estimate earnings in this environment really is a bit of a waste of time and I know that analysts are trying desperately to work out what a company's earnings are going to be but we've seen almost 150 companies pull their earnings guidance. Those companies don't know what their earnings are going to be. They're currently locked down, They're not in business. There's no way Flight Centre can tell you ... Graham Turner can't tell us what earnings are going to be in 12 months or 24 months time, can't tell us what are they going to be in six months time so you know-What are they going to be in six months time? So we just assume that revenue is zero and earnings are torched for the next 12 months, and then what we do is we start putting conservative estimates around what the longterm earnings of a company might be remembering that a company's worth the present value of all its future cashflows, not just the 12 months, or 18 months.

And so, even that is going to be really, really rough. When we do all of that we get to a point where we think the market is maybe fair value to a little bit expensive because we think that the market is being overly optimistic about how quickly we come out of this. It's right to be optimistic that they'll be an end for the lockdowns. It's wrong to be optimistic that we go from ... We're really push starting the economy again and that we go from a stalled economy to something that's reasonable or acceptable in a short space of time I think that's optimistic.

Where we'll get to is that in 12 months time, or in 18 months time, we've still got a sputtering economy. We've got massive day leveraging to occur. There's lots of government debt. And so, that's going to take some time to work its way through, and that means that we'll end up in market, Paul, that won't look anything like the market that we saw before. You know that 10 years of north easterly markets with no negative years? That's not going to happen again. We're going to return to.

POC: Yeah, to the right decade.

RM: Yeah, we're going to return to normal markets, what I call normal markets, the markets I learnt to invest in when I came out of university in the 1990s. That's you get a positive year, you get a negative year, you get a positive year, you get a negative year. And we don't know what order they'll take but it'll be more cyclical than unidirectional.

POC: So what sectors are really concerning you the most, and is it the more defences that you're holding at the moment in the portfolio, or is it some of the more growth stocks that have really been beaten up in value? Where are your analysts really using their time?

RM: So we, again, not concerned about sectors, but looking for opportunities, what we did before the crisis emerged, or before the outbreak emerged, or became serious. It had already emerged because just on a side I came back from an overseas trip in late January my family and I were all wearing face masks at the airport in Tokyo, and also at the airport in Sydney, and on the plane.

And so, coronavirus was an issue then, so when we got back to Sydney, touched land again, and went into the office we gathered our research together. We were tracking testing rates around the world. We could see that it was going to get a lot worse, so we increased our cash waiting quite considerably. And then, what we also di, and this answers your question, what we also did is we moved the portfolio to a lower beater portfolio so we moved into more what I regarded as high quality defensive ... I shouldn't say high quality because all of our holdings are high quality, but bigger cat high quality defensive companies with a lower beta.

So we held more cash and we reduced the volatility of the equity in part of the portfolio. Now, what we're doing is we're thinking about what other sectors and companies that might be most leveraged to a recovery. And some of those things for example some of the roads, so Transurban, for example, Atlas Arteria which owns a big stake in about 2800 kilometres of French toll roads. France is shutdown at the moment, completely shut down. There aren't many cars driving around, and that's going to return, and logistics will be an important part of the recovery story.

And so, we're going to see a lot more road transport. We're going to see a lot more people travelling domestically because probably international travel will slow for a while or stay shut down for longer. And so, that's an example of where we're trying to make investments now without necessarily reducing our cash very much, we are reducing cash, but also increasing the beater, or the riskiness of the portfolio. And riskiness, I don't mean we want to make risky investments. We just want to increase the exposure to the recovery.

POC: So you have actually reduced your cash holding over the last eight weeks?

RM: Just slightly. No, not over the last eight weeks. Probably over the last three, so over the last three weeks we've reduced the cash slightly, but we're also increasing the beater of our invested portfolio, so pulling out of things that have held up really well. So reducing for example Telstra which has held up really well, relatively speaking. It's gone down much less than other things. And now, we're increasing our exposure to those things that have gone down a lot that we think are safe, high quality, but leveraged to the recovery.

POC: Now, moving onto the Australian dollar, it's fallen considerably against the US dollar over the last couple of months, and certainly has acted as a cushion to our economy. What companies are the winners, and who are losers as a result of the fall in the A dollar?

RM: The A dollar, you might remember going into the crisis the A dollar was about 65 cents, or there about, 64 or 65 cents. It then fell during the crisis to about 55. It's now back to 64, so it's almost as if for the dollar the crisis never happened. On a net basis it hasn't fallen all that much. Trying to pick the currency is really, really difficult. I moved a lot of our term deposit money into US dollars and British pounds, this is personally, ahead of the crisis and that was about 64 cents.

I exited those positions at about 61 or 62 cents thinking it had fallen as much as it was going to, and then it fell to 55. It's now bounced back to 64. The whole point of that story is it's really, really hard to pick currency movements. It's just you know the big moves but the little moves are just noise and it's difficult to predict. We want to have exposure to businesses that are growing overseas. That means we're hoping that the Aussie dollar falls rather than rises, but we also own domestic businesses, so it doesn't matter that much to us.

Rather than thinking about where the Aussie dollar is going to go we're thinking about where companies are generating their revenue, and if they're generating their revenue in a way that isn't necessarily exposed to the vicissitudes of the economy, for example, a company like a medical company. Avita Medical for example. It sells the re-cell application for burn victims, and so it sprays skin cells onto the burn site helping recovery rates speed up, reduce hospital times, and so on. So that's a business where the product being sold isn't discretionary, and if it's not discretionary then it's less likely exposed to the economy.

And so, they're the sorts of businesses we want to gain exposure to. And I know it's nothing to do with the currency but it's how we think about earners, so we're not thinking about does this earn Aussie dollars or does it earn US dollars. That doesn't matter as much to us simply because we don't really have a view on the currency. What matters to us is just where it's generating its revenue from and is that revenue channel exposed to the economy in any way?


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POC:It's interesting there I guess that at the end of the day we can't pick the A dollar on with you, that there are very few, if any, people that can actually trade currency and trade currency profitably, but I think a key comment and the theme that's coming through from our discussion this morning, Roger, is that difference between a consumer staple and a consumer discretionary, i.e. companies that are manufacturing something that is a discretionary spend versus a staple, like as you say the skin cell spray on for burn victims, or toll roads, or those types of companies.

I think if you do build a portfolio with an anchor to a consumer staple you certainly should have lower level of volatility compared to the broader market there.

RM: Paul, if I can just add ... That's a really good comment that you make. People immediately turn ... When they think about consumer staples they think about the supermarkets for example, and just one caveat with the supermarkets if anyone's thinking about that is that we believe that they've really performed their role in a portfolio now, so Cole's and Woollies they held up really well of course because people were hoarding toilet paper amongst other things, but you've-... hoarding toilet paper amongst other things, but you've got to remember now what that's done is it's front loaded. It's brought forward a lot of earnings for the supermarkets, so people ... if people's houses are now stacked to the rafters with toilet paper, they're not going to need to buy that product from the supermarket for some months and you won't be able to return it either. So it means that that revenue source has been front loaded or brought forward. So just remind yourself of that if you think that supermarkets are going to continue doing as well as they've done in the recent past.

POC: Yeah, they certainly appeared for mine that it's a temporary yearning spike that will certainly normalise I think in line with society getting back to whatever the new normal will be, post COVID-19.

POC: We normally finish with asking our guests for any tips on investing but I thought particularly at the moment, have you got any thoughts or comments for the listener in terms of navigating the current financial crisis we're experiencing?

RM: Yeah. I think the bottom line, what this has demonstrated to me and to everyone that follows us has been that value investing works, value investing is not dead. When we spoke, Paul, last year, we were very out of step holding that cash and people thought we're crazy not participating in the biggest bull run in history or one of the longest bull runs in history. People started to say value investing is dead, value investing doesn't work anymore. I'm going to plant my flag in the sand and say it does work, it works really well, it will always work. It goes through periods of underperformance, but eventually markets prove that buying high quality businesses when they're cheap will work decade after decade after decade. So just keep doing that.

POC: I think over the last couple of years, I have seen a number of articles even questioning whether value investing was dead and why anyone should have a value style in their portfolio. I remember chuckling because as a younger guy starting in this industry in the early 1990s, I remember a similar debate around growth investing as well. I think at the end of the day, both of them have a role to play in the client's portfolio that I think particularly you should get, I guess a lower level of volatility out of a value style investment strategy as opposed to a growth style.

RM: Yeah, I think that the value and growth are two sides of the same coin. You know, you can't value a company unless you know what its growth is going to be. I'm happy to buy a high growth company, but I just want to pay a reasonable price for it and that's what everyone should be doing. I think that's your point.

POC: Exactly. Exactly. Finally, given most of us are now working from home, what tips can you provide our listeners for surviving at home in isolation and really not annoying the family too much?

RM: Well, I think the issue is ... it's a good question. We are created to be relational. Humans are relational beings. We like gathering. That's why pubs make so much money, people like to get together. That won't change and so it's important to recognise that that is important, that that's essential to our DNA. Working from home isn't really an issue provided you can still talk to people and I think what we're doing today, Paul, talking on a podcast, we use, my family use Zoom. I don't think it's secure enough so I don't use it for work but we use Teams, Microsoft Teams and Skype. Connecting with people is really, really important. We've got a team of gardeners in our garden at the moment planting some plants so I go out there, keep my distance and just have a chat to those guys and see how they're getting on. It's just important to change the people you're talking with. It's important to talk to new people or different people all the time. And it's important to get outside, go for a walk, and you won't bump into people literally but as you walk past, say good day and yeah, have something to say up your sleeve because that breaks the monotony of working from home.

POC: Yeah. I must admit getting the dogs out for a walk of the day, I've been amazed at how much more social everyone is.

RM: Paul, I reckon if we could understand dogs and we could understand what they were saying, if we could convert them, to convert their language to English, that'd be saying "Please don't take me for another walk today."

POC: Thanking you and thanking Montgomery for the support and the products you've got available on the platform to listener. I hope you guys are all safe and well and thank you for joining us for today's portfolio construction podcast and I look forward to joining you soon. Thank you.

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