Since our last note, it is clear to all that the novel coronavirus has morphed into the most significant crisis in post-World War 2 history. For financial markets, it cannot get any worse than the potential shutdown of the global economy. This is what markets are fearing. Accordingly, we have seen the fastest bear market in history, and value destruction in line with or greater than the 1987 stock market crash and the more recent Global Financial Crisis.
We all know the current framework. To conquer the medical crisis, authorities are closing down non-essential activity and this risks creating widespread economic dislocation - unemployment, credit risk, ultimately defaults.
The severity of this economic and financial market downturn will be a function of the duration of the quarantine period and the ability to maintain a minimum, although significantly reduced, level of economic activity. Unfortunately, no one can reliably claim that they know how long the quarantine period will persist and what level of economic activity will be achievable.
These crises typically peak, and thus markets bottom, when peak fear and panic cross paths with peak monetary and fiscal response. With this crisis it will also require a peak in fear related to the infection rate – so we need relative infection and mortality rates to subside.
On the monetary front, central banks are taking a “whatever it takes” mentality to ensure financial market liquidity. Banking capital and liquidity entered the crisis at record levels and regulators have learnt from the GFC. They are allowing banks to draw down on capital reserves if required and providing targeted support for loans.
On the fiscal front, we are seeing record stimulus announcements globally. Authorities have panicked and that is a good sign. In the US, we just need the House and Senate to agree on their proposals.
So the real issue now is fear and a plateauing of infection rates. China claims to have achieved a reduction in infection rates and Korea and Singapore have done so. Traffic jams returned to Beijing in a sign that life is getting back to normal as China declares victory over the virus. In contrast, Italy is still in crisis and markets are discounting for the risk that the rest of Europe and the US follow suit.
From an equity market perspective, we all know that the best time to buy equities is when markets are most fearful. You are unlikely to see fear greater than it is today. However, the ability to buy is dictated by one’s investment psyche and investment time horizon and liquidity. When businesses that under normal circumstances - very solid businesses - are moving between 30%-50% in a single day, it can be very difficult and gut wrenching to execute purchases. But in my mind, there is no doubt that one should be at least thinking very carefully about putting cash to work, if not actually starting to do so.
To be a successful investor, you have to be counter-cyclical and we have always highlighted that this should also be the case when using PM Capital funds within your portfolio. In 2009, we highlighted that it was a once in a lifetime opportunity in credit and a once in a generation opportunity in equities. Today I believe we have a once in a lifetime opportunity in cyclical stocks (those most impacted by short term economic events).
When we do conquer this current virus, valuations in cyclical sectors of the market will be recognised as being extraordinary, exceeding the return opportunity for the global market index coming out of the 2009 post-GFC lows. The way you deal with the extreme daily “mark to market” price action is to hedge with an appropriate permanent cash position, depending on your risk tolerance.
Again, on the assumption that the virus is dealt with over the next six months, the size of the fiscal response is likely to see an explosive recovery in those stocks most impacted today as well as significant sector rotation.
From a stock perspective, the most pressing issue is dealing with liquidity issues over the next six months as revenues and cashflow decline. In situations like this, you always get hidden surprises, but we have reviewed each stock in our portfolio in reference to their ability to deal with both the short term and long term dynamics presented by this crisis and thus their ability to capture the upside recovery that may occur after this extraordinary set of circumstances. The stocks held in our investment themes have numerous advantages and upside valuation potential, among them:
Theme: Housing – Ireland and Spain
Stock: Cairn Homes
Cairn operates in a housing market structurally undersupplied and possesses a land bank that cannot be replaced. It should emerge in a stronger position as smaller builders cannot access capital and may be forced to leave the industry. Cairn has minimal debt, ample debt facilities and positive free cash flow.
Upside potential: Under normal activity levels, free cash flow yield of ~25% per annum over the next 5 years which will be returned to shareholders in the form of dividends and buybacks. Normalised 2023 PE net of expected cash returns to shareholders = 2x.
Stock: Freeport-McMoRan Copper
Owner of some of the premium long life, low cost copper/ gold ore bodies. While the copper price is likely to be soft near term, ~25% of consolidated revenues comes from gold holdings. China (45-50% of global copper demand) is gradually bringing its economy back online with the likely assistance of fiscal stimulus programs. On the supply side, at the current copper spot price ($2.15) new supply is unlikely and others with high cost production now loss making, therefore may close. Freeport has no material debt obligations due until Q421.
Upside potential: At a copper price of $3, with normalised production from the Grasberg mine, Freeport is trading at 3x earnings. At 10x earnings = +300% potential upside.
Theme: Domestic banking – US and Europe
Stocks: Bank of America/ JP Morgan/ AIB
These are dominant domestic franchises. Although there will be an earnings impact from the crisis, Bank of America and JP Morgan came into it with record balance sheet capital and liquidity. JP Morgan’s 2018 annual report called itself “a fortress company with a fortress balance sheet”. Regulators have learnt from the GFC and will allow capital to be drawn down. Once US leading franchises pass this crisis test, they will re-rate as well as benefit from the earnings recovery. JPMorgan’s earnings power in a normal environment is ~ $11 per share. At 15x earnings this would equate to potential upside of 100% from the current share price.
The European banking sector has probably the most upside of any sector provided capital is adequate to deal with the shut-down. While they are the most vulnerable to an economic shut down and one should never bet on the macro (which we have mistakenly done), pricing is becoming compelling. On the capital front, by way of example, Commonwealth Bank of Australia has $1 of capital for every $13 of loans, predominantly house loans. AIB has $1 of capital for every $6 of loans, predominantly housing loans. However, CBA sells at 8x pre-provision earnings, while AIB sells at 2x.
Theme: Service monopolies
In a duopolistic position globally, the movement of cash to electronic and online transactions has accelerated as a result of the crisis, causing an uptick in Mastercard’s structural revenue growth potential longer term. It has minimal debt and low capex needs.
Upside potential: Structural growth makes it a high value business = 25+ PE. A ‘buy and hold’ strategy delivers acceptable 10%+ returns to investors even if the stock does not rerate from current 19x FY21 PE ratio.
Theme: Gaming – Macau
Stock: Wynn Resorts
As a global premium casino operator, Wynn has been directly affected by closures. However, long term earnings power should be unchanged post-coronavirus – historically gaming has always recovered. Wynn has no material capital expenditure programs, $2.4 billion in cash ($8 billion net debt), and no debt maturities before 2022 – it could handle 15 months of lock down.
Upside potential: Wynn’s valuation (peak to trough) has gone from – $21 billion (pre-US China trade dispute) to $4 billion (current). Management’s 2021 guidance (earnings under normalised environment) at the current price gives a 27.5% free cash flow (FCF) yield. A single digit FCF yield = +300% valuation upside potential.
Theme: Alternative asset managers
Apollo’s performance fees will be affected in the short term. However, with one of the most respected management teams on Wall St, Apollo has significant permanent capital and record dry powder (funds yet to be invested) - perfect for the current environment. It is effectively debt free with very low capital requirements.
Upside potential: Apollo’s normalised earnings power of $3.50 per share would put them on 8x earnings. In better times it will trade at 20x earnings = +150% valuation upside potential.
Theme: Industrial – Europe
Siemens, a best in class global businesses across medical equipment, digital factories and mobility, will see demand in key regions affected. However, positive structural drivers remain in place for its equipment and technology that are critical in the new economy. Industrial businesses are effectively debt free and highly free cash flow generative.
Upside potential: Siemens’ normalised earnings power of €8 per share would put them on 8x earnings multiple. It should trade at 16x earnings in a normal environment = €128 or ~100% upside potential.
Please note the above commentary is in response to questions from clients in relation to the strength of companies in the portfolio, their the ability to deal with the immediate economic shut-down occurring in many regions around the world, and the potential upside capture assuming they get through the current pandemic environment.
It is obviously a very difficult time for all. The good news is that we do have very capable people in Australia dealing with these issues and it is critical that we give them the respect and support they need to deal with their responsibilities. From an investment perspective, it is critical that we maintain our long term discipline. I wish everyone the best.
Chief Investment Officer
Portfolio Manager - Global equities
This note is issued by PM Capital Limited ABN 69 083 644 731 AFSL 230222 as responsible entity for the PM Capital Global Companies Fund (ARSN 092 434 618). It contains summary information only to provide an insight into how we make our investment decisions. This information does not constitute advice or a recommendation, and is subject to change without notice. It does not take into account the objectives, financial situation or needs of any investor which should be considered before investing. Investors should consider a copy of the Product Disclosure Statement which is available from us, and seek their own financial advice prior to investing. Past performance is not a reliable guide to future performance and the capital and income of any investment may go down as well as up.