The purpose of this update is to give investors an idea of our areas of focus when guiding the portfolio through this extremely difficult time.
Rather than concentrating on the direct medical effects of the current pandemic – we do not profess to be medical experts – we are concentrating on the factors that we believe will have the most impact on the investments we hold, and therefore managing the priorities of protecting capital as much as possible while also positioning the portfolio for future opportunities.
To proclaim the severity of the moves witnessed over the last month as unprecedented is not an overreaction. The intensity of response to the novel coronavirus has not been seen since the GFC, and then some. The recent hoarding phenomenon is not restricted to toilet paper. We are seeing it in equity and debt markets - act now, rationalise the decision later.
Our casino holdings are obviously directly impacted, and in a material way, by the restriction of individual movement. Prior to the impact of COVID-19 we were able to buy Wynn Resorts on a 10-11% free cash flow yield (based on management’s 2020 guidance, which we viewed as achievable in light of relatively conservative Macau estimates). Today the business is trading on 28% free cash flow on those same estimates. While the company is unlikely to achieve these in the same 2021 financial year, this does in our opinion represent the normalised earnings base of the business, creating an extremely attractive opportunity at these levels albeit one that will be highly volatile.
We have seen these extreme valuation opportunities before. We acquired our first Macau gaming position, SJM Holdings, during the GFC. Our initial position was acquired for HK$1.69 in March 2009, down 45% from its IPO price less than twelve months prior. Fast forward three years and we had ~70% of our initial investment back as dividends, this increased to ~180% over five years.
Wynn, like SJM Holdings during the GFC, is just one example of the extreme valuations we are seeing in portfolio companies.
The price action witnessed at the individual stock level has materially changed the risk reward proposition for the portfolio. There has been and is likely to be a heightened level of portfolio activity. Positions that are down may be sold, not because we do not envision a positive return over a three to five year period, but because a greater return can be achieved elsewhere.
Corporate balance sheets
While we remain confident in the long term earnings profile of our holdings, predicting the earnings of any business over the next twelve months has become extremely difficult and is subject to a wide margin for error. Given the short term outlook, liquidity and balance sheet strength becomes particularly important.
It is ironic that in a world of low interest rates and near free money, which we have been living with since the GFC, a focus on corporate balance sheets and liquidity requirements have to a large extent been relegated to secondary considerations. However, at the centre of a crisis these issues returned to be front and centre in investors’ minds. Debt covenants, interest cover and credit lines will now form the majority questions asked to corporate management teams.
In this respect Asia is relatively well placed. A conservative corporate culture has typically led to lower levels of gearing and therefore healthier balance sheet structures. As an example, the widespread trend witness in the United States of debt-funded buybacks has not been prevalent in Asia.
Looking across the portfolio, approximately 40% of the businesses we own hold net cash positions, in some cases material as a percentage of their market capitalisation.
- Dali Foods Group – 20%
- SABECO – 20%
- TravelSky Technology – 25%
- China Mobile – 50%
For the companies that do have debt, these are typically longer dated maturities with manageable debt obligations over the forward twelve month period and they retain ample cash balances to meet any short term working capital or interest requirements.
There does remain a tail of companies (one or two small positions) that are likely to require capital in the next twelve months, we are monitoring these positions very careful and have had dialogue with the board and management teams of these companies to address this issue.
Entering this period of uncertainty with a strong balance sheet will allow the companies within our portfolio to navigate the reduced operating activity which many will experience in the coming months and see them well positioned to regain business once coronavirus infections are brought under control.
Asian Infections rates and pace of normalisation
China, the original epicentre of the virus, has been successful in slowing the rate of confirmed cases. Over the past fortnight newly confirmed cases have averaged well below 50 per day and largely been confined to Hubei province or been imported cases of Chinese abroad retuning to China. At the time of writing recovered cases also stand at over 70,000.
In February, at the height of their outbreak China made the difficult decision to restrict the travel of over 700 million citizens, many with very strict lockdowns measures confining people to their primary residence indefinitely (most notably Hubei) . The sheer quantum of this number is remarkable - over 10% of the world’s population. At the time this move was considered draconian. Now, quarantining and restricting the movement of citizens are being adopted by most countries as a primary measure to stop the spread of the virus.
Many people have questioned the accuracy of China’s data, and these may be well placed concerns – particularly in the initial stages of the outbreak. However, supporting this data is the fact that China has gradually brought its industrial infrastructure back online since the start of March. A weekly study by Bernstein Research estimates that between 90-100% of China’s manufacturing capacity is now back online. Traffic congestion, air pollution readings and subway usage also continue to increase week over week while still being well below pre-virus levels.
Other countries in Asia where we have access to more robust data are also showing encouraging signs. Korea, the second hardest hit country in Asia and one which saw its rate of new daily infections peak at 813 on February 29th , has now recorded less than 100 new cases per day for the past week with a declining trajectory. This has been achieved by very aggressive testing measures.
Singapore, Taiwan and Hong Kong, where monitoring and testing measures have also been amongst the most prolific, likewise have managed to maintain infection rates at very low levels and consequently the economies and industry have continued to function. Macau, important for the portfolios gaming positions, has recorded only a handful of imported cases month to date.
Observing the pace of daily inflection rates suggests Asia has come to terms with how to manage the spread of the virus effectively. We are watching to see if these successes experienced to date are being maintained. What Asia also shows us relative to other places is that the pace and decisiveness of a country’s response to the virus dictates the inflection point in infections and goes a long way to determining how long inevitable quarantine periods with ultimately be. The largest catastrophes from both a health and economic perspective will be in countries where authorities are slow to act and the healthcare systems become overwhelmed, requiring a very strict response.
PM Capital Asian Companies Fund
This note is issued by PM Capital Limited ABN 69 083 644 731 AFSL 230222 as responsible entity for the PM Capital Asian Companies Fund (ARSN 130 588 439). 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.