- COVID impacts
- Quality portfolios
- US housing
With the daily flow of new case rates remaining above 100 in NSW, and outbreaks springing up across the country, attention is now returning to the sectors most vulnerable to COVID’s impacts, notably unsecured consumer credit (Z1P, APT), REITs (particularly the retail and office exposed names), travel (FLT, WEB, CTD) and oil & gas (as lockdowns mean less driving, less air travel, and so on).
The reasoning is straightforward, the longer the lockdowns, the greater the earnings impact, and with less fiscal assistance on offer than in prior lockdowns, the greater the uncertainty around a) balance sheet strength b) working capital, cashflows & inventory and c) management confidence in the outlook, which is important for sustaining investor risk appetites. You can look through a lot of things when management sounds upbeat, less so when they don’t.
Our investment approach in direct equities is Quality Growth at a Reasonable Price (called QGARP). As you can see in the graph below we aim to have a high and enduring (persistent) factor loading to the Quality investment style.
Many managers will say they are a Quality style manager, but then subsequently prove not to have any statistical significance associated with the Quality factor loading. We believe it is critical that a manager is “true to label” and will behave in a manner consistent with the expectations of the advisors and clients that have allocated capital with those characteristics in mind.
Due to interesting (but perhaps not for this note) statistical properties known as multi-collinearity the Growth factor tends to show up as a negative factor loading to Value.
You can see our portfolios tend to be allocated towards the larger capitalisation stocks, but it isn’t a primary target, and lately we’ve found ourselves looking more towards midcaps in a hunt for reasonably priced Quality companies, mainly due to the very-nice-to-have problem of corporate activity/M&A/takeovers across stocks we owned (SYD, SKI, ALU, IRE, CWN). We still retain SKI, and are hopeful of a higher bid developing, but have exited the others. SKI is also a nice stock to have in the portfolio whilst the current COVID resurgence accelerates.
You might be tempted to glance twice at CWN, amongst the list of names, in a conversation about Quality companies, given the recent publicity, but the Barangaroo assets are world class, and our entry point was very attractive (the reasonable price part of QGARP).
Typically, a quality company will have a rolling regression factor premia loading like that of Sydney airports (SYD), shown below. Anything above .50 is quite strong, and you can also see that SYD had been pretty expensive right up until COVID, at which point the stock moved right into our preferred nexus of Quality at a Reasonable Price.
The “sleep at night” factor associated with our preferred style; the typically predictable, stable earnings structures, robust margins, and strong balance sheets of the stocks we own, have performed very well in aggregate, and is a particular source of portfolio resilience and comfort as COVID related uncertainty heats up.
US housing has been on fire. Demographics, as millennials move into their prime homebuying years, has been a major driver, as has declining interest rates. Rounding out the top 3 reasons for US housing strength is supply, in which the boom years of the pre-GFC gave way to a decade long bust, causing the supply of new homes to fall into deficit.
Those are the fundamentals. Equally, with dwelling valuation ratios now exceeding the 2006 levels in terms of price-income, price-rent, we’ve got good reason to worry that prices have been pushed too far, too fast. Anecdotal stories of desperate bidders making offers without seeing the property, developers taking only “top dollar” bids, and even a story one would-be home owner who offered the naming rights to their as yet unborn child round out a market marked by froth.
The same sort of behavioural patterns that are associated with unsustainable pricing environments are writ large in the graph below, which shows home equity withdrawal in the US. Such withdrawals are often used to finance consumption via the wealth effect, and are by definition unsustainable.
There are good reasons to be defensive in the current market. Across our diversified investment portfolios we are underweight equities, and within equities, continue to allocate to Quality as our preferred investment approach. We also remain underweight the emerging markets, due to concerns about COVID’s impact on markets with less developed medical and financial institutions.
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