Archive for category: News & Insights

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The live webinar was held on Wednesday, May 20th, 2020

Overview

Income in a very low rate environment

Rates are at historic lows and heading lower, while around the world banks are slashing dividends or scrapping them altogether. Our panellists share their best ideas for generating income during the crisis, and how you can help retirees meet their income and cash flow objectives.

Host: Veronica Klaus (Head of Lonsec Investment Consulting)

Brook Sweeney, Senior Investment Consultant, Lonsec
Vimal Gor, Head of Bond, Income and Defensive Strategies, Pendal
Amy Xie Patrick, Portfolio Manager, Pendal
Anton Tagliaferro, Investment Director, Investors Mutual Limited
Michael O’Neill, Portfolio Manager, Investors Mutual Limited

 

 

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A period of rapid change, coupled with the recent bout of heightened volatility, hasn’t aided the growing list of challenges facing the funds management industry.

The biggest challenge currently confronting fund managers within the Australian Equities sector (and potentially across most sectors) is one of survival. Fund management businesses that were already under pressure from insourcing investment management activities by super funds and low-cost index investing have now been hit with a significant loss of funds under management given downward market movements.

Lonsec Australian Equities sub-sector performance

Sub-Sector	Average 1 mth	Average 3 mth	Average 1 yr
Absolute Return	-12.70%	-14.79%	-7.93%
Core / Style Neutral	-21.49%	-24.52%	-15.28%
Geared	-44.06%	-48.70%	-37.06%
Growth	-18.70%	-21.05%	-11.16%
Income Dividend Focused	-21.13%	-25.12%	-18.27%
Income Specialised	-18.80%	-22.16%	-16.17%
LIC	-18.44%	-24.62%	-12.01%
Responsible Investment	-21.31%	-24.12%	-14.51%
Value	-22.62%	-27.19%	-20.57%
Active Extension	-23.60%	-26.10%	-16.90%
Variable Beta	-17.25%	-19.89%	-13.30%
Microcap	-26.05%	-31.95%	-16.79%
Mid Cap	-21.16%	-25.41%	-18.19%
Small Cap	-23.72%	-27.96%	-18.43%

Source: Lonsec. As at 31 March 2020

Boutique outfits without sustainable business models are increasingly susceptible to significant operational shocks in the current environment of uncertainty. Fund managers with lower funds under management are under increasing pressure to shore up their balance sheets and capital base via cost cutting or by entering into strategic partnerships. This is one key area of focus for Lonsec analysts currently reviewing the Australian Equities sector. That said, the underlying value proposition of boutiques remains compelling, with strong track records, high alignment with investors and autonomy to make decisions and set their own destiny.

The next challenge is the sheer uncertainty of what will happen next. The bottom up consensus earnings forecasts for flat growth in FY20 are not reflective of the current environment. The magnitude and duration of the virus induced disruption remains uncertain, attributing to market participants heavily discounting near term expectations. Over half of ASX 200 companies have downgraded or withdrawn earnings guidance due to the lack of visibility in assessing the extent and severity of the COVID-19 outbreak. Investors are now ready to disregard earnings this year and possibly well into 2021.

In an environment where ‘kicking the tyres’ is difficult, fund managers within the Lonsec universe are maintaining close contact with company management, looking at alternative sources of insights and closely monitoring news flow. While staying true to their traditional bottom-up approach, fund managers are also increasingly taking into consideration ‘top down’ risks, given the prevailing macroeconomic environment.

Importantly, fund managers within the Lonsec universe have stress tested their portfolios and conducted a review of their holdings, focusing on balance sheet resilience to help get through the current downturn. Any question marks around the strength of company balance sheets (i.e. high debt levels and low interest coverage ratios) has, in many instances, resulted in exiting its position.

The most recent drawdown has two stark contrasts compared to previous sizable downturns; the speed of the fall and the concentrated number of outperforming stocks. The dispersion of stock returns has spiked despite elevated sector correlations.

The consensus within the fund management community is that of cautious optimism, given Australia is already seeing the green shoots of a slowing of the spread and flattening the curve. This suggests that stocks exposed to the domestic economy will be direct beneficiaries.

A number of fund managers are taking advantage of opportunities in companies that benefit from the COVID-19 outbreak and stocks with leverage to a recovery. In particular, the surge in data usage emanating from government-imposed restrictions are positively impacting the likes of NextDC and Megaport. Supermarket operators Coles, Woolworths and Metcash are seeing a sharp bounce in their top-line sales as households hoarded a range of grocery staples including toilet paper and pasta.

As part of the ongoing review, Lonsec is monitoring for any ‘style drift’ in strategies chasing ‘high quality’ stocks.

History doesn’t repeat itself, but it often rhymes

If the GFC was any guide, one of the most profitable ways to generate short term gains was via capital raisings. This time is no different. A recent report by analysts at Macquarie who looked at the performance of 35 deals that had raised a combined $15.4 billion since 18 March 2020, found 74% of the deals were trading above their offer price, while raisings had on average returned 17% to date.

Within the small cap sector since late March to 22 April 2020, 29 companies raised capital totalling $5.4bn at an average discount of 22.2%. Only 6 of the 29 companies were trading below their placement price.

Many of these companies have benefitted from steps announced by regulators to facilitate capital raisings. In late March, and in response to the COVID-19 pandemic, the ASX temporarily increased the threshold to 25% (from 15%) for placements without needing to obtain shareholder approval. Last week, the waiver was amended to require additional disclosure by companies taking advantage of new share placements rules. Companies need to explain in detail how the shares are allocated, and which investors received stock, amid concerns existing investors are being diluted. For example, NextDC handed 20% of the stock issued in the placement ($672 million) to new investors at the expense of existing shareholders.

A large number of fund managers currently reviewed by Lonsec are taking advantage of this phenomenon, but the approach varies from taking  their pro-rata allocation, investing in a stock with the intention of topping up at the capital raising stage, or using their networks to get an allocation despite not having previously held a position in the company.

Fund managers are finding new sources of dividend income

Fund managers across the board are expecting company dividends to come under pressure due to liquidity concerns and balance sheet stress. The ability to cancel or delay dividends may prove an important source of funding to preserve balance sheets and may also help avoid dilutive equity raisings. Fund managers expect any unpaid dividends to be kept on balance sheets as retained earnings for future dividends.

% of dividends exposed to COVID-19 disruption

Source: AMP Capital

As at 30 March 2020, ASX 300 dividends announced but not paid totalled around $14 billion. Of these around $450 million have been cancelled and $540 million deferred.

Lonsec expects all Income strategies to be impacted as dividends for banks, property and infrastructure companies are expected to decline as companies try to counter demand shocks through rapid cash conservation measures. For example, National Australia Bank recently cut its dividend by 64% to protect their capital positions in anticipation of rising bad debts. Historically (over the last five years), the Financial Services sector and Materials sector have paid 33% and 27% (respectively) of total dividends (net) paid by companies.

The market expectation is for average DPS to fall in the region of 25–30%, but fund managers expect this to recover by 2022. Prior to the current crisis, yield (cash dividend plus franking) was near 7% (add a further 2% for option-based strategies). These numbers will obviously fall, but the belief is they are unlikely to approach the level of bond yields.

Importantly, fund managers have found new homes in their quest for yield. Resources stocks are the new ‘kids on the block’ when it comes to dividend payers. Resources companies are benefiting from strength in commodity prices, weakness in Australian dollar and strong balance sheets. Stocks such as Rio, BHP and Fortescue now within the ‘low probability of dividend cuts’, whereas the previous ‘annuities’ being the bank dividends are under continued pressure. Lonsec notes that given resource companies are generally capital intensive, cyclical (commodity cycle), and have higher operational risks, they are not the best ‘through the cycle’ dividend plays. For example, BHP had to cut its dividend following the Samarco dam disaster.

Dividends will be cut, making the avoidance of dividend traps more important than ever. It is important for fund managers to be cognisant of the potential for stocks to cut their dividends and adjust their portfolios accordingly, rather than just remaining systematically overweight those stocks with the highest historical yields.

Managers are getting ahead of the regulatory curve

The ban on short selling during the GFC opened up a lively debate on how markets should function. While the merits of a short selling ban may be dubious, fund managers are nonetheless prepared for this. While this would not be a big deal in isolation, fund managers need to make sure they are not exposed to many illiquid or highly shorted names. In the event of a short selling ban, history suggests that many would more actively use shorting of the index for hedging purposes.

Similar to past crises, the COVID-19 outbreak will mark a key point in history. Key structural trends are likely to emerge, and fund managers have begun pondering the implications for their strategies. Themes include the transition to a more digital world and focus on automation, having been further highlighted by the enforced digitisation of workplaces. Changing consumer behaviour such as an increase take up of e-commerce and the fragility of global supply chains have also been brought into stark attention. How these broader trends will impact the economy is a different question, but they will undoubtedly work to reshape the future investment landscape.

There has been much debate as to whether the market has reached its bottom. Trying to pick market inflection points be it the top or bottom range of the market can be difficult in the best of times. The last two months have felt like an eternity not only in terms of markets but from a life in general perspective. Many of us are working from home, homeschooling our children, we are rolling back the years with petrol prices and many people close to us have seen their businesses and job security plunge into uncertainty.

We’ve seen markets fall faster than during the financial crisis over a decade ago and at the same time we’ve seen central banks and governments respond quickly and in an unprecedented fashion in terms of scale. On average, governments have committed approximately 10% to 15% of their annual GDP to implement backstop measures to prevent their economies plunging into a deep recession or a depression. The US Federal Reserve has injected markets with a massive liquidity boost not only buying US treasuries but buying investment grade credit and high yield bonds.

So, have we seen the bottom or is there more downside to come? The fundamental question is how much of any future bad news has the market already priced in. This is one of the key things we asked ourselves in our most recent investment committee meeting. If we break down the key factors of our dynamic asset allocation process, we believe that over the long-term valuation is a key indicator of future returns, but that over the medium term where we are in the cycle, liquidity and policy have an important influence on markets.

Based on these factors our view is that risk assets are more attractively priced than they were prior COVID-19.  Policy and liquidity is accommodative to risk assets, economic data is negative and shorter-term sentiment indicators remain negative albeit risk gauges such as the VIX index moving down from their highs.

In a nutshell, we believe that market volatility will persist, there will be further bad news to come, but if we look ahead three years, we believe asset prices are likely to be higher than they are today. Based on this view we have neutralised our slightly underweight exposure to risk assets and reduced our exposure to alternative assets and cash.

So, don’t try to pick bottoms. We know that it doesn’t end well. In such environments where news is changing on a daily basis it is important to focus on your investment philosophy, process and investment time horizon.

Stay safe and healthy.

The A-REIT sector had a torrid March as the COVID-19 virus hit Australian shores. Local investors are now familiar with both the devastating health consequences of the virus as well the unprecedented social distancing measures that governments have been forced to implement to curb its spread.

These measures have hit the A-REIT sector hard, with retail assets being particularly impacted by the mandated closure of non-essential businesses, and the decision by some large national retail groups to temporarily reduce their bricks and mortar footprints. However, as the economic fall-out from C-19 grows wider, the other key sectors – office and industrial – will increasingly feel the impacts of falling business confidence and GDP.

There is a silver lining for investors, though. A-REITs have entered the C-19 market with a more defensive financial profile due to the GFC learnings. Hence, while the C-19 impacts will squeeze liquidity, raising the risks of capital raisings and distribution deferrals, investors should avoid the insolvencies or deeply dilutive rights issues that plagued the sector in 2008-2009.

The scale of the A-REIT sell-off can best be ascertained by a review of the 31 March 2020 performance data for its headline index, the S&P/ASX 200 A-REIT Index (XPJ). The XPJ provided investors with an abysmal -35.2% total return for the month of March – a negative monthly return which even eclipsed the worst of the GFC period. This calamitous result has also skewed the longer-term track record for investors, with the three- and five-year total returns now also falling into negative territory (-6.4% p.a. and -1.2% p.a. respectively).

This was despite the A-REIT sector having performed strongly in the calendar year 2019 due both to the bottom-up success of the Goodman Group in rolling out its specialist logistics business plans, and strong asset performance for the office and industrial sectors. After such a large price move, S&P noted in its March index update that the sector was trading at 0.56x book value and an indicative forward yield of 6.8%, which at face value would appear an attractive valuation entry point. But first we need to better understand why the index was sold off so heavily.

Where the retail sector goes, so goes the index

The A-REIT sector is highly concentrated, with a handful of names accounting for the majority of the market cap. For example, we have provided some analysis on the current price action for individual REITs with a market cap above $3 billion (see table below). This group of eight REITs currently accounts for approximately 80% of the XPJ’s market cap. What this also means is that some bottom-up issues for a large REIT or sector can have a similarly large impact on the index.

When comparing the drawdown of these REITs from mid-February to their March lows, we can see that this sector was the retail-only REITs such as Scentre Group and Vicinity Centres, which had significantly worse drawdowns of 62 to 64%. Further, while Scentre, for instance, has clawed back some of the drawdown, it is still much further off its mid-February peak compared to the broader sector. Given this, a greater understanding of the dynamics at play in the retail sector will go a long way to gaining a better understanding the current A-REIT dynamics.

Large-cap A-REITs have suffered large drawdowns since COVID-19 hit

ASX Code	Name	Last  15’Apr	Mkt Cap $’b	% of Index	Sector	Mid’Feb Price	Mar’20 Low	Draw down	Recovery	% off Feb
GMG	Goodman	13.22	24.7	25%	IND	16.62	9.60	-42%	38%	20%
SCG	Scentre	2.13	10.7	11%	RET	3.70	1.35	-64%	58%	42%
DXS	Dexus	9.47	10.2	11%	DIV	13.41	8.03	-40%	18%	29%
MGR	Mirvac	2.24	9.0	9%	DIV	3.32	1.65	-50%	36%	33%
GPT	GPT	4.00	8.0	8%	DIV	6.27	2.82	-55%	42%	36%
SGP	Stockland	2.95	6.9	7%	DIV	5.19	1.72	-67%	72%	43%
VCX	Vicinity	1.40	5.1	5%	RET	2.36	0.91	-62%	55%	41%
CHC	Charter Hall	7.71	3.5	4%	DIV	14.03	4.93	-65%	56%	45%

Source: Lonsec, IRESS

Retail REITs globally have been facing long-term structural headwinds due to strong competition being placed on certain segments, such as apparel and department stores, by the advent of online shopping. Retail REITs have been seeking to negate this challenge by changing their leasing mix to more ‘experienced-based’ tenancies offering services such as dining, cinemas, gymnasiums and healthcare.

If consumers are going online to shop for some of these disrupted categories, then landlords need to pull the services lever to restore foot traffic. Scentre is a good example of this dynamic, having been particularly successful in executing this strategy with 43% of the stores across its platform categorised as ‘experience-based’ at the end of 2019. The combined impact of a softer department store and specialty rental sector, along with the additional leasing and fit out costs of the forced conversion, has also impacted the operating cash performance and balance sheet metrics of the retail REIT sector versus office and industrial. This saw retail specialist REITs enter 2020 with reduced liquidity and more stretched balance sheets.

Unfortunately for retail REITs, a tenancy portfolio heavily weighted towards ‘experience-based’ tenancies rapidly morphed into a portfolio full of ‘non-essential’ services in the C-19 pandemic. Forced closures have also occurred at the same time as foot traffic has declined due to both isolation directives for the general public and the drop-off in international travel, which in turn has led retailers with large national ‘bricks and mortar’ store networks temporarily closing their shops.

The end result has been a perfect storm for retail REITs faced with the prospect of a large decline in Funds form Operations (FFO) due to reduced variable rents, rent relief support for impacted tenants, and ultimately increased spreads on lease renegotiations and higher vacancies.

A-REIT balance sheets are holding up in face of the COVID-19 crisis

Despite the headwinds of C-19, balance sheet conservatism means it is still unlikely that larger trusts will need to resort to the deeply dilutive recapitalisations witnessed during the GFC. As the table below shows, balance sheet metrics for the top five A-REITs by market cap as at 31 December 2019 indicate that debt remains manageable. Outside of Scentre Group, the other large REITs all have conservative metrics, with gearing ratios well below 30% and Interest Coverage Ratios (ICRs) above 5x. Further, the composition of their loan books are demarcated by a much greater exposure to bond markets, longer-dated terms to maturity, and ample liquidity.

Balance sheet metrics for top five large A-REITs remain relatively healthy

ASX Code	Name	Gearing ratio	ICR   (x)	Liquid. $’b	Bonds	Term Mat. (Yrs)	Current Refis $’b	Int. Costs
GMG	Goodman	10%	18.5	2.4	100%	6.3	0.3	2.9%
SCG	Scentre	33%	3.6	1.8	64%	4.2	2.5	4.2%
DXS	Dexus	26%	5.7	1.3	65%	7.4	0.4	3.5%
MGR	Mirvac	21%	6.1	0.9	94%	7.7	0.2	4.5%
GPT	GPT	22%	6.7	1.3	86%	7.7	0.1	3.6%

Source: Lonsec, Company Financial Reports

The outlier here, however, is Scentre Group, with the longer-term retail sector headwinds meaning it entered the C-19 period with both a higher gearing ratio of 33%, a lower ICR of 3.6x, and the need to refinance over $2.5 billion in debt expiring in the short term. This, along with the more acute impacts on its operations from C-19, is a key reason for its recent underperformance versus peers. However, even Scentre’s metrics are well below the GFC, when the average gearing ratio was closer to 40% and the ethos of financing long-term assets with short-term bank debt was in the ascendancy.

There is still a great deal of uncertainty and many moving parts to the C-19 pandemic, including government policy responses, and likely many months before the economy returns to normal (or as close to normal as we can expect). Overall, however, the major A-REITs appear in good shape and are well positioned to weather the storm without the scale of the recapitalisations we saw in 2008-09.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

There is a powerful maxim best suited to the current predicament faced by markets, and that is, there are decades where nothing happens, and there are weeks where decades happen. The advent of 2020 has brought with it unprecedented volatility, with markets whipsawing erratically and appearing to have detached completely from the underlying fundamentals. No sooner had investors been beaten into submission from depression era plunges in equity markets, were they then riding a jubilant wave of euphoria on a spectacular relief rally. Unfortunately, there is no investing rule book which outlines how to effectively manoeuvre your portfolio while the global economy is placed in suspended animation and a deadly viral pathogen wreaks havoc. However, if there was ever an opportunity for active investing to shine, this is it.

In the midst of a lethal pandemic gripping markets, investors have also been dealt a one-two punch of a brutal collapse in oil prices amid a price war between Saudi Arabia and Russian. As such, the price of West Texas Intermediate (WTI) has plummeted from US$62/bbl to a low of US$20/bbl, and now seriously threatens the viability of a highly leveraged global energy industry. While lower oil prices translate into lower transportation costs, this is less relevant given large swathes of the globe are in lockdown and the airline industry has drastically curbed output.

Source: Bloomberg

Importantly, with the price of oil well below break-even, exploration and production will come to a standstill and untold numbers of jobs will be lost. Bizarrely however, in a market gripped by panic, the mindset has inexplicably shifted from selling anything (barring safe-haven currencies and US Treasuries) to a dramatic reversal bordering on irrational exuberance. This is perfectly exemplified by the FOMO (fear-of-missing-out) driven bull market rally, where investors are piling in despite the IMF now predicting the deepest economic downturn since the Great Depression of the 1930s. Astoundingly, the S&P 500 has now notched a 25% return from the depths of the recent bear-market low.

Source: Bloomberg

So, this leaves the pundits questioning, has a technical bottom been found in the markets, or are we witnessing a textbook bear-market rally? In the case of the former, perhaps it’s the invisible hand of the market looking through to a solid economic and corporate upturn. Conversely however, the rally could simply be driven by over-optimism around global governments and central banks being ‘all-in’ amid past condition to ‘buy-the-dip’. Given the magnitude of the uncertainties we’re faced with, intuition favours the latter. This has tended to be the consensus view held among Australian equity portfolio managers when posing the same question during meetings as part of Lonsec’s annual review process over the course of the first two weeks of April. Moreover, some Managers are bearishly predicting a re-test of the lows experienced in March.

Historically, downward trending bear markets have frequently been plagued with sharp relief rallies, only to run out of steam and reverse course. Logic likely dictates that given the magnitude of the deteriorating fundamentals and economic data, a sustained recovery from here is likely over-optimistic. This was evidenced throughout the latter stages of 2008 where the S&P 500 was in the grips of a death-spiral despite numerous surges ranging from 10-25%, to ultimately bottom in March 2009. Furthermore, if using weekly jobless claims in the US as a proxy for the health of the global economy, the outlook appears dire. Jobless claims continue to skyrocket and take the cumulative total number of people who have lost their job since March 2020 to almost 17 million. In the singular month of March these jobless claims have already far outstripped the devastation witnessed during the Great Recession of 2008.

The dislocation in the credit markets has likewise been pronounced, and counterintuitively, this has spread to sovereign bonds which are typically immune from indiscriminate selling. Perversely, the US Federal Reserve has resorted to not only purchasing sovereign debt, but also sub-investment grade bonds through high-yield credit ETFs. In a sign of how distorted capital markets have come, the Fed is now extending credit to cash-starved corporates in attempts to stymie a systemic economic contagion in which credit markets freeze and liquidity evaporates. Once again, this type of intervention is without precedent and has significantly stabilised markets through keeping these companies on life-support whilst the ‘risk-off’ sentiment remains heightened. However, both credit spreads and trading in credit default swaps (CDS) remain elevated which suggests a marked disconnect between the ‘blue-sky’ scenario priced into equity markets, and fixed income securities languishing in the doldrums. Consequently, in the face of such ghastly economic data, one would imagine that the ‘Fed-Put’ is starting to weaken. Alternatively, perhaps we’re witnessing the last vestiges of blood being wringed from the retail investors with quantitative trading driving momentum higher before a swift ‘pump and dump’ ensues. So, for those telling themselves that this time is different, a word of caution, as history does not repeat itself, but it does rhyme.

Source: Bloomberg

The global economy is now likely wrestling with a complete paradigm shift in how globalisation is viewed. The longer we remain in lockdown limbo, the greater the push will be for a secular and structural de-globalisation of the world economy in the post-crisis landscape. Not only has the world been devastated through the effects of a global health catastrophe, but Orwellian impositions on our personal liberties have been thrust upon us that would have been utterly inconceivable barely months ago. Moreover, the chasm between the ‘haves’ and the ‘have-nots’ has radically deepened as a wider dispersion between the working class and the inner-city elites has been exposed. Given the increasing social unrest we’ve already witnessed unravelling in supermarkets, it’s not a stretch to see this playing out on a broader scale. Likewise, the America First mantra now appears less xenophobic as countless other countries have adopted even more radical shifts to protectionism in a fight to survive. A likely consequence of this would be the return of innovation and manufacturing to many countries, where previously this function had been outsourced to China. Case in point being the world’s reliance on China for life-saving pharmaceuticals. Australia imports approximately 90% of medicines, where an outsized reliance is placed on China to meet these needs. As such, given the supply chain vulnerabilities exposed by COVID-19, a re-assessment of Australia’s sovereign capability to meet our domestic pharmaceutical consumption is warranted. Secondly, corporate vanity and window dressing will likely take the back seat as companies are forced to re-focus on their core stakeholders when staring down the barrel of economic ruin.

The exogenous COVID-19 shock has exposed significant vulnerabilities in the financial system yet has also created potentially lucrative investment opportunities for rational investors. Whilst it might be difficult to maintain a dispassionate outlook at this juncture, remember that it isn’t the end, and that markets will bottom well in advance of a positive shift in investor sentiment. If history is anything to go by, you should never let a good crisis go to waste and use this opportunity to dollar-cost-average, as this could be our March 2009 moment. With that said however, the market always delights in humbling the masses, so proceed with caution.