Investors have traditionally seen the largest 20 companies in the S&P/ASX 200 Index as the Australian champions that should form the backbone of an investment portfolio.

These names have become a staple for many investors if only because we don’t see a lot of rotation among them, even over relatively long periods of time. These companies have historically been banks, telcos, and even media conglomerates that sat at the centre of Australia’s news and entertainment industry.

In the Australian investing mindset, these companies are associated with industry leadership, proven business models, and high dividends. They are valued for the strength of their market position and the fact that they have been a feature of the corporate landscape for decades. Often, the longer investors hold these shares, the more reluctant they are to sell them.

However, given the market turmoil in the wake of COVID-19, investors are starting to ask themselves if they have become too reliant on these names. With companies forced to cut, delay, and even cancel dividends, the traditional view of blue-chip investing is starting to change.

Today, newcomers like Australian Healthcare giant CSL, major supermarkets in Woolworths and Coles, key Consumer Discretionary player Wesfarmers, and not to mention BHP are playing greater prominence within a balanced portfolio. While the banks still feature heavily, their dominance has dwindled post the GFC as regulation and lower interest rates limit their growth opportunities.

The role of large-cap shares in your portfolio

In Lonsec’s view, there is an important role for large-cap shares within a diversified portfolio. However, focusing too heavily on a handful of large companies and expecting them to do the heavy lifting can result in poor performance and likely will not be serving the investor’s needs and objectives.

The COVID-19 crisis has no doubt exposed a number of investors who believed they could rely on a company’s size and track record without considering their sources of risk or how exposed they were to certain sectors.

Diversification is critical when constructing a portfolio. This means having suitable exposures to different sectors, company sizes, and geographic regions. It also means understanding how your portfolio is positioned to manage various risks and opportunities as they emerge.

Heading into 2020, Lonsec’s portfolios were defensively positioned, with overweight exposures to the Health Care and Consumer Staples sectors. Following changes made in March, we increased our defensive exposure with companies we considered had a higher degree of earnings certainty, strong balance sheets, and a margin of safety that would help withstand the cashflow crunch.

At the other end of spectrum, the outlook for the Financials, Energy, and Consumer Discretionary sectors remains challenging, and Lonsec has remained underweight these sectors. Some companies like JB Hi-Fi and Harvey Norman reported surprisingly strong sales numbers, likely due to a switching of discretionary spend from food and leisure due to families being in ‘lockdown’, as such this is likely to be a short-term spike.

As short-term stimulus measures come to an end, these sectors may come under increasing pressure, and stock selection within these sectors will become critical.

Banking on the banks is not always wise

In terms of the banks, it’s very difficult to be positive. The Financials sector fell 20% over the first half of 2020, and while the banks are still generating a return on equity, the days of shareholders enjoying ROEs of around 15% are likely a thing of the past. Regulators have been working with the banks to help absorb the shock, but valuations remain low.

The key headwinds are the ultra-low interest rate environment, which has eaten into lending margins, and whilst mortgage deferrals have the potential to increase bank earnings (by inadvertently increasing their mortgage books), although the risk is that these actually turn into impairments. The banks may need monitor dividends or raise capital should this eventuate.

While ANZ and WBC looked to suspend their interim dividends, NAB cut their dividend by more than 50%, but sought to raise $3.5 billion from shareholders, which has been highly dilutive. Given APRA’s written guidance to the banks that they should be limiting discretionary dividend payments, boards are likely to be conservative with payout ratios until there’s further clarity. While the full impact is difficult to gauge at this time, the bottom line is that we should not expect the sort of dividends we have seen in the past, at least for the foreseeable future.

The effects of COVID-19 on the market has prompted investors to reconsider their understanding of blue-chip investing and the strategies that rely heavily on them. For many investors, expanding their horizon has helped put things in perspective. Asian markets are a good example of how dynamic things can be even at the high end of the market cap, which has seen the rise of different blue chips compared to Australia.

Asia certainly is showing strong growth in the tech sector, but the market is also benefiting from the rise of the middle class. When you look at the Financials and Consumer Discretionary sectors there, they have a higher EPS growth trajectory compared to Australia, simply because of those demographic factors that are driving earnings.

Looking further afield can also help investors identify a wider set of opportunities, even during the COVID-19 pandemic. Suddenly we’re working online, and many have been surprised at how seamlessly this happened. This has been facilitated by the rise in a host of digital services, which have allowed consumers and businesses to continue operating even during lockdown.

In Asia, the so-called fourth industrial revolution—new developments in automation, AI, and machine learning—combined with the demographic headwinds, is creating a lot of new growth potential. These could become the new blue-chip shares of the future, if they aren’t already. Alibaba and Baidu are prime examples of this. If Australian investors want to benefit from the growth in these companies, they need to expand their definition of blue-chip.

Including international blue chips in your portfolio is an important way of diversifying your risk and gaining exposure to different sources of growth. There are a range of products that help investors target these sectors, but the key is how these products are used within a broader risk-managed portfolio. Taking an active approach to managing these exposures is also key, especially given market dynamics can change incredibly quickly in the current environment.

Blue-chip shares have served Australians well, but the days of using the likes of BHP or Telstra to form the nucleus of an Australia-centric portfolio are over. If investors want to capture the new growth opportunities in world driven by technological change, while avoiding the potential dividend trap of traditional blue-chip shares, it’s time to start thinking differently.


SuperRatings Executive Director Kirby Rappell shares the latest performance results for superannuation funds and the future outlook for the industry.

Members should be prepared for more ups and downs. However, a patient approach has paid off for members over the long term with the median balanced style fund returning 7.0% per annum since the introduction of superannuation in 1992.




Any advice that SuperRatings provides is of a general nature and does not take into account an individual’s financial situation, objectives or needs. Because the information that SuperRatings receives about superannuation and pension financial products is from a number of sources, it is not guaranteed to be completely accurate. Because of this, individuals should, before acting on the information, consider its appropriateness having regard to their own financial objectives, situation and needs and if appropriate, obtain personal financial advice on the matter from a financial adviser. Before making a decision regarding any financial product, individuals should obtain and consider a copy of the relevant Product Disclosure Statement from the financial product issue.

The live webinar was held on Wednesday at 10 AM AEST, 1st July, 2020


We were blown away by the response to the Lonsec Webinar Series, which saw over 3,000 people attend across five webinars. Unfortunately, given the range of topics and limited time available, we weren’t able to get to everyone’s questions. So for this webinar, we opened it up to the floor. Join our portfolio construction experts in an exciting panel discussion.

Moderator: Brook Sweeney, Senior Investment Consultant


• Lukasz de Pourbaix – Chief Investment Officer
• Veronica Klaus – Head of Investment Consulting
• Dan Moradi – Portfolio Manager, Listed Products
• Deanne Baker – Portfolio Manager, Multi-Assets


If you attended our live webinar, please note that further instruction on how to receive the CPD Points will be delivered to your inbox in the next 5-10 business days. Whilst we aim to ensure every attendee receives CPD Points, it is within the guidelines provided that you are required to attend the full duration of the live webinar to receive your CE accreditation. Our technology platform collects data that reflects the duration and your full engagement during the live session.


The content, presentations and discussion topics covered during this event are intended for licensed financial advisers and institutional clients only and are not intended for use by retail clients. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented.
Except for any liability which cannot be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, these presentations or any loss or damage suffered by the attendee or any other person as a consequence of relying upon the information presented.

This information is provided by Lonsec Investment Solutions as a corporate authorised representative of Lonsec Research Pty Ltd who hold an AFSL number 421445. This is general advice, which doesn’t consider your personal circumstances. Consider these and always read the product disclosure statement or seek professional advice prior to making any decision about a financial product. You can access a copy of our financial services guide at

This video is provided by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research). LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406. Past performance is not a reliable indicator of future performance. This is general advice, which doesn’t consider your personal circumstances. Consider these and always read the product disclosure statement or seek professional advice prior to making any decision about a financial product. While care has been taken to prepare the content of this video, LIS makes no representation or warranty to the accuracy or completeness of the information presented, which is drawn from public information not verified by LIS. The information contained in this video is current as at the date of publication. Copyright © 2020 Lonsec Investment Solutions Pty Ltd ACN 608 837 583

In this episode of Market Narratives, Lonsec’s Chief Investment Officer, Lukasz de Pourbaix, tackles a range of controversial topics and their implications for portfolio construction.

Is this the new normal or merely the continuation of what have now become conventional policy responses? Is there wisdom in crowds, or is there persistent overvaluation in popular stocks like the FAANGs? Which parts of the market are beginning to appear attractive and how can you position your portfolio to take advantage of them? Tune in to find out.

Market Narratives is a podcast series produced by Investment Magazine that features unorthodox conversations with thought leaders influencing the world of fiduciary investors.

During our previous Asset Allocation Committee meeting we expressed a desire to further diversify our exposure to credit securities within our portfolios. This view was driven by the significant pull back in credit markets in March, which Lonsec believes provided an opportunity to enter certain parts of the credit market, such as syndicated loans, which were previously considered fully valued.

This view has since been implemented within Lonsec’s Multi-Asset and Retirement Managed Portfolios. The allocation further diversifies the portfolios away from duration risk (interest rate risk associated with government bonds), and diversifies the sources of income, most notably within the Retirement Managed Portfolios, which have been impacted by the deferral and reduction in company dividends within the equities component of the portfolios.

In our most recent Asset Allocation Committee we have not made any changes to the existing asset allocation settings. The previous move to neutralize our slightly underweight exposure to equities has benefited the portfolios as equity markets have continued to rise on the view that COVID-19 cases have peaked across many key economic regions, and that economies will begin reopening for business. At the same time, the market has reacted favourably to further fiscal stimulus packages announced in Europe and China.

The output from our asset allocation model has not changed materially since our previous meeting. Some notable changes, however, include the reduction in valuation opportunities within equities, given that share markets, most notably in the US, have recovered since their trough in March. Our valuation model indicates that most asset classes are trading at fair value, with the exception of government bonds, which continue to look expensive, and A-REITs, which look attractive on a relative basis.

Liquidity and policy remain favourable as central banks and governments continue to prop up economies via monetary and fiscal easing measures. Cyclical indicators reman weak, with most economic indicators such as unemployment figures and PMIs continuing to show weakness. Finally, risk indicators such as the VIX and MOVE indices continue to trend down. Indeed, the MOVE index, which measures implied volatility within bond markets, has returned to pre COVID-19 levels.

While markets have shown strength, risks remain. The impact of COVID-19 on company earnings remains unclear at this stage, while the market has been pricing in negative news, meaning any news regarding company earnings that is worse than expected will likely adversely impact markets. Geopolitical risks, while ever present, are in the spotlight again. Tensions between the US and China are elevated, and the path forward is unclear. This is against the backdrop of the upcoming US election in November and recent civil unrest within the US following the death of George Floyd at the hands of US police.

Finally, if we try to look ahead, one of the risks the market is not factoring in is inflation. While our view is that inflation is not a risk in the near term, possible structural shifts to the make up of economies on the back of COVID -19, specifically the potential decline in globalization, changes in supply chains, and the re-emergence of manufacturing industries in service-based dominated economies, may see prices of goods and service increase in the future.

In the shorter term, should we see the ‘V’-shaped economic recovery, the risk of inflation is a plausible scenario given the magnitude of stimulus we have seen in recent months. Within our portfolios, we do have exposure to assets that can offer some inflation protection, notably via infrastructure and gold exposures.

Whether in business, investing or life generally, when circumstances change, we need to be able to adapt quickly. The COVID-19 pandemic has forced us to transform our family, social and professional lives in a matter of weeks while contending with the uncertainty of lockdown and social distancing measures. For trust-based businesses that rely on face-to-face interactions with clients, the transition to online meetings and remote work has been disruptive but manageable.

While COVID-19 is not the teacher we were looking for, we’ve learnt to adapt in the face of a global challenge that affects everyone, albeit in different ways. It’s not the strongest that survive, but those best able to adapt to environmental shifts and identify opportunities, even in a world of chaos. When markets enter a period of extreme volatility, investment managers need both discipline and the flexibility to respond quickly. Likewise, when a client’s wealth is on the line, advisers need to be there to provide reassurance, and be in a position to implement changes to the portfolio as soon as the need arises.

Many advisers Lonsec has spoken to have been surprised by their ability to transform their business practices seemingly overnight. Being able to adapt and pivot as a business is essential, and it’s no different in the investment world. For many advisers, however, making timely changes to their clients’ portfolios remains a challenge. This is where managed accounts can play a critical role in responding to market dynamics while giving clients confidence that their portfolio can actively manage risks and won’t be left behind when the market comes back.

Over the past two months, Lonsec has made a number of changes to its suite of managed portfolios and SMAs, ranging from asset allocation adjustments through to individual fund manager and stock changes. These changes have been made to further diversify the portfolios, manage risk, and take advantage of investment opportunities where there has been significant dislocation in markets and value has been identified. In such an environment, the ability to implement in a timely manner has been important as market dynamics have shifted quickly.

The managed account structure has facilitated the efficient implementation of these changes. In practice, the process of making an investment decision – from the time the investment committee meets, to the implementation of the changes, through to the communication of these changes to advisers – takes around two days. Compare this to the conventional process of making an investment decision, sending a Record of Advice (ROA) to clients, awaiting a response, and then implementing the proposed changes across your client base.

All this can take up valuable time. While managing these changes, advisers also need to focus on running their business and helping clients through a period where many may be feeling distressed as their finances come under pressure, their job security is at risk, or their retirement savings have taken a hit.

An example of the value of being able to implement in a timely manner can be demonstrated by a change to asset allocation Lonsec made on 14 April 2020. Lonsec increased the portfolio allocation to equities within our multi-asset and listed portfolios from a slightly underweight exposure to a neutral exposure, thus increasing the weight to risk assets. The allocation was funded from our alternative and cash exposures, depending on the portfolio. The investment thesis was driven by an improvement in asset price valuation metrics, improved liquidity in markets, and a reduction in some of the risk indicators Lonsec monitors. At the same time, we recognized that economic data is likely to be poor and there is still significant uncertainty around how company earnings will be affected by the pandemic.

However, looking forward over a three-year period, we believed a neutral exposure was warranted. Since the change was implemented, both domestic and global equities have risen, recouping some of the losses experienced in March. While we believe it’s almost impossible to time markets – and Lonsec doesn’t make short-term tactical moves – being able to implement investment views at the time a decision is made can be beneficial to clients, particularly in periods where market dynamics are changing quickly.

Like many things, we often recognize the value of something once things take a turn for the worse. When markets are going up and volatility is low, as was the case leading up to pandemic, portfolio implementation doesn’t rank highly in terms of importance. However, when markets begin shifting rapidly, the value of efficient implementation becomes all too clear, especially for advisers looking to maintain contact with their clients and communicate the benefits of their advice in a highly challenging market.

April saw a rebound in risk assets as markets were buoyed by the prospect of economies slowly reopening for business as the number of new COVID-19 cases appear to have passed their peak in many key economies around the world. Markets were also supported by ongoing policy actions from central banks and governments, which has seen liquidity in markets significantly shift from being problematic a couple of months ago to being flush with liquidity as central banks ramped up their asset purchasing programs.

Economic news however continues to be poor. The Australian unemployment rate rose from 5.2% to 6.2% in April. What this figure does not factor in is the number of people who have effectively exited the labour force as well as people who are underemployed as a result of their work hours being reduced. In the US, unsurprisingly retail sales took a significant hit dropping 16.4% in April, with clothing sales down by about 80% since the end of February. Only food consumption was up by 10%, which was no doubt fuelled by ‘panic buying’. Amidst the negative news, Chinese industrial production continued to show signs of rebounding.

A key question we are asking ourselves is to what degree the negative economic news has been priced into the market and to what extent will markets continue buying into the central bank liquidity story. We believe that markets have factored in some of the bad economic news however much will depend on how quickly economies can reopen and that the rate of COVID-19 cases remains stable. Central banks have responded rapidly, and the scale of response has been unprecedented. However, a spike in cases and economies re-entering a ‘lockdown’ scenario would be negative for markets.

Our most recent asset allocation change was to move towards our neutral weight to equities reducing our alternatives and cash allocation. Our asset allocation views take a 18 month to 3 year view and while we see risks ahead and economic news is expected to be poor, we are also seeing valuation opportunities in some asset classes. Policy and liquidity are conducive to risk assets and risk indicators such as the VIX Index have been moderating.

However, we remain cautious and from a bottom-up investment perspective we have been focused on further diversifying our portfolios. Within equities we are seeking to increase our exposure to managers, sectors and stocks which have a bias towards companies with more sustainable earnings and sound balance sheets. In terms of income, we are factoring in a 30% reduction in income from dividends and we are seeking to diversifying our sources of yield to certain segments of the credit market particularly within our retirement focused portfolios. Finally, we have been adding a small exposure to gold within our multi-asset and listed portfolios. Gold provides defensive characteristics during deflationary periods and times of economic uncertainly. Additionally, it can act as a good hedge against inflation, which while not a concern today, may be an issue in the future given the scale of monetary and fiscal stimulus supporting economies currently.

Stay safe and healthy.

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.

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.

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.