Positioning for a global recession
A global recession is inevitable in the wake of the coronavirus pandemic. Catriona shares her focus on strong balance sheets, resilient earnings and positive exposure to the dramatic changes taking place in the global economy.
Catriona Burns The question is, will economies bounce back like the market seems to be assuming, and that’s yet to be seen, but certainly the market is trading like we’re in the hope stage.
These are big numbers and big chunks of the economy that will come back but there will be a lag. In that environment, people are going to have to be more thrifty. Businesses like Amazon (NASDAQ: AMZN) for example, where e-commerce and online shopping were trends already, this has really accelerated those trends.
What would coronavirus have been like 20 years ago? It would have been much more isolating than it has been today. That’s been the upside, seeing everyone’s adaptability and ability to use technology to stay connected. Definitely upfront it was getting that separation between home and work and working out new workflows.
What took them 500 days in the GFC, they did in three weeks in this crisis. Liquidity and don’t fight the Fed!
James Marlay Given that we’re doing quite well here in Australia, relative to some of the overseas markets, the US for example which is a really large market, how does that impact how you’re thinking about investing, that relative performance of people dealing with the virus and with countries dealing with the virus?
Catriona Burns When you look overseas, it really depends on the market. Say the US, the headline number of cases is very high with very dense cities like New York, where it seems obvious that that would be the case because of the density of living. Then you’ve got to overlay that with the actual deaths and the US doesn’t look as bad on that metric compared to Europe.
Yes, the different economies have reacted differently. They’ve got different numbers of ICU beds, and hence the number of deaths is different across different geographies, but no one’s been left untouched. China obviously went in first and has come out first. The level of government intervention in an economy obviously plays a role in terms of how quickly you can test people. That’s another factor, the level of testing in different geographies. We look at each geography and make a call on where they are, and how they’re being affected by the coronavirus.
Even more important is often looking at the sector because within an economy, particular sectors are actually benefiting and thriving in this environment, whereas others are really struggling, whether that’s travel and leisure, heavy capital equipment, autos, or trucking. Those sectors are finding it very tough, whereas, cloud players like Microsoft (NASDAQ: MSFT) and Amazon are benefiting. In the healthcare sector, there’s a number of players that are really benefiting. As much as looking at countries and deciding where you want to invest, having a sector overlay and deciding what companies still look great in this environment is another interesting way to look at it.
James Marlay Well let’s dig into that a little bit further. At the sector level, where have you been spending your time and how have you tilted the portfolio?
Catriona Burns In terms of sectors that will do well in the next 12 months, we think healthcare will do well. And if you look at valuations relative to the market, it looks pretty compelling. You have to go through the different segments of healthcare, it’s not just a broad sweeping statement. There are some parts of the sector, like hospitals, that are really trying to adjust their businesses to this new reality. In med tech equipment, in some parts of pharmaceutical, we think they’ll do well over the next coming period. I also think in the technology space there are a number of businesses that are really benefiting and will do well. Again, it’s going through the sector and finding companies that you think the valuation is compelling.
James Marlay It’s often in the moment things, people often extrapolate the present a long way into the future. On some of those trends that emerge, we’ve talked about flexible working and online retail, what’s your view on how enduring they’re going to be and what are some of the themes that you think are really going to take hold?
Catriona Burns That’s a good point. Some of the things we’re seeing are temporary. There will be a degree of flexibility in the workplace, but in many cases, you will still go back to an office. And a lot of the themes will ease over time and people will eventually come back to restaurants, it might be at lower levels than it was before. A couple of themes that we think are more enduring, one is around thriftiness. We think it’s inevitable we’ll go into a recession coming out the other side of coronavirus, and if you look at the number of people that are going to be unemployed, the industries that will have more lasting pain, it’s sectors like tourism, for example. Domestic tourism we think will come back quicker than international, but mass tourism, it’s an $8.8 trillion industry, it counts for 10.4% of global GDP. That’s a big chunk of GDP that’s not going to bounce straight back. The same with the restaurant industry. It employs, in the US, one in 10 people. These are big numbers and big chunks of the economy that will come back, but there will be a lag. And we think in that environment, people are going to have to be more thrifty. They are going to have to watch where they’re spending their money. On that thematic, we’ve bought the largest dollar store operators across the US and Europe. That’s Dollar General (NYSE: DG) in the US, B&M Value Retail (LON: BME) in Europe and in Japan, we own the low cost discount supermarket retailer called Kobe Bussan (TYO: 3038). We think they are plays on that thematic of inevitable thriftiness that comes through from consumers in the world post-coronavirus.
James Marlay You mentioned the ‘R’ word, recession, and with the word inevitable in front of it. It was actually one of the questions from your shareholders, which was, “do you think we can avoid recession and if not, what are some of the recession proof companies, or how are you positioning the portfolio to endure that?” Could you go into a bit more detail on why you see the recession coming and talk about what you’ve done to the portfolio to recession proof it?
Catriona Burns There are these big chunks of the economy that aren’t going to bounce straight back. You’ve locked down in many countries and even in the countries that haven’t locked down, you’ve seen social distancing implemented. With that, and the output gap that has been created, and the concern that we haven’t got a vaccine at this point, people are going to be concerned still that there may be a second wave. And everyone’s going back to looking at what happened with the Spanish flu. There were three waves and the second wave was worse than the first wave. Even if that doesn’t occur, people will worry about that occurring until there is a vaccine developed. In which case, there is going to be a large amount of job losses – 33 million people in the US, some of those will come back because they are more temporary, but some won’t. There will be a hole and there will be a recession, a global recession. Governments and central banks have thrown what they can at it. They’ve solved the liquidity issue, they haven’t necessarily solved the solvency issues that will come about. In my view, we will have a global recession and there will be countries that come out quicker and that are better positioned, but it won’t be an easy operating environment.
James Marlay And at the portfolio level, talk me through recession proofing. How have you thought about doing that?
Catriona Burns In terms of the portfolio, the characteristics of the companies we’ve chosen, we’ve really looked at earnings resilience, we’ve looked for companies with really sound balance sheets, really high quality management teams and strong market positions. The piece that is harder in this kind of environment is working out what actually does have earnings resilience, because when the economy is good and companies and countries are growing well, you can hide a lot of ills and you don’t see the cyclicality that is inherent in a lot of businesses. We’ve done a lot of work analysing businesses through prior crises to come up with ideas and stocks that we think will do well and will be resilient. Some of those sectors are things like the dollar stores, where you don’t have a job so you’re going to try and save money.
Other areas are consumer staples companies, they’re very defensive, they tend to do well in this kind of environment. And then auto-parts retail. When you’re cutting things, you are still going to get your car repaired. You won’t buy a new car, but you will get your car repaired. Home improvement tends to be quite resilient, relative to obviously buying another handbag, you fix your house.
James Marlay The run on Bunnings has been incredible.
Catriona Burns Exactly, unfortunately no sport on TV and coronavirus has meant there’s a lot more handiwork getting done.
James Marlay Yeah, or not so handy. In the world, your investment universe, there are some truly outstanding, absolute global leaders. A crisis like the one that we’ve had, a lot of things get marked down and some of those stocks that may be on the wish list, become attainable. Did you have a wish list and were you able to pick off some of those bigger names, because I know you tend to hunt in the small-cap world?
Catriona Burns Yes, absolutely we have a wish list. Inevitably when you’re seeing hundreds and hundreds of companies a year, you’ll often come across businesses that are multi-year growth stories, great management teams, strong, dominant market positions, high returns on capital, but the piece that’s missing is often valuation. You have your wish list of companies that you’d love to own if there is a market correction. We have a wish list and in the sell-off in March, there were those sorts of businesses that sold off 20% to 40%. And we were able to add a few of those names, particularly in the larger end of the market, because with all the uncertainty, we did want to keep liquidity because who knows in terms of exactly how this plays out, so you want some liquidity to be able to raise cash if things start to get significantly worse.
We did add a few of those names. We added some Microsoft, some PayPal (NASDAQ: PYPL), some Visa (NYSE: V), some Adobe (NASDAQ: ADBE). Wonderful businesses that hadn’t necessarily ticked the box in terms of valuation, we were able to add some of those in the downturn.
A few of them we’ve trimmed now because they’ve had phenomenal runs. We’re also overlaying at the moment the uncertainty and there has been some new winners. Businesses like Amazon, for example, where e-commerce and online shopping were trends already, but this has really accelerated those trends. What were already winners have become even bigger winners and it’s the same for businesses like Microsoft, the cloud businesses of both Amazon and Microsoft, just doing phenomenally well. And I don’t think that’s a trend that’s going to slow down.
James Marlay What’s happening in the small-cap space? Is that the new opportunity set for you?
Catriona Burns Definitely. We tend to love small mid-caps because there can be a lot more inefficiency at that end of the market. You can often get businesses that really do have long, long runways of growth because they just haven’t captured all of the opportunity that’s available to them because they’re often younger in life. That’s a key hunting ground for us for ideas. And we have seen a number of stocks in the small mid-cap end of the market come up as interesting. For example, the number three toy company, Spin Master (TSE: TOY), Canadian listed, fell 75% from December to March. We didn’t own it, but we knew the stock, we knew the management team and were able to buy it on single digit price-to-earnings (P/Es) and it’s gone up significantly since then.
There have been some great stocks in the small mid-cap end of the market. HelloFresh (ETR: HFG) was a business we’d bought last year – a meal kit delivery company, clear beneficiary, we already owned it, we knew the stock, knew the management team. When coronavirus hit, we thought it would be a key beneficiary and were able to add some more of the stock. And it’s gone from 16 to 38 euros in very short order and still growing phenomenally well. So there have been some names like that. In the more mid-cap end we added some Activision (NASDAQ: ATVI) and EA (NASDAQ: EA), which are in the video gaming space. Clearly with everyone home, we thought video games would see a nice boost in terms of engagement levels. We were able to add those names. We’ve seen in the recent results in the last week or two very strong numbers delivered.
James Marlay One of the other things that people are really keen to understand is what happens to supply chains in the wake of what’s happened?
Catriona Burns 80% of US pharmaceuticals are produced out of China and 97% of antibiotics come from China and India. There are some startling figures. What coronavirus has highlighted is that reliance and the risk around that. It was firstly the tariff war, the China-US trade war, that really highlighted that dependence on China. Now we’ve had coronavirus, where you’ve had issues with getting ventilators, with getting personal protection equipment for doctors and nurses and those critical supplies. That’s not a nice situation to be in when you can’t get those crucial medical supplies. It has highlighted to businesses more widely, that they do need to think about diversifying their supply chains. And I think inevitably you will see companies push to make sure that they aren’t purely reliant on places like China.
That does lead to advantages for some of the bigger companies that have the capital to diversify. If you’re a smaller business with only capital to put a plant in one spot, then that’s going to be tough. It does give advantage to capital light businesses that aren’t reliant on putting CapEx in all different markets around the world to grow. Whether that’s tech companies that can obviously expand quickly without needing capital, or automation firms, will benefit. Because as you bring manufacturing and production back locally, labour is a big differential between emerging markets and developed markets. You need to automate to take out some of that cost differential. It’ll be an interesting realisation coming out of coronavirus and out of the trade wars, that we do need to have diversified supply chains.
From a portfolio perspective, like you look at the leverage of a balance sheet for any company, you will look at where the supply chain is, the risk around the supply chain and whether you can gain advantage from this situation or whether you’ll be at a disadvantage.
James Marlay And is that an investible theme or is it just a bit too early?
Catriona Burns It’s investible in respect to finding capital light businesses at this point, in say the tech space. From the automation names, some of them are very cyclical, so you’ve got a bit of time as they wear the pain of coronavirus today. Over the long-term, they look very interesting.
James Marlay What’s the cash level in the portfolio at the moment? On the last investor call, it was relative, not fully invested, sub 10% in cash. Whereabouts is that sitting at the moment? How are you thinking about that liquidity in that cash position?
Catriona Burns The cash at the end of February was about 10%, through March it went up to 19.5%, today it’s about 16%. Higher, relative to 31 December, but not at any extreme level. We’re cautious because there is a lot of uncertainty at the moment. We’re able to still find ideas, we’re just being very selective on what we’re buying and choosing those businesses that we think are very resilient. Whether we get a U, a V, or a W shaped recovery, there is uncertainty and it will depend on at what point we get a vaccine, how quickly economies rebound coming out of lockdowns and general social distancing requirements for different economies. We’ve chosen to keep the cash slightly higher than it had been, and focus on those businesses that have resilient earnings, strong balance sheets and that will weather, whichever outcome we get in terms of the bounce back.
We appreciate how tough this time must be for all our shareholders, the uncertainty that everyone is living through. We’re diligently working on the portfolio, really focused on trying to generate strong returns for shareholders and appreciating that it’s not an easy time for them to be living through at this point.