Global sharemarkets have rallied strongly from their March lows thanks in the main to the huge fiscal and monetary actions by governments and central banks around the world. However, the economic outlook remains uncertain as the length and depth of the economic downturn as well as the strength and sustainability of the expected recovery remain difficult to forecast.
In Australia, the unemployment rate is likely to go over 10%, with activity at virtually zero in many sectors. Some of those unemployed people will return to work as we start seeing parts of the economy reopen such as restaurants and casinos.
Demand lower for longer
There are many differing theories and views about whether the recovery will be V-shaped, U-shaped, L-shaped or W-shaped. We believe we are moving into an environment where demand may be sustainably lower for many sectors. As the lockdown unwinds, we will get a fairly strong short-term recovery with a jump in spending as people rush out and spend things such as their JobKeeper allowance and government grants—the question then will be how sustainable will demand be given potentially much higher unemployment?
We believe that the Australian economy won't return to the same level as it was pre-COVID for some time. Some sectors which employ a lot of people—such as immigration-related activities, tourism, student travel and accommodation—look like they will take a fairly long time to recover. Meaning that certain parts of the economy could be subdued for a while.
Thus at IML, we are going through a stock-by-stock analysis to assess what we believe will be the ongoing, sustainable demand and revenue from various sectors of the economy. One factor that concerns us is the high level of household debt in Australia where in places like Sydney and Melbourne, it is not unusual to see mortgages of half a million to a million dollars or more.
While low interest rates will help people in jobs keep up with their mortgage payments, if unemployment goes up—especially in well-paid jobs such as airline pilots, hotel management and advertising agency staff and where some people probably have quite large mortgages—then it is probable that the overall level of demand will take a while to recover once the government stimulus fades.
Assessing companies and prices
Given the economic uncertainty, as well as reviewing the demand outlook for each industry, we are assessing the outlook for prices of goods and services within each industry. This is important as lower prices can have a big impact on the bottom line of companies, especially in a low-demand environment.
On the flip side, we are also looking for factors that may help certain companies improve their bottom-line outcomes. Initiatives such as increasing market share, if they have weak competitors or the ability to cut costs to drive productivity. It is also particularly important for companies to have a strong balance sheet given the current uncertainties.
And the last part of the puzzle is to assess whether a company’s share price is adequately pricing in the future outlook, and clearly we are looking for what we believe are undervalued companies.
Positioning our Australian equity portfolios for the current outlook
This is a period of time where virtually every business in the world has been impacted to some extent by the shutdowns and travel bans.
Some companies are adjusting quickly by tweaking their business model and many are being quite nimble. Most companies we talk to are cutting costs by cutting staff—which is unfortunate for the people involved—but in a lower demand environment, companies have to trim their organisational strcture.
We are mainly sticking to companies where the level of demand seems more transparent, in terms of where the economy is sitting today and where it will probably grow in future. Examples where demand is not easily forecast might include a building materials company or a company that supplies toilets for renovations. There is a question mark on the future level of home renovations given that unemployment may increase and demand for housing will slow as immigration reduces.
We feel fairly comfortable on the positioning of our portfolios for what we believe will probably be a recovery to a lower level of sustainable demand compared with the economy before the epidemic.
Three attributes we are seeking in our portfolios now
We are looking for the same attributes as always seek but referencing the more uncertain environment and subdued outlook.
We are looking for companies with:
1. a strong competitive advantage, for example, companies that are number one or two in their industry, which gives them scale.
2. recurring, predictable earnings that will be relatively stable, even in a recessionary environment and that continue to pay healthy dividends to shareholders—examples are companies like Telstra, Amcor and Coles.
3. experienced and capable management teams as a recessionary environment is when good management stands out. We are looking for high quality management teams that have been around a while that have seen various cycles.
As mentioned earlier we are also focusing on companies’ balance sheets as this is really important in times like these where many companies’ earnings could be under some pressure. A strong balance sheet when competitors are weak could give an ability to take advantage of opportunities in the marketplace.
We want to buy these companies at a reasonable price. In the current environment this means that we are looking to buy companies where a more cautious outlook is already priced in.
Anton Tagliaferro is Investment Director at Investors Mutual Limited. While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.