Since the COVID-19 induced market low, our fund has put a substantial proportion of our cash to work. But we’ve been very selective about the companies we bought.
We added to our holdings in Macquarie Financial Group, Westpac, Commonwealth Bank, and Scentre Group. And we are building additional positions in undisclosed stocks. In the process, our cash has fallen from more than 30 per cent to below 20 per cent, the lowest for some time.
It might be reasonable to interpret our moves as implying a bullish view of markets. That however is not the case.
Our most recent analysis suggests market prices are broadly at their most extreme valuations since The Montgonery Fund’s inception. And keep in mind that our analysis excludes further potential earnings downgrades amid an information vacuum inspired by hundreds of companies pulling their earning guidance, as well as stale sell-side forecasts for earnings and balance sheets.
Additionally, it is fair to say neither in my lifetime, nor in my reading of history, have I ever seen a human-inspired economic calamity such as the world is now experiencing. Here, I am not talking about the virus itself but the hard-stopping of the global economy at a time when elevated debt levels suggest the world can least afford such a hit to aggregate cash flows. In recent years, global debt has soared to a level unprecedented in history thanks to consumers, corporate share buybacks and governments.
While markets laud, and rally on the back of, central bank counter-measures to buy individual corporate bonds, it should be noted that such action only has the effect of maintaining low rates for companies that would otherwise already be bankrupt. It does not generate revenue or customers for those companies being ‘supported.’
Of course, all of this bond buying support must be funded by the printing of money, something markets are currently cheering.
But the US printing of money with gay abandon and without limit, under the auspices of Modern Monetary Theory, is not helping to finance military or economic domination, which in the current geopolitical environment is probably wise. Instead, the money being printed is merely being used to buy the bonds of, and support low interest rates for, rubbish, Triple C-rated, junk companies. It suggests something undesirable will probably emerge.
The unanswered multi-trillion-dollar question
Whether the current economic disaster can be repaired through the printing of money remains an unanswered multi-trillion-dollar question. The same goes for whether it leads to inflation, or possibly hyperinflation after excess productive capacity is soaked up.
Returning to the more immediate question of domestic equity valuations, even by extending valuation metrics to include earnings two years out, valuations aren’t all too compelling. And we would argue the level of uncertainty and volatility in the economy, means forecasting earnings even for the next quarter remains a complete guess.
With that in mind it is reasonable to conclude that much of the support in the stock market is inspired by gambling rather than solidly supported fundamental analysis.
One only needs to look at the 1,500 per cent rise in the price of Hertz after it declared bankruptcy on May 22, and the support for its billion US dollar capital raising after telling investors the shares could ultimately be worthless, that a material level of speculation is evident.
A return to “normal” levels of economic activity could take much longer than the “return to normal” implied by current aggregate share prices. A slow and halting recovery, rather than the quick and easy one implied by market prices, puts shares at a significant risk of disappointment. This risk must be assessed as minimal for any position investors now add to their portfolios.
Rather than chasing the highly speculative growth stories that are currently rallying the most, it may be prudent to reduce the volatility of one’s portfolio and concentrate investments on liquid, high-quality businesses.
Zero interest rates, treasury money printing and central bank bond buying is definitely supporting the speculative activity currently evident in markets but longer term investors already know that such dislocations between prices and real business activity do not last.
If something can’t last forever, it must stop. Stocks with the highest prices, and therefore the highest bars set for earnings, will be those that fall the hardest.
Assessing risks and potential rewards
Our recent purchase of relatively boring Woolworths (ASX:WOW) reflects a positive outcome from an assessment of the risks and potential rewards. Woolworths enjoys a defensive earnings stream with a solid and growing yield, the loss of competitors such as Target, leverage to a recovery through the ALH pubs business, a hedge against any food inflation, and a significant lead to Coles in data-driven cross-selling to an additional one-million online and ‘Rewards’ customers signed up during the pandemic lockdowns. Indeed, Woolworths may be re-rated on the back of a change of status to ‘growth.’
Equally boring, our increased weighting towards banks when they were trading at a rare discount to NTA, and despite a challenged short to medium term operating environment, also reflects an assessment of the balance between risk and reward.
Our lower levels of cash today are therefore less a reflection of any increased conviction in a bright future for broader equity markets, but rather the product of assessing prevailing value and stock-specific risks and rewards.
Investors would be wise to understand whether rational assumptions of growth justify the inflated prices being paid for growth stocks. In many cases we believe investors have suspended reality and that’s why we have kept investing but reduced risk by focusing on quality and size.
The Montgomery Fund and Montgomery [Private] Fund owns shares in Macquarie, Westpac, Commonwealth Bank, Scentre Group and Woolworths. This article was prepared 23 June with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.