01 October 2020
This report has been prepared by Northcape Capital, the underlying investment manager for the Warakirri Ethical Global Equities Fund.
For the month of September the MSCI World Index fell -3.42% in USD or -0.38% in AUD terms as the AUD depreciated relative to the USD given the risk-off tone to markets during the month. This was the first monthly decline for the index since March. By sector, utilities, materials and industrials were the top 3 outperformers while energy; financials; communication services and information technology were the relative underperformers.
Looking at the largest market within the index, the S&P 500 index was down 3.92% in USD terms bringing its YTD return to 4.09% and following on from a very strong monthly gain of 7.01% in August. The correction started in early September after a run-up in late August through to 2nd September where the S&P500 index set 9 new closing highs (7 in August alone). The correction comes after a 114 trading day period when the index gained 60% since the lows in late March. For the quarter ending 30 September the S&P 500 gained 8.47% in USD terms.
Reflecting on the recent US 2Q earnings season, the low analyst estimate expectations resulted in a high positive surprise rate with 413 of the S&P500 index companies beating lowered estimates representing a 82.3% beat rate on EPS and there was a 62.5% beat rate based on revenue.
Looking back on September, there were three key areas that moved markets: 1) US fiscal stimulus negotiations; 2) US Presidential election; and 3) COVID infection resurgence in developed markets.
1.US fiscal stimulus delays
The passing of liberal U.S. Supreme Court Justice Ruth Bader Ginsburg brought the politics of her replacement out into the open with the Republicans wanting to quickly fill the spot with their own conservative nominee while the Democrats wanting the process to be delayed until after the swearing in of a new president. This set of events certainly reduced the odds of an agreement on difficult and complex negotiations for a new COVID fiscal stimulus package before the November 3rd election and added to a risk-off tone to US equity markets during September.
Further fiscal stimulus is key to help reduce the impact of a second wave of unemployment as the benefit of programs such as the Payroll Protection Plan have now ended and businesses are still struggling given the prevalence of COVID, making the economic recovery ahead still fragile in the near-term and further lengthening the time before the economy returns back to pre-COVID levels.
Continued liquidity in the short-term as a material tailwind to equity prices given the ultra-accommodative monetary policy stance of the Fed since the arrival of COVID (over $3tn printed), combined with fiscal stimulus.
2.US Presidential election risks: Be prepared for potential turbulence and volatility in the months ahead.
Another topic that is also starting to add to market uncertainty revolves around the US Presidential election scheduled for 3rd November, and not just on the outcome of the election. Uncertainty is compounded by the timing of when we may know who won the election. There is a high probability of a contested election regardless of the initial outcome given some consternation around potential mail-in ballot fraud. The concern is that Republicans intend to largely vote in person while a greater percentage of Democrat supporters intend to vote by mail.
We can see an outcome where the Republicans look like they get an early lead due to a delay in counting mail-in ballots potentially leading to a disputed election.
While each state typically chooses electors by popular vote, it is interesting to note that there is nothing in the Constitution that says this should be the case as the Supreme Court affirmed in Bush v. Gore that a state “can take back the power to appoint electors”. Looking at some of the key swing states, the Republicans control both legislative chambers in the six most closely contested battleground states, which raises the risk that these Republican-controlled legislatures can just decide the election result on its own. This could raise questions around the integrity of the US political system.
It is worth mentioning that another wild card has been thrown into the US election with President Trump catching COVID-19 in early October, just a month out of what is likely to be one of the most significant US election outcomes in our lifetime. Looking back in time, there has never been a US presidential election where a fatal disease has struck one of the candidates this close to election day.
In 1944 Franklin Roosevelt was ill and fatigued running for a fourth term, but his political opposition was weak, and the US was in the midst of World War II so this did not materially alter the outcome. In 1919, Woodrow Wilson did catch a severe case of the Spanish flu, but that was in the fifth year in his second term and was able to carry out his duties.
Premium for November VIX futures is greater than October now, highlighting increased risk on a messy US election process and expectations of elevated volatility.
3.COVID resurgence second wave in Europe and US
In the US, a chaotic school and college reopening resulted in an unsurprising spread of the virus (and potential further spread when college students return home later in the year). There are 27 states where there are elevated levels of COVID cases (greater than 20 cases per seven day moving average per hundred thousand population). We think caution ahead is warranted given heightened risks of an even larger second wave in the US.
This could come in the form of a continued reinfection of the first wave, and/or a true second wave involving some mutation of COVID that makes it more contagious, more fatal or both. Should this hit, history shows that it typically produces a much worse second wave which has been a feature of the four worst pandemics in the past 105 years.
As at the end of September, there were over 7.2m reported COVID cases in the US and over 206,000 reported deaths. There are several vaccines being tested though we are not optimistic on the vaccine being an immediate silver bullet to ending COVID.
There is a growing concern over a pullback in openings due to higher COVID infection rates along with the reintroduction of restrictions in both Europe and the UK. Spain for instance, has ordered a partial lockdown in the capital, Germany will limit the size of gatherings and Italy will consider extending its state of emergency until January. The UK Health Secretary has imposed stricter restrictions across the northwest part of the country amid a surge in infections and the UK Prime Minister has not ruled out stricter national measures should cases continue to rise.
Portfolio Strategy and Review
We have gone through and reviewed our current holdings and portfolio positioning with regards to the two key near-term risks of a COVID second wave and an US election and are comfortable with the current positioning.
Our more defensive positions such as Dollar General and Givaudan were the two best contributors to performance in September with the stocks up 7.0% and 5.8% respectively in AUD. There was no material company specific news for either stock during the month.
Dollar General continues to execute well with their strategic growth initiatives as well as on the day-to-day execution to take advantage of the material increase in sales driven by COVID and the recession as their addressable market is increasing with new trade-down customers now visiting their stores as is typically seen during recessions.
On the other side of the ledger, of the stocks owned in the portfolio the main detractors were Informa and Macquarie Group. Informa reported its 1H20 result during the month which was a little worse than we expected from a revenue and earnings perspective given that the Events business has largely come to a halt due to COVID. That said Informa is likely near a trough from an earnings perspective and is one of our COVID recovery beneficiaries. There was good cost cutting action taken and with a repaired balance sheet and positive free cash flows going forward we think the risk/reward looks attractive. Macquarie provided an update to their FY21 guidance reiterating earnings to be slightly down vs last year, but with more of a 2H earnings skew (mainly driven by timing of asset realisations) resulting in a slight 3% downgrade to earnings expectations by the market for the year. We continue to like Macquarie’s fundamentals with its exposure to asset management and green energy projects along with their capital allocation skills.
Key company results and news flow over the month are summarised below:
Nike reported 1Q21 results which was a home run, following an unusually disappointing previous quarter. Revenue and especially profitability were well ahead of consensus expectations and its own guidance which amazingly seems to lead to the conclusion that COVID-19 only had a negative impact for just one quarter. Revenue is now back to the same level in the prior comparable period last year and the company expects revenue to accelerate in 2H21 to generate around high-single-digit to log-double-digit % revenue growth for the FY21 year.
A big driver of the result continues to be the direct-to-consumer channel of which online is the biggest part, with COVID-19 accelerating online sales from 20% to 30% of the total sales mix in around two quarters. Margin benefits of this shift are not visible yet given Nike is aggressively lowering their excess inventories currently which should be a good tailwind in the periods ahead.
Informa reported 1H20 results which were messy as expected given the Events business (2/3rds of overall revenues in 2019) had effectively come to a halt due to COVID. The result was actually slightly better than consensus expectations, though it was still pretty brutal for a traditionally predictable and stable business. The good news is that Informa is probably around trough levels from a revenue and earnings perspective and due to aggressive cost cutting the company will be cash flow positive and is expected to remain so in the future. Combine this with a solid balance sheet that has been repaired by an equity raising (we bought after this event), gives us comfort that the Company can ride out the current COVID headwinds without structural damage to the business.
At current depressed price levels, the risk/reward looks attractive and Informa is one of our COVID recovery exposures.
Visa provides cyclical exposure to a recovery in cross-border travel that will recover at some stage in the future. Meanwhile it continues to be well positioned to benefit from being involved in new payment flows; the trend to a greater shift to digital payments and continued displacement of cash. Domestic payment volumes in the US and other developed countries around the world have rebounded quicker than expected, and in recent months have been at higher levels than in the prior year. Over the medium-term, Visa could get involved in other adjacent projects and services such as providing authentication capabilities beyond payments as the world continues to move more digital for transactions and payments. Visa is one of the few trusted sources of an individual’s digital identity and is uniquely positioned on a global basis. An example could be Visa providing know-your-customer (KYC) authentication services for a fee.
Nvidia: After months of rumours and speculation, Softbank finally announced the sale of (most of) ARM Holdings to Nvidia. We have written before about the complexities of this deal and it is safe to say that they will likely need the unusually long deal window of 18 months to get approval from regulators and clients. If we assume the deal goes through, there are plenty of things to get excited about and we are sure the sell-side will.
What is clear is that the combination of two leading semiconductor platforms can open up new markets for Nvidia. However, to throw around a new TAM of $250bn for the combined companies, where ARM got to an annualised revenue of $1.8bn after 30 years, is typical Nvidia grandstanding. The deal metrics work fine as there are no issues with the balance sheet. Softbank will remain below 10% as shareholder of Nvidia and with a bit of optimism you can get the deal to be accretive as well. Are we excited? Absolutely, but at the current multiple of 50x for Nvidia one needs to be. We do not change our immediate views, except to say that sell-side optimism will support the stock before the deal potentially happens in Q122.