How Longwave invests during uncertainty

– David Wanis, February 2020

Fear over coronavirus was the most significant factor during the month. In the face of this extreme uncertainty, we consider how investors might respond, how to separate logic from emotion and how to remain focused on finding quality companies at increasingly good values.

The ever-present lines of defence in our portfolio are quality, liquidity, value and diversification. The objective is to withstand economic and market stress and emerge on the other side. Before seeking bargains or pursuing growth, we need companies that have the highest chance of survival.

First, Longwave invests only in companies that have real, cash-producing, profitable (and sustainable) businesses. The primary defensive measure during extreme economic uncertainty (say from either a recession, a significant reduction in temporary demand or a disruption to supply) for a company is a buffer of positive monthly cash flows. Investors may become alarmed if, during a 3, 6 or even 12-month period, the profits of a business come under so much duress that they temporarily disappear altogether. However, going from profitable to just breaking even would not be the worst thing happening to companies across the economy during such an event. With all else being equal (and subject to the health of the balance sheet), a reduction in profits is not a failure event.

Second, we only invest in companies that are both profitable and have conservatively- financed balance sheets (with either low or no debt). This affords the company numerous options. It creates a covenant buffer for earnings, should operating conditions deteriorate considerably. Unused credit creates a source of cash that can be drawn upon to bridge temporarily lower cash flows. Should market values become compelling, optionality exists for a company to pursue attractive M&A or share buybacks by having access to cash or credit that many over-indebted firms may lack.

These two criteria of business quality and financial robustness are the bedrock of our investment approach. Looking at our portfolio today and having just completed 1H20 results, we are comfortable that it remains well-buffered against uncertain and adverse economic developments. Results delivered across the portfolio showed in general strong underlying fundamental performance in many companies, with balance sheets in good shape. The same cannot be said for many parts of the market.

While quality protects us during economic uncertainty, liquidity provides us the optionality to take advantage of opportunities. We choose not to invest in many small companies that meet all our other quality criteria but have a real liquidity risk. As we get paid properly for liquidity risk, this may be an opportunity in the future.

Then, of course, there is valuation. A company must meet our requirements of quality and liquidity to ensure the investment proposition is reasonable. We do not pursue cheap companies that fail to meet the quality hurdle, as we have learnt the hard way that in order to bridge a valuation gap, a company must first survive.

To invert the problem, investors can perhaps consider companies that are not profitable – or worse, are still generating significant cash losses (more common today in small caps than for much of the past decade), companies with limited financial resources or excessive financial leverage, stocks that have limited liquidity to cope with shareholders who panic at the wrong time, or stocks that are priced at valuations unjustifiable by even the most optimistic forecast – because optimism is coming out of assumptions fast.

Pricing a temporary shock in the absence of fear

How should the market react to a business that is unlikely to fail, but likely to experience a temporary and significant hit to profits? Take, for example, a small retailer who would suffer a terrible quarter or six months of trading if consumers were to stay home during a pandemic (real or imagined).

Sims Limited (SGM) serves as a useful case study from a calmer time in markets.

Sims announced on 28 October, 2019 that their 1H20 result would deliver an operating loss, reversing to a small (A$20-50m EBIT) profit for the full 2020 year as temporary issues related to trade wars and the knock-on effects to scrap prices impacted business profits during the fourth quarter of 2019. This is a business that previously (F2019) made A$230m in underlying EBIT and had been profitable for nine of the previous ten years. The share price fell 9% on the day (no one likes a negative surprise like that) but almost immediately recovered and four months later, the day after the full 1H20 result was released in February, the share price was almost 9% higher than it had been prior to the October update.

Management at the time noted “Our strong balance sheet will allow us to navigate this period of market volatility. This, coupled with our disciplined approach to capital expenditure and cost management, will put us in a strong strategic position when the market normalises”. This sounds like a good recipe for many companies over the next 6-12 months.

In our view, the market had looked at the long-term value of the Sims Limited business and taken the short-term trading performance within the context of a good balance sheet (A$223m of cash, A$72m debt), a sensible management approach and performance being related to temporary factors likely to reverse in the future. This is worth keeping in mind.

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