Unprecedented market events have precedence

– David Wanis, March 2020

The majority of historic market events are unprecedented. Markets don’t fall 30-40% due to events that have been observed many times before, and COVID-19 is clearly unprecedented for investors. Rather than speculate on what may change, we can instead look at the precedence of the unprecedented, invert the problem and identify clues to what likely won’t change and how we can capture the current market opportunity.

What doesn’t change?

  • Human nature: An emotional reaction to uncertainty seems to be consistent in almost every crisis. “Unprecedented” events tend to trigger overwhelming behavioural bias. This is a bit like using history to estimate a worst-case scenario. By definition, the previous worst case when it occurred was unprecedented and absent from all prior scenarios up to that point. Everyone seems to keep their emotions in check and their investment processes intact until it is needed most – in the face of unprecedented events.
  • The future: Always uncertain, despite how investors want to believe it isn’t. A pandemic is a reminder that we never know, and how we recover from a pandemic is almost as unforecastable as the pandemic itself. The range of possibilities is now wider than the market had previously considered, but the ability to pick the path that reality takes is no easier today than it was two months ago. Doubling down on forecasting the future is unlikely to be fruitful.
  • The capital structure of a business: Laws enshrine rights to different stakeholders (creditors, employees, lenders and equity holders) in a company. In response to COVID-19, the government has sought to hibernate businesses through the pandemic by temporarily altering or time-shifting arrangements (indirectly and by suggestion if not by law). However, capitalism is built on these foundations and it is unlikely they are torn down in this crisis.
  • The nature of assets (mostly): When expectations are tempered, most assets tend to behave broadly in line with these expectations. Equities are risky assets that are most reactive to uncertainty. Bonds and cash preserve near-term wealth. Private assets remain illiquid and may or may not be worth their marks. Gold acts as a safe haven, but with only 5,000 years of history further out-of- sample observation may be needed. Most of the portfolio heavy-lifting in crisis markets is done by asset allocation, not stock selection.
  • Long-term performance: Equity investors own perpetuity cash flows, which create long-duration exposures and should be aligned with holding periods of five years or more. Buying low is easy to say, but hard to do (see ‘Human nature’) and the past six weeks serve as a reminder of this reality. For true long-term investors buying at today’s prices represents an opportunity rather than a risk.

By considering what doesn’t change we can start to build a map for the unknown. Without specifically forecasting the future, we can estimate how human behaviour, the nature of assets and the capital structure of a business may react to shock, stress and uncertainty. Our experience investing through the GFC has provided one roadmap for the current environment.

Dusting off the GFC roadmap

The phases we saw in the GFC were;

  • “Unprecedented” shock causes all stocks to fall
  • First-order earnings downgrades: market focuses on companies with greater estimated direct shock exposures
  • Credit breaks: US high yield (HY) spread widening to >650 bps
  • Balance sheet focus: downgraded earnings and a breakdown in credit sees the market shift focus to financially weaker companies
  • Second-order exposures: second-order impacts and liquidity constraints (forced sellers) emerge, market focuses on companies with earnings risk not initially considered, corporate debt becomes a greater focus and government policy responses emerge.
  • Recapitalise or fail: companies with weak balance sheets face a stark choice – recapitalise with fresh equity (or government support) or fail. Small companies face a far greater risk of failure in the absence of recapitalization and the fragility of small and micro caps comes into focus.
  • Recovery in markets: assuming the economy has stabilised

Given the sheer magnitude and uncertainty of COVID-19, what took months to progress through the GFC is happening in days or weeks. Using the GFC roadmap, Stages 1 and 2 occurred in late February, Stages 3, 4 and 5 were passed in March and now in early April, Stage 6 is well underway. During the GFC, it took ten to twelve months to get to where we are today. If the 20th of February is the starting point for this crisis, the COVID-19 journey has taken six to seven weeks.

The path to recovery remains a big unknown. Additional capital for weakened companies should cover some but not all potential future scenarios.

We have so far participated in three recapitalisation events (IDP Education, WebJet and Kathmandu) as they are all businesses we like and owned and were done on very attractive terms relative to alternative opportunities. We believe they raised enough equity to survive all but the most pessimistic scenarios – but we cannot rule those out. There were numerous raisings we did not participate in, either for reasons of business quality, weak balance sheet strength (some companies only raised what they could rather than what they needed) or valuation. Many businesses look underpriced in this market, so recapitalisation proposals need to be weighed up against other available opportunities.

Disclaimer

This communication is prepared by Longwave Capital Partners (‘Longwave’) (ABN 17 629 034 902), a corporate authorised representative (No. 1269404) of Pinnacle Investment Management Limited (‘Pinnacle’) (ABN 66 109 659 109, AFSL 322140) as the investment manager of Longwave Australian Small Companies Fund (ARSN 630 979 449) (‘the Fund’). Pinnacle Fund Services Limited (‘PFSL’) (ABN 29 082 494 362, AFSL 238371) is the product issuer of the Fund. PFSL is not licensed to provide financial product advice. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited (‘Pinnacle’) (ABN 22 100 325 184). The Product Disclosure Statement (‘PDS’) and Target Market Determination (‘TMD’) of the Fund are available via the links below. Any potential investor should consider the PDS and TMD before deciding whether to acquire, or continue to hold units in, the Fund.

Link to the Product Disclosure Statement: WHT9368AU

Link to the Target Market Determination: WHT9368AU

For historic TMD’s please contact Pinnacle client service Phone 1300 010 311 or Email service@pinnacleinvestment.com

This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.
Whilst Longwave, PFSL and Pinnacle believe the information contained in this communication is reliable, no warranty is given as to its accuracy, reliability or completeness and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Longwave, PFSL and Pinnacle disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information. This disclaimer extends to any entity that may distribute this communication.
Any opinions and forecasts reflect the judgment and assumptions of Longwave and its representatives on the basis of information available as at the date of publication and may later change without notice. Any projections contained in this presentation are estimates only and may not be realised in the future. Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information contained in this communication is prohibited without obtaining prior written permission from Longwave. Pinnacle and its associates may have interests in financial products and may receive fees from companies referred to during this communication.
This may contain the trade names or trademarks of various third parties, and if so, any such use is solely for illustrative purposes only. All product and company names are trademarks™ or registered® trademarks of their respective holders. Use of them does not imply any affiliation with, endorsement by, or association of any kind between them and Longwave.

Receive news and insights