Global Equities: February 2020 Commentary

05 Mar 2020

By Delft Partners

February was dominated by fears associated with the global spread of the coronavirus COVID-19. February started in relatively quiet fashion as we observed a generally positive Q3 results season in Japan, however, towards the end of the month corporate news was overwhelmed by a rising scale of panic in global markets associated with COVID-19.

The Australian dollar continued to weaken during February bring the World Value Weighted index return in AUD terms to -c.6% with the currency ending the month trading at just above US 65 cents.

At the time of writing, there are 86,032 confirmed cases of COVID-19 in 64 countries and territories, of which 92.1% of cases (and 96.4% of the 2,942 deaths) are in China, the country of origin. It may therefore come as a surprise to hear that the market in China rose by 1.96% in February. Hong Kong fell by just 0.80%. There were significant falls in Japan, the USA and Europe, which all fell around 9%. 

A key factor in the relative stability of the equity market in China appears to be the news that since 18^th February the number of patients recovering from COVID-19 is exceeding the number of new cases.  We are not downplaying the tragic events associated with COVID-19, however, in strictly market terms this is a familiar response to an unexpected event with an uncertain impact and time frame as the number of new cases COVID-19 rises in exponential fashion.  That initial panic and negative response moves to a period of recovery when the degree of impact is better understood and the level of uncertainty declines.  The pattern of market recovery in China is therefore “normal” in the context of the apparent reduction in the number of new cases and the volume of recovering patients.  That pattern of recovery can be expected to follow in other countries around the world as the response to COVID-19 plays out in valuations of equity markets.

We are maintaining our view that China’s better communicated and proactive response to COVID-19 in 2020 versus SARS in 2003 may have exaggerated the global stock market volatility, however, that isn’t a reason to abandon risk assets. We provide in bullet point format, some of our thoughts on “where to” from here.

• We wrote at the end of 2019 that returns of 8% pa may be the best outcome for equities which is less than we saw in very recent times but is good relative to zero returns on cash and barely above that on government bonds. This is still our central estimate.
• We positioned the Global High Conviction strategy in stocks on lower than average multiples with evidence of change for the better. The returns to Momentum investing relative to Value have been extraordinary over the last 5 years. This is unlikely to continue.
• Equities are again the ATM and some of the selling is becoming indiscriminate. Interestingly Asia and China held up well against the USA and Europe. Cheaper markets and stocks tend to do better on the downside in the face of unforeseeable events.
• This gives companies and politicians a chance to blame COVID-19 for already softening earnings and growth.
• The structural response to the epidemic may have longer term ramifications which we are pondering. Inventory management has become ‘just in time’ to the considerable benefit of company cash flow but supply chain disruption has caused problems for Apple, Microsoft, HP and probably every company with global sourcing. Just in time may not cease but we may see the end of single supplier/country sourcing. Additionally, the extent to which global companies should have lower risk premiums (higher P/Es) because they are more diversified by geography and product line will be re-assessed. Mobile and temporary labour seem to be big inputs into Technology hardware supply chains and consequently their premium P/E will need re-assessing if they are vulnerable to viral outbreaks?
• It is now unlikely that interest rates will be going higher in 2020. At current levels of interest rates and cost of capital, the cost of a loss of 6 months’ earnings is very low in such a long duration asset as equities.

Investors selling into this type of volatile environment typically “forget” to re-enter the markets as fear generates too many confusing signals.  In terms of long-term investment outcomes, it is always better to be a net buyer in this type of situation. We expect to look back at the early months of 2020 as a period of market “noise” and not the key component of our investment returns.

We made one major change in the strategy in February, selling Amada Tools and re-investing in NTT Docomo. This is a Japanese mobile telecommunications company on a P/E of 16x and a yield of 4%. The most interesting part of the business is the Smart Life business segment which handles the finance or payment services, shopping services, and life-related services. It also contains video and music distribution, electronic book-store service, and online shopping service. We anticipate this division boosting the overall growth rate of a mature but financially stable company; one which is also buying back its own shares.

The high conviction strategy holds 30 stocks and remains value biased with risk taken predominantly in stock positions but with an underweight in Europe and to the Euro; an underweight in global banks and overweight positions in Japan and Asia, particularly IT companies and industrial companies trading on significant discounts to their USA equivalent.

An update on a new strategy:-

Delft was appointed sub adviser of a global equity trust recently by Tamim. This trust will be different from the Global High Conviction strategy in a couple of ways. First the benchmark will be the more standard capitalisation weighted benchmark as opposed to one weighted toward Value attributes which we deploy for the high conviction strategy. The companies included in the two benchmark indices are identical; what is different are the % weights for each name. The Cap weighted index has a meaningfully higher weight to the ‘more expensive’ USA market. We illustrate below the differences between the two in terms of regional and sector weights. Risk and return from the two benchmarks will be different, allowing clients to make a choice between value biased or capitalisation weighted. (We do not offer a growth or momentum strategy.)

Secondly the trust will be available to qualified ‘wholesale’ investors with $100k minimum subscriptions which is a smaller minimum than High Conviction which is a direct IMA.

There will be no change to the investment process nor team used to select and weight stock positions.

With subscriptions into the trust arriving in January and then February we were cautious at first at investing into such a rapidly rising market in January, and then wary of trying to catch the “falling knife” in February. Consequently, the trust is approximately 65% invested and looking to invest to 100% over the next weeks. Please contact Tamim or Delft if you wish to learn more.