Searching for future quality in unprecedented times
4 May 2020
What’s happening in the market?
We believe that this is the sharpest and fastest contraction in economic activity that we have seen since the second world war. These are unprecedented times, there’s never been a time where whole industries have just stopped with a zero revenue situation. Companies that appeared to be defensive prior to the COVID 19 outbreak have turned out to be anything but defensive. Dividends are disappearing and equity capital raising, as we have seen already, has become the norm due to balance sheets becoming increasingly pressured in many industries. There is some good news however, investors understand what’s happening and markets are moving ahead of the sales side estimates and discounting a lot of these scenarios very quickly. Another positive is the extent of the fiscal support and monetary stimulus that has come in to assist companies, their employees and the markets. Throughout these turbulent times our team remain focused on the four key pillars of Future Quality.
How we see the world differently
The four pillars of future quality
Focus on Valuation
With the anticipation of more bad news coming and the very sharp fall that we’ve seen in markets, the valuation spread, the gap between the most expensive stock and the cheapest stock, has become extraordinaryily wide. There’s only two other times that it has been this wide, during the GFC and the great depression. If credit spreads can continue to improve then the market won’t worry about new bad news on the earnings front, bad would become good and the value rally that people are looking for would come into play. But there are a lot of ‘ifs’ for this scenario to play out, especially the many unpredictable COVID 19 variables, such as new case numbers, death rates, virus stabilisation and when we will actually return to some level of normal activity. At this time there is a huge range of potential outcomes, so our focus and approach is to stick to the facts around wide valuation spreads, the scale of the fiscal and monetary stimulus and how it can be put to good use, not just for public companies but also for the many smaller private companies that make up the economy and many supply chains that serve our public companies. We will need a certain set of circumstances from the policy side, the virus outcome and a return to normal economic activity for that value to be realised.
Better Quality Balance Sheets
We’re looking for quality businesses to own and invest in. Those that can sustain that quality into the future and earn higher returns on capital not just for today, but for the long term. A company’s balance sheet, today more than ever, is going to dictate the company’s strategy. If a company is in a zero revenue situation and has a compromised balance sheet, that will dictate the strategy that the business follows. So our focus is on companies with better quality balance sheets, companies that are self-financing and are appropriately financed with a lower level of debt than the average business. Better quality balance sheets lend the company’s management teams a lot more choice and flexibility in the strategic actions they are able to take. That’s critical in sustaining the franchise quality of the business through these difficult periods and then positioning the franchise to recover and come out on the other side with a quality business.
The Importance of Stakeholders
Companies should not only be servicing shareholders, we think they also need to look after their stakeholders. It’s important to retain suppliers and employees so that they will be there in the future. Companies also need to work with government and regulators and potentially put assets to work into supporting relief efforts, whether it’s manufacturing ventilators or face masks or something else, if a company has a strong enough balance sheet then they should be in a flexible position to retain labour and support the supply chain. This will mean a company can go back to full capacity quickly without losing those vital stakeholders and that in turn will be good for shareholders. These companies will emerge with a better quality franchise in the future. So again the strength in the balance sheet is permitting these businesses to do the right thing.
Nikko Asset Management New Zealand Limited (Company No. 606057, FSP22562) is the licensed Investment Manager of Nikko AM NZ Investment Scheme, Nikko AM NZ Wholesale Investment Scheme and the Nikko AM KiwiSaver Scheme. This material has been prepared without taking into account a potential investor’s objectives, financial situation or needs and is not intended to constitute personal financial advice, and must not be relied on as such. The Product Disclosure Statements are available on our website: https://www.nikkoam.co.nz./invest/retail