Mark Draper

Mark Draper

Wednesday, 13 May 2020 07:53

Property Trusts after COVID-19

Following the most savage sell off in REIT’s since GFC, investors are left to decide whether to buy the lower prices or sell on the basis that COVID-19 has forever changed property.

During the month of March, the REIT’s index fell 35%.  While the sector fared worse during GFC, this sell off has been fast and brutal. 

Investors need to understand that not all REIT’s are created equal and they generally fall into 3 sectors:

  1. Retail
  2. Office
  3. Industrial

One of the major risks for property investors is vacancies and COVID-19 may cause vacancies through business bankruptcies.  The retail property sector is at the epicentre of this risk.  This risk would appear to be in current prices and Hugh Dive (Portfolio Manager Atlas Funds Management) is of the view that “some of the sentiment towards retail appears excessively bearish.”  He makes this point by backsolving the current share price of GPT Group’s property portfolio of retail, office and industrial assets.

The table below shows that at current prices, GPT investors are assigning GPT’s 12 shopping centres a value of $650 million.  According to Dive “this appears to be unlikely for a collection of assets that generated profits of $326 million last year.  If you demolished the shopping centres, the land value is most certainly worth a lot more than this.”

Pete Morrissey (CEO Real Estate Securities, APN Property Group) says that “COVID-19 is a catalyst to speed up the tenant turnover/bankruptcy and rent reversion cycle that was likely to continue for several more years into a compressed period.  While this may bring pain to landlords and tenants it could also see the emergence of a more vibrant, customer focussed retail sector.  Those properties that are well located with owners focused on meeting consumer needs will continue to drive solid return outcomes once markets stabilise.”

Dive summed up his views on retail property with “human beings have consistently enjoyed shopping and dining in public areas for two and half thousand years since the agora was built in Athens in the Fifth CenturyBC and it is hard to make the case that COVID-19 in 2020 totally changes that behaviour”.

A common theory with office space is that COVID-19 will permanently change the demand profile for office space as companies move their employees toward working from home.  

Morrissey says “While we don’t disagree entirely with this we do question whether corporates will be willing to forego the obvious gains from staff networking efficiencies and personal interactions/collaborations across their organisations.”  He also introduced the prospect that tenant space savings from staff working at home could be offset by social distancing requirements being introduced to the office.

Dive believes “that COVID-19 will reduce the demand for office space and rents will fall, but we don’t see a fundamental decline in value of office real estate.”  This is largely due to the tight vacancy rates in Sydney and Melbourne that should provide some support to rents over the coming years.

Industrial property would seem to be the most insulated sector from the impact of COVID-19.

“Industrial property, in particular logistics is likely to see a minimal impact from COVID-19 as their tenants are likely to see solid demand through 2020” according to Dive.  

Morrissey agrees and adds “increasing infrastructure spending, growing e-commerce, and a renewed focus on shoring up local supply chains will be an ongoing tailwind to drive industrial property demand.  Low vacancy rates across the sector indicate that industrial property is not over-supplied”.

Those investors who remember the highly dilutionary capital raising’s from REIT’s during GFC should take comfort in the low gearing of the sector today.  Average gearing today is around 28% compared to GFC levels of around 40%.  Dive is of the view that while we have seen a few small opportunistic capital raisings in 2020, we are unlikely to see a large number of jumbo ‘life or death’ capital raisings in the REIT sector like we saw during GFC.

Investors can gain access to REIT’s by either purchasing them directly via the ASX, or through diversified property funds such as those offered by Atlas Funds Management and APN Property Group.  ETF’s are another way of gaining property exposure, but investors should be aware that the property index is dominated by retail property if choosing to index their property exposure.

It is said that it is always darkest just before the dawn.  Long term investors could well make good long term returns from sifting through the REIT wreckage.

 

This article was written by Mark Draper (GEM Capital) and was published in the Australian Financial Review on Wednesday 13th May 2020.

The investment team at Montgomery Investments have put together another informative report that covers various aspects of the current investment landscape.

In this report the team looks at:

- Is it time to get back in

- How should you think about cash?

- Looking through market volatility for opportunity

- 4 criteria to consider before buying shares in this market

 

To download your copy of this report, click on the report below.

 

The COVID-19 (coronavirus) pandemic has shaken the global population to its core. The personal toll is enormous, and the fear, immense. In this special feature I will explain what the virus is, what makes it unique and the progress that has been made in developing a treatment and vaccine. The collaboration between pharma, biotech and medtech companies, as well as researchers has been astounding and gives me great confidence that we will win this fight.

Within a very short period of time, the world has shifted its focus to a virus that measures roughly 50-200 nanometres1. Suddenly, we have all become familiar with scientific terms such as viral spread, PCR testing capacity, antibodies, viral shedding and many more. Economists have become epidemiologists hoping to model the outbreak, while we have also witnessed the limitations of many healthcare systems.

Viruses are a part of life. There are plant viruses, animal viruses and viruses that infect bacteria. Over time, outbreaks occur and can be devastating. Polio was an example of a seasonal, frightening viral epidemic in the 1940s and 1950s that was eventually eliminated by vaccination. There is no reason to believe that we will not be successful combating SARS-CoV-2, the new coronavirus.

SARS-CoV-2 is a member of the Coronaviridae family, a rather large clan with two subfamilies (Coronavirinae and Torovirinae) that can infect humans as well as animals. These subfamilies have several members and there are four coronaviruses that we have all most likely had exposure to. They cause mild symptoms, such as the common cold and require no diagnostic testing. However, occasionally we see a coronavirus that causes very unpleasant diseases, such as SARS (2002/2003), MERS (2012/2015) and now COVID-19.

This latest virus outbreak will change our view about this viral family, vaccination, pandemic preparedness and antiviral therapeutics. It is highly plausible that we may require vaccination against this culprit with additional booster shots annually. Given what we are seeing today, this new coronavirus is here to stay.

Viruses are simple but sophisticated creatures. They have an outer shell and sometimes an inner one as well. Inside, is the viral genome, often with some viral functional proteins attached to it. The outer shell tends to have family-specific characteristics that determine which and how the virus infects its host. Coronaviruses like respiratory and gastrointestinal tracts. So-called spike proteins that sit on the outer shell of the virus have a high affinity for proteins localised in our throat, lungs and gut. It is this outer shell that disintegrates when it contacts soap, hence the reason why washing our hands is so crucial. Similarly, we as the host, are crucial for the survival of the virus. Viruses cannot replicate by themselves, they need the host’s ‘machinery’ to multiply. Viruses are masters at exploiting the host’s machinery and they know how to adapt, so it is essential we deny them any opportunity to find another host by practising social distancing. Some viruses are very clever, they have worked out that causing mild disease is better as the host keeps socialising, which guarantees survival of the virus, while the more aggressive (not so clever) viruses cause devastating diseases and hence eliminate themselves quickly. SARS-CoV-2 falls into the sophisticated category as it replicates in the upper respiratory tract (e.g. throat), causing mild symptoms vs. its cousin SARS-CoV that settles deep in the lungs. Transmission from the throat is much easier and hence requires drastic actions to slow it down and stop its spread. Scientists are closing in on this virus a lot faster than we have ever seen before.

What we learnt from HIV

Thanks to the advanced scientific tools we use today in the laboratory, we have been able to identify and study SARS-CoV-2 and its lifecycle at a rapid speed. It is worthwhile revisiting the AIDS/HIV epidemic in the 1980s to understand how far we have come. In 1981, the US Centres for Disease Control and Prevention (CDC) started to see patients with diseases that occurred due to a malfunctioning immune system. However, nobody knew what was causing this immune deficiency. A year later, the disease was called AIDS (Acquired Immune Deficiency Syndrome). In 1983, French scientists postulated that a retrovirus could be the cause of AIDS, which was confirmed by US scientists the following year. In 1985, the US Food and Drug Administration (FDA) approved the first commercial HIV blood test that detected antibodies in a patient’s blood. A molecular test, similar to what is being used today to detect SARS-CoV-2, was only available for HIV in the mid-1990s. The first antiviral drug was approved in 1987. Compare this timetable to the current pandemic. Late last year, news emerged from China about a respiratory disease that did not test positive for any known respiratory pathogen. It quickly emerged that it was due to a new coronavirus. The genome of the virus was rapidly sequenced and distributed to scientists globally and molecular tests were established. Biotechs and pharmaceutical (pharma) companies quickly looked inside their drug cabinets for potential therapies as well as how their technologies could be applied to make specific drugs and vaccines for this new virus. It has been a phenomenal global effort. Currently, we are awaiting clinical trial data for the first repurposed antiviral therapy (Gilead Science’s Remdesivir, which was originally developed to treat Ebola), while the first vaccine is also already being tested in humans. It may feel like a long time but it has only been months.

The virus itself is being studied intensely by several groups around the world. The spike proteins that make up the outer shell have been analysed and scientists have elucidated the structure of one of the viral functional proteins called protease, which is immensely important, as it will allow scientists to develop anti-protease inhibitors, which were crucial in treating HIV.

Scientists are simultaneously studying the immune system’s response to the virus and have identified Interleukin-6 (IL-6) as a key mediator, hence Roche’s IL-6 Antibody Actemra is being used to treat COVID-19 in some hospitals, while clinical trials are ongoing. Meanwhile, Sanofi/Regeneron’s IL-6 antibody has also just entered clinical trials for COVID-19.

We know from previous viral outbreaks that patients who have recovered from a virus will have produced antibodies that neutralise the virus, so Japanese pharmaceutical company, Takeda has started collecting plasma from patients who have recovered from COVID-19 to give to patients currently suffering from the disease. CSL has recently joined Takeda to work together on such a plasma-derived product.

Regeneron, a US biotech, is using its antibody engineering capability to find antibodies that target the virus. Those antibodies should move into human testing later this year. Alnylam and Vir Biotechnology are working on a long-acting small interfering RNA (siRNA) therapeutics targeting the virus. Vir is also working on antibodies with GSK.

The ability to explore and investigate so many different drug modalities was not possible during other viral outbreaks as we did not have the technological capability.

Global collaboration

There has been a lot of debate about the lack of testing capacity, but overall, the scientific community, including biotechs, pharma and medtechs, have all shown great leadership in this pandemic. The collaboration and sheer speed in detecting the virus and developing a treatment have been unprecedented. Not that long ago, pharma and biotechs were in the political crossfire regarding high drug prices. In this pandemic, the industry has the opportunity to set the record straight and show their full capabilities. In years to come, this industry, along with the medical profession, will be viewed through a very different lens.

Vaccines, the holy grail to combat infectious diseases, are also experiencing immense activity by traditional vaccine companies and also by biotechs who use new transformative technologies, such as messenger ribonucleic acid (mRNA).

The concept of a vaccine is simple. A venture capitalist recently described it in the easiest possible way; likening a vaccine to sending a “wanted criminal dossier” to the immune system, that shows the immune cells what to look out for and prepare to capture the ‘criminal’. Sometimes, the immune cells are able to see the picture of the criminal just once to ensure the immune cells can fight off the criminal, other times, they need to be reminded again i.e. get a booster.

The criminal dossier can come in different forms. It can be very detailed (a weakened form of the virus) or it may only have some very poignant features of the criminal (parts of the virus that are very immunogenic).

It takes time for laboratories to make a virus that replicates the criminal dossier. Firstly, scientists need to figure out how best to make it, or which part of the virus they should focus on. Manufacturing then has to be scaled up, which all requires a significant amount of money. The vaccine then needs to be tested at length and many millions/billions of dosages have to be manufactured. Today, four companies dominate the vaccine industry (GSK, Pfizer, Sanofi, Merck) with Australian company, CSL a distant fifth and Johnson & Johnson always keen to participate.

The potential long lead times and significant upfront costs have, however, not deterred Sanofi and Johnson & Johnson from applying their more traditional vaccine-making approach. Both companies are actively working on the criminal dossier and Johnson & Johnson is due to start trials later this year.

Platinum has followed the vaccine space for more than a decade and we have long hoped that technology advances would one day change the way vaccines are made. Using cell lines (where a permanently established cell culture multiplies indefinitely) has been one significant step along this path, but overall, the vaccine industry has remained a tight oligopoly.

In recent years, the potential to use mRNA as a therapeutic treatment and as a vaccine has emerged. We have been following the progress closely and invested in two companies in this space, Moderna and BioNTech, some time ago. The pandemic has placed mRNA and both companies firmly in the global spotlight. US-based Moderna was able to start clinical trials within 63 days of receiving the genomic sequence of the new virus. BioNTech has been slightly slower, but recently expanded its partnership with Pfizer and also entered a partnership with Chinese company, Fosun to develop its vaccine candidate. Curevac, another privately- owned German mRNA biotech backed by SAP co-founder Dietmar Hopp, is also busy developing a vaccine, while Sanofi recently expanded its alliance with biotech, Translate Bio.

Using mRNA for vaccine development is quite an elegant approach and Moderna and BioNTech have invested considerable effort in designing and selecting the best possible mRNA molecule for a respective protein of interest. It remains to be seen if it works, however, both companies have received support from the Bill and Melinda Gates Foundation and have large partners for various pipeline products. Some established vaccine makers are sceptical, but Moderna has been the first to take their mRNA to the clinic.

mRNA explained

mRNA is a molecule that functions naturally in our bodies as an intermediary between our genes and our proteins. It is the blueprint for our proteins and essentially a copy of the gene encoding the protein. If designed and delivered correctly, cells will recognise the mRNA and start making the protein. For vaccines and therapeutics alike, the mRNA can be quickly designed (by the right team of scientists) in the lab once the scientists know which is the correct viral particle to make. Usually, several mRNAs are made and scientists quickly assess which one is the most suitable. Manufacturing these chemical molecules (or information molecules, as Moderna calls them) can be done with a much smaller manufacturing footprint and also at a fraction of the cost of making traditional vaccines or protein therapeutics, as it is not a protein, it is the information to make the end product. In the end, the 'active’ product, the vaccine or the therapeutic protein, is made by the person who receives the mRNA injection. Humans essentially function as the manufacturing site for the mRNA vaccine.

We are convinced that these multiple vaccine efforts (traditional and modern) will result in a product, potentially as a first-generation product that will give companies time to refine their efforts and develop the next generation of longer-lasting vaccines.

A global logistical exercise

Apart from the scientific approach that is being undertaken to combat the virus, this pandemic is also witnessing large- scale crisis planning and management in different countries.

Molecular testing has been a key pillar in managing the viral spread. It is clear, however, that the supply of these tests cannot fulfil demand. Each country has taken slightly different approaches to testing. Some countries are actively looking for asymptomatic infected individuals, while others are struggling to keep on top of the symptomatic patients. Testing guidelines will undoubtedly change over time and serological testing, whereby a test determines antiviral antibodies in a patient's blood, will complement molecular testing in the future.

In a pandemic, facts determine your management plan and as the facts change so should the plan. Many people worry when plans change, but in the crisis we are experiencing today, it is paramount that countries adjust their plans to address the changing dynamics.

Our knowledge of the SARS-CoV-2 virus and the COVID-19 disease has rapidly grown and changed as physicians in different countries gained first-hand experience. Throughout this pandemic we have drawn on a number of sources, including the New England Journal of Medicine (NJEM), a weekly medical journal published by the Massachusetts Medical Society, Dr Anthony Fauci, one of the lead members of the White House Coronavirus Task Force in the US, the German federal government agency and research institute, Robert Koch Institute, along with a German virologist Professor Drosten (coronavirus specialist) and several of his colleagues.

These learnings and the exchange of these experiences is vital to form response plans. One of the key learnings in recent months has been the fact that this coronavirus can spread very quickly. This is due to its preference for residing in the upper respiratory tract, as highlighted above. This means it often causes milder symptoms that can go undetected. The biggest challenge is to break this rapid spread and protect vulnerable individuals. In an ideal world, everyone would be tested. A swab kit would arrive in your mailbox (similar to the bowel cancer test kit), you would take a swab, it would be collected by a courier and the results emailed to you in a matter of hours. What would be even better though, would be a molecular test that people can do themselves at home. This would quickly identify who is infected and who needs to self-isolate.  Unfortunately, these tests are not available to us today, so the next best option is what is currently being practised in many countries; quarantine, social distancing, drive-thorugh testing facilities, and tracing potential infections practively.  Sophisticated piont of care testing that could be done at home or at the local medical centre is emerging rapidly, with companies such as Roche, Qiagen (soon to be part of Thermo Fisher) and Cepheid (now part of Danaher), key platers developing this technology.

At the core of this pandemic, due to the rapid spread of the virus, is the ICU capacity of hospitals. In the current phase of the pandemic, the focus hence needs to be on ensuring we have enough ICU beds and ventilators. Globally, we are seeing different ICU capacities and thankfully we are seeing a move to central ICU bed co-ordination. Germany, for example, is moving to real-time monitoring of its ICU beds as well as transporting patients from neighbouring countries. All hospitals have to work together, which has been a challenge, particularly in the US. We have learned from Italy’s experience that it is important to have COVID-19 treatment centres protecting non-COVID-19 patients. This pandemic is as much a logistical and planning exercise as it is a scientific endeavour. It will highlight very quickly the shortcomings of our healthcare system along with our past desire to be as supply chain efficient as possible.

However, there will be a next phase to this pandemic, and that will be when we start to return to our offices and gradually begin to socialise again.

During the next phase it will be about recovered patients and keeping on top of regional outbreaks and next-generation diagnostic tests that identify antibodies to the virus. Many of these tests are currently receiving media coverage, however, I would caution that these tests are not yet ready to be used widely. The potential for false negatives is not a risk we want to take currently; it takes days to develop antibodies and hence molecular tests remain the best approach to detect an infection early.

However, the presence of anti-SARS-CoV-2 antibodies in the blood means the person has been infected sometime in the past and hence are now regarded as being immune, which will be important when we are ready to return to work. In Germany, for example, the debate is currently about issuing “immunity certificates” for those who show positive antibody titres in their blood. It is still unclear, however, how long this immunity will last. In the months to come, detection of the virus and our immunity will remain paramount until we have therapeutic options and a vaccine.

At Platinum, we have long believed that diagnostic tests will become a key pillar of healthcare, be that in oncology, inflammatory diseases or infectious diseases. The aim in healthcare should be prevention, which requires tools to detect changes in our body early with precision. This is the same with the current virus, if we can detect it quickly, we can prevent it spreading. This pandemic challenge has placed the healthcare industry squarely in people’s minds. It has shown how limited our arsenal of antiviral therapies is and highlighted how our approach to vaccine development has to be overhauled. In the world we are living today, with all the digital factory technology that is available, manufacturing vaccines strikes us as 'old style’. Given we have seen several coronavirus outbreaks in the last 18 years, it is more likely than not, that this coronavirus family will continue to cause us harm and hence having a vaccine, or possibly an annual coronavirus vaccination booster would be worthwhile investing in. We are firm believers that current events will change healthcare systems and most importantly, will highlight what a vital role biotechs play today.

The biotech industry is relentless in its search for new technologies and new therapeutics. Bankruptcies are rare and failure does not demotivate them, to the contrary, it motivates them.

For now, as Germany’s chancellor Angela Merkel recently said, the best therapy we have for SARS-CoV-2 is to stay at home.

 

This article has been reproduced with permission from Platinum Asset Management.  The article is written by Dr Bianca Ogden (Healthcare Portfolio Manager Platinum Asset Management).  

Dr Bianca Ogden, MBio (Tübingen), PhD (University College London), has been the portfolio manager for the Platinum International Health Care Fund since 2007 and leads the healthcare sector team. Molecular biology was Bianca’s first love before she discovered the joys and challenges of investing. After spending some time at Swiss pharmaceuticals company Novartis researching new HIV drugs (one of which has been approved and is in use today), Bianca went on to complete a PhD at UCL, investigating Kaposi’s sarcoma-associated herpesvirus. She then migrated to Australia and joined Johnson & Johnson as a molecular biologist, researching new drug targets in oncology. Bianca embarked on a career change and joined Platinum as an investment analyst in 2003. Her rich knowledge base in molecular biology and first-hand insights into the pharmaceutical and biotech industry give her a unique ability to delve deeply into the fundamentals of healthcare companies and identify those with a solid foundation in scientific research.

 

 

COVID-19 has challenged the assumption that infrastructure investment offers defensive revenue characteristics that tend to hold up during periods of economic stress.  

Investors need to appreciate that not all infrastructure assets are the same, and that each sub-sector will react differently to COVID-19.

Infrastructure can broadly be separated into at least 3 categories:

  1. Regulated assets, including electricity transmission lines, gas pipelines and water distribution systems.
  2. Transportation assets, including toll roads, tunnels, bridges, seaports and airports.
  3. Communication assets, including radio and television broadcast towers and wireless communication towers.

So far during the COVID-19 crisis, the revenues and share prices of regulated assets and communication assets have shown great resilience.  This makes sense as a business such as Spark Infrastructure, who provides the power line infrastructure to supply electricity to homes in South Australia and Victoria, will continue to be paid to transmit electricity with or without COVID-19.

The infrastructure sector that has seen the most disruption through the lockdown of populations has been the transport assets which includes toll roads and airports.  Transurban (tollroads) and Sydney Airport have seen share price falls of around 25 – 40% since the end of February 2020.  These assets would seem to provide investors with great opportunity for future profit, due to the high level of uncertainty that is currently reflected in their share price.

There has been much made of Sydney Airports debt, however if the airport closed tomorrow, it has enough funding to cover all expenses and refinancing requirements for at least a year.

Clearly passenger numbers at Sydney Airport will be down for some time, however analysts can arrive at a valuation materially higher than the current share price even allowing for some dramatic falls in passenger numbers.  A model we have read includes a 90% fall in international traffic for the next three months and then a 50% decline for the remainder of the year.  This scenario assumed for domestic passengers a 60% decline for three months and a 20% decline for the remainder of the year.  Short term earnings fall by around 40% under this scenario, but shareholders have over 80 years remaining of a 99 year lease over the Sydney Airport, which makes short term earnings movements less relevant.

What is more relevant is whether Sydney Airport is likely to breach any of its debt covenants, and whether it needs to raise capital by issuing new shares at discounted prices and diluting existing shareholders value in the process.

Sydney Airport’s debt covenants are not publicly available, but analysts are of the view that they are no more onerous than those originally set out in 2002.  Under the above modelling, Sydney Airport would be unlikely to breach its debt covenants.

Transurban, which is an owner of multiple toll road assets faces some risk of particular roads breaching debt covenants, but as a group Transurban looks to be well capitalised and not likely to need to raise capital on the basis that the lockdown period lasts for 3 – 6 months.

The key risk facing investors with respect to transport infrastructure assets revolves around knowing how long the population lockdown will last for.  The modelling outlined earlier shows that Sydney Airport would be unlikely to need to raise capital if the lockdown lasted for 3 months, but a lockdown of 6 months would intensify pressure on debt covenants and a capital raising.  The length of the lockdown in ‘unknowable’ at this stage but the message is clear, the longer the lockdown, the more damage is done to earnings and to valuations.  

Investors would be best served to think in terms of scenarios, rather than absolute points at this stage and remain flexible in their thinking to accommodate new information as it comes to hand.

Out the other side of COVID-19, as with past disruptions it is highly likely that airport traffic and toll road traffic recover to reach new highs. A case could also be made for greater motor vehicle transport as commuters could seek to avoid the health risks associated with public transport.  Lower bond rates could also provide a tailwind to infrastructure valuations.

While no-one knows how COVID-19 plays out yet, what we can say with certainty is that that toll road traffic should return faster than air travel passenger numbers.  This means that toll roads should offer less earnings risk than airports at the present time.  

  

This article was published in the Australian Financial Review during April 2020.

Wednesday, 01 April 2020 14:07

It's business as usual at GEM Capital

 DSC8783We hope that everyone who reads this article is safe and healthy.

At this time we simply wanted to confirm that GEM Capital is fully operational and fully functional.

Half of our team are working from home, and a skeleton staff (by their own choice) are continuing to work in the GEM Capital office while maintaining strict social distancing measures.

In the event that a full lockdown was required, we have the IT systems and equipment for everyone to work from home remotely without impacting on our capacity to continue to provide service to our clients.  Some of our team work part time from home before the COVID-19 crisis, so we know our systems are fully capable in this area.

We have invested in a new phone system which allows each of our team to use their mobile phone as an extension of the office phone which creates seamless communication.  This ensures that even if we are working from home, clients can ring the office number as normal and continue to speak with us.

Over the years, we have ensured that our IT systems offer great flexibility for our team to work with, and one of the benefits of this approach is that they will work even if our team is forced to work from home.

Wednesday, 01 April 2020 13:23

Alibaba - why the smart money likes it

Chinese CurrencyWith the Chinese middle class population forecast to double to over 600 million over the next 5 years, which in turn increases consumer spending, it is not difficult to see why the ‘smart’ money is investing in Alibaba, one of China’s largest companies that is likened to Amazon, eBay, Paypal and Google all rolled into one.

Alibaba was founded during the 1990’s by Jack Ma who realised at that time China lacked technology in the business world.  Alibaba, now one of China’s largest companies, listed in 2014, and today is highly profitable with a market capitalisation of over US$580bn.  This is about 6 times larger than Australia’s largest company CSL.

Alasdair McHugh (Product Specialist Baillie Gifford) is attracted to Alibaba due to their very strong position in ecommerce transactions in China where their market share is over 60% by gross merchandise value and likely to rise further.  He also likes the fact that the original co-founder and visionary Jack Ma is still involved in the business.  

According to the China Ministry of Commerce, total retail sales across China increased 8% in calendar 2019, for a total of RMB 41 trillion (AUD $9 trillion).  Consumption contributed over half of China’s economic growth.  Online retail sales for the year was RMB 8.5 trillion (AUD $1.87 trillion) up 19.5% from the year before.  It is clear that consumption is now a major driver of economic growth in China, and online retail is an important driver of consumption growth. Alibaba’s dominant position means it is well placed to capture this growth.

The scale of the opportunity is extraordinary and underestimated by certain investors, particularly some from the west who still consider China as a risky emerging market.  But McHugh suggests that those who still treat China as an emerging market are overlooking the fact that the addressable market for Chinese consumer spending is 1.3 billion people.  

Illustrating this point was the recent ‘Singles Day’ held in November 2019 where another record was broken with total sales of RMB 268.4bn (approx. AUD $59.2bn).  Almost 1.3 billion packages were delivered by Alibaba from ‘Singles Day’ orders and of those 960 million were delivered within one week.  This is equivalent to 2.3 times the combined online sales of Black Friday and Cyber Monday in the US.  It reflects the strength of Alibaba’s digital economy and of Chinese consumers consumption power.

Joe Lai (Portfolio Manager Platinum Asset Management) says that “mobile monthly average users on Alibaba’s retail marketplaces in China reached 824 million in December 2019, an increase of 39 million from the previous quarter”.  

Beyond the ecommerce business, Alibaba operates the largest cloud computing business in China, Alibaba Cloud.  Many believe that this business can ultimately become the largest division within the company despite it presently representing less than 10% of overall revenue.  Revenue from Alibaba Cloud grew by 62% over the year to December 2019.

A fascinating aspect of Alibaba’s recent quarterly earnings update related to the company’s involvement in procuring and delivering 40 million units of medical supplies worth around AUD$100 million to Wuhan which has been impacted by Covid-19.  This shows a company that is so much more than an online retailer. 

Lai points out that “The Alibaba ecosystem keeps delivering new sources of value to shareholders.  Amid the Covid-19 lock down in China, Alibaba’s new enterprise communication app, DingTalk, has achieved new prominence.  Alibaba introduced a new digital health check in feature on DingTalk, which as at February 2020, had recorded more than 150 million daily health check ins.”

While currently investors are obsessing over Covid-19, Alibaba management said “17 years ago, the ecommerce business experienced tremendous growth after SARS.  We believe the adversity will be followed by changes in behaviour among consumers and enterprises and bring ensuing opportunities.  We have observed more and more consumers getting comfortable with taking care of their daily living needs and working requirements through digital means.” 

With the huge growth in China’s middle class and online commerce in coming years, combined with Alibaba’s dominance across retail, financial and computing businesses it’s clear to see why the company is in Platinum and Baillie Gifford portfolios.  Investors can of course buy Alibaba directly either on the Hong Kong or US exchange and can also gain access to it through managed global funds.

 

This article appeared in the Australian Financial Review during March 2020 - written by Mark Draper GEM Capital

Wednesday, 01 April 2020 13:04

Solvency and Debt in time of crisis

This article was written by Hugh Dive - Atlas Funds Management and he has generously authorised its reproduction ..... Thanks Hugh!

 

Alongside the worldwide devastation as healthcare systems struggle to cope and deaths are well into the tens of thousands, the COVID-19 crisis is having a chilling impact on Australian corporates. Many companies are removing profit guidance given less than a month ago, cancelling dividends, raising debt, and in the last five days attempting to raise capital. Eleven years ago during the GFC many companies raised equity, often at deep discounts to their share price, as nervous bankers put pressure on management to shore up weakened balance sheets. In some situations, companies were forced to raise equity as their bankers were unable to refinance loans that had become due in a frozen credit market. 
 
In this week’s piece we are going to look at the various debt measures that we examine to assess a company’s solvency. These measures provide insight into whether management will be forced to raise equity during times of stress.

Gearing


Gearing is the most commonly discussed measure of a company’s debt. It indicates the degree to which a company’s business is supported by equity contributed by shareholders, as opposed to debt from banks and bondholders. Gearing is measured by dividing net debt by total equity (assets plus liabilities).  During times of buoyant business conditions, companies with a high level of gearing generally deliver higher returns to investors. However, when the tide turns, highly geared companies have a riskier financial structure and have an increased chance of going into administration or having to raise equity to retire debt.

Most companies on the ASX have a gearing ratio between 25% and 35%. However, the level of gearing needs to be assessed in the context of the industry in which the company operates.  Utilities such as Spark Infrastructure with regulated revenues can “safely” have a higher level of gearing than a highly cyclical stock such as Myer or Qantas. The latter two have more variable earnings and thus a variable ability to meet interest payments.

The key weakness in using gearing alone to measure a company’s solvency is that it assumes that the company’s assets can be realised for close to what they are valued on the balance sheet. The shortcomings of this approach are especially apparent for companies with a large proportion of intangible assets on their balance sheet, such as goodwill stemming from acquiring other businesses at prices above their net asset backing. In 2019 AMP’s gearing increased rapidly after the financial services company wrote down the asset value of its troubled wealth management and life divisions by $2.5 billion. Shortly after writing down the value of its assets, the highly geared AMP both cancelled its dividend and conducted a $650 million equity raising at a 16% discount to the share price at the time.

Companies such as Medibank PrivateJanus Henderson and A2Milk are in the fortunate position in 2020 of having no net debt on their balance sheet. As a result, each has a negative gearing ratio and is facing no anxious discussions with their bankers. By contrast AMP, Pact and OohMedia (which raised $167 million last week) all have high levels of gearing.
 

Short-Term Solvency


Short-term solvency ratios, such as the current ratio, are used to judge the ability of a company to meet their short-term obligations. The current ratio divides a company’s current assets by their current liabilities (i.e. liabilities due within the next 12 months). Firms can get into financial difficulties despite long term profitability or an impressive asset base if they can’t cover their near-term obligations. A current ratio of less than one would indicate that a company is likely to have trouble remaining solvent over the next year, as it has less than a dollar of assets quickly convertible into cash for every dollar they owe. A weakness in using this measure to assess the solvency of a company is that the current ratio does not account for the composition of current assets which include items such as inventory. For example, winemaker Treasury Wine reports a robust current ratio. However, a large proportion of current assets are inventories of wine which may be challenging to convert into cash at the stated value during times of distress (panic buying of wine notwithstanding).

A further limitation of the current ratio in assessing a company’s financial position is that some companies such the ASX, Coles and Transurban which have minimal inventories or receivables on their balance sheet. This occurs as they collection payment immediately from their customers, but pay their creditors 30 or 60 days after being invoiced. These companies will tend to report current ratios of close to 1. Alone, this figure would indicate that these companies may be in distress. Indeed Coles has a current ratio below 1, which far from being alarming is due to the nature of the grocery business. Suppliers such as Kellogg’s and Coke are paid on terms between 60 and 120 days after they deliver their goods which creates a large current payables balance, while the receivables balance is small when customers pay for their cornflakes or Diet Coke via direct debit. This favourable mismatch between getting paid and paying their suppliers allows Coles and Woolworths to report an alarming current ratio that is effectively a loan from their suppliers to fund the grocers’ working capital.
 

Interest Cover


A debt measure that we look at more closely than gearing is interest cover, as this measures cash flow strength rather than asset backing. Interest cover is calculated by dividing a company’s EBIT (earnings before interest and taxes) by their interest cost. The higher the multiple, the better. If a company has a low-interest cover ratio, this may indicate that the business might struggle to pay the interest bill on its debt.

Before the GFC, I had invested in a company that had significant asset backing held in the form of land and timber. Using gearing as a debt measure alone, Gunns appeared to be in a robust financial position. However, interest cover told a different story. The combination of a rising AUD (which cut demand for its woodchips) and weak economic conditions resulted in Gunns having trouble servicing their debts despite their asset backing, and the company ended up in administration.

As interest rates have trended downwards over the past decade, it has become easier for companies to pay their declining interest bills, so in general, the interest cover ratio for corporate Australia has increased. Across the ASX companies such as JB Hi-Fi, Goodman Group, Wesfarmers and RIO Tinto all have an interest cover of greater than ten times. At the other end of the spectrum Nufarm, Viva Energy, Boral and Vocus all finished 2020 with interest cover ratios less than three times, which is likely to result in some worried discussions with their bankers. Nufarm has since sold its South American crop protection business with the proceeds going to pay down debt.  
 

Tenor of Debt


A very harsh lesson learned on debt during the GFC was not on the absolute size of the debts owed by a company, but the time to maturity – known as the tenor of the debt. The management of many ASX-listed companies sought to reduce their interest costs by borrowing on the short-term market and refinancing these debts as they came due. While this created a mismatch between owning long-dated assets that were refinanced yearly, it was done under the assumption that credit markets would always be open to finance debt cheaply. This strategy worked well until global credit markets seized up in 2008 and a range of companies such as RAMS and Centro struggled to refinance debts as they came due.

When looking at a company’s solvency during times of market stress, one of the critical items to look at is the spread of a when a company’s debt is due. If the company’s debt is not due for many years, management teams may not be forced by their bankers into conducting dilutive capital raisings during a period of difficult economic times. In the ASX over the next year Seven West Media, Downer and Southern Cross Media all have significant levels of debt to refinance, which may prove challenging in the current environment.

After the GFC many of the larger ASX-listed companies have sought to limit refinancing risks by issuing long-dated bonds in the USA and Europe. Toll road companyTransurban does carry a large amount of debt, but as you can see from the table below, the maturities of these debts are spread over the twenty years with an average debt to maturity of 8.4 years.

Similarly, at the smaller end of the market, the supermarket landlord SCA Property has minimal debt due over the next three years after issuing long-dated bonds in the USA. While COVID-19 is disrupting SCA Property’s business in March 2020, this spread of debt maturities positions this property trust better to ride out the current storm.


 

Covenants


Covenants refer to restrictions placed by lenders on a borrower’s activities and are contained in the terms and conditions in loan documents. These are either affirmative covenants that ask the borrower to do certain things such as pay interest and principal, or negative covenants requiring the borrower not to take on more debt above a certain level – for example; gearing must stay below 60% or an interest cover above three times. For investors, covenants can be difficult to monitor since, while companies reveal the maturity, currency and interest rate of their debts in the back of the annual report, disclosure on debt covenants is generally relatively weak.

Debt covenants were something that received little attention before the GFC when a covenant linked to Babcock & Brown’s market capitalisation triggered the collapse of the company. In June 2008, Babcock & Brown’s share price fell such that the company’s market capitalisation fell below $2.5 billion, and this triggered a covenant on the company’s debt that allowed its lenders to call in the loan.  After this experience, very few borrowers will include a market capitalisation covenant in their debt, as this leaves the company vulnerable to an attack by short-sellers. More recently in 2019 when Blue Sky Alternatives breached covenants, bondholders called in the receivers to protect their loan.

In 2020 amid the COVID-19 crisis, debt covenants are once again in the minds of investors, particularly in the hard-hit media and listed property sector. In the media sector, a fall in TV advertising revenue of 10% is likely to trigger Seven West Media’s debt covenant of 4 times EV/EBITDA (enterprise value divided by earnings before interest, depreciation and tax).

In listed property, the embattled shopping centre trusts have more breathing room, as they entered 2020 with a lower level of debt. The key covenants for Scentre are gearing (less than 65%) and interest cover (higher than 1.5 times). For the gearing covenant to be breached, the independent valuation of Scentre’s assets would have to fall by 60% from December 2019; for the interest cover to be breached, earnings would have to fall by 60% assuming no change to Scentre’s cost of debt.
 

Hedging


In the context of debt, hedging refers to the addition of derivatives to limit the impact of movements in either interest rates or the currency in which the debt is denominated. Many Australian companies borrow in Euros, US dollars and yen – both to take advantage of the lower interest rates in these markets, but more importantly to borrow money for a longer-term.  In 2020 the Australian dollar has fallen 12% against both the Euro and the US Dollar.

Companies that have significant un-hedged debt – such as building materials company Boral – will see their interest costs increase, especially if the company does not have enough foreign earnings to service their debt. This situation occurred in 2010 for Boral and required a dilutive $490 million to keep the company within their debt covenants. In December 2019 Boral’s debt was A$2.8 billion, but currency movements over the past 90 days have added $340 million to the struggling building materials company’s debt pile.

Our take

The upcoming year  will be tough for Australia’s companies as the sudden step change in demand is very different to the falls in 1987,1991,2000 or 2008/09. While demand for goods and services fell during these previous times of stress, some companies are now facing a government mandated shut-down in their businesses.

On a more positive note businesses are also likely to find more sympathetic bankers in 2020 than they faced in previous recessions, as well as massive government support. During the GFC,  the banks themselves were not well placed to help businesses, as issues with the global banking sector were at the heart of the crisis. The banks were de-levering their own balance sheets, while struggling to explain collapsed credit markets and the problems created by complex financial instruments to hostile politicians. Given that the shutdowns from COVID-19 are a temporary state of affairs and in light of the massive fiscal stimulus, we would expect the banks to give many struggling firms a degree of leeway over the next year.

 

 

Tuesday, 17 March 2020 15:02

Alibaba - why the smart money likes it

With the Chinese middle class population forecast to double to over 600 million over the next 5 years, which in turn increases consumer spending, it is not difficult to see why the ‘smart’ money is investing in Alibaba, one of China’s largest companies that is likened to Amazon, eBay, Paypal and Google all rolled into one.

Alibaba was founded during the 1990’s by Jack Ma who realised at that time China lacked technology in the business world.  Alibaba, now one of China’s largest companies, listed in 2014, and today is highly profitable with a market capitalisation of over US$580bn.  This is about 6 times larger than Australia’s largest company CSL.

Alasdair McHugh (Product Specialist Baillie Gifford) is attracted to Alibaba due to their very strong position in ecommerce transactions in China where their market share is over 60% by gross merchandise value and likely to rise further.  He also likes the fact that the original co-founder and visionary Jack Ma is still involved in the business.  

According to the China Ministry of Commerce, total retail sales across China increased 8% in calendar 2019, for a total of RMB 41 trillion (AUD $9 trillion).  Consumption contributed over half of China’s economic growth.  Online retail sales for the year was RMB 8.5 trillion (AUD $1.87 trillion) up 19.5% from the year before.  It is clear that consumption is now a major driver of economic growth in China, and online retail is an important driver of consumption growth. Alibaba’s dominant position means it is well placed to capture this growth.

The scale of the opportunity is extraordinary and underestimated by certain investors, particularly some from the west who still consider China as a risky emerging market.  But McHugh suggests that those who still treat China as an emerging market are overlooking the fact that the addressable market for Chinese consumer spending is 1.3 billion people.  

Illustrating this point was the recent ‘Singles Day’ held in November 2019 where another record was broken with total sales of RMB 268.4bn (approx. AUD $59.2bn).  Almost 1.3 billion packages were delivered by Alibaba from ‘Singles Day’ orders and of those 960 million were delivered within one week.  This is equivalent to 2.3 times the combined online sales of Black Friday and Cyber Monday in the US.  It reflects the strength of Alibaba’s digital economy and of Chinese consumers consumption power.

Joe Lai (Portfolio Manager Platinum Asset Management) says that “mobile monthly average users on Alibaba’s retail marketplaces in China reached 824 million in December 2019, an increase of 39 million from the previous quarter”.  

Beyond the ecommerce business, Alibaba operates the largest cloud computing business in China, Alibaba Cloud.  Many believe that this business can ultimately become the largest division within the company despite it presently representing less than 10% of overall revenue.  Revenue from Alibaba Cloud grew by 62% over the year to December 2019.

A fascinating aspect of Alibaba’s recent quarterly earnings update related to the company’s involvement in procuring and delivering 40 million units of medical supplies worth around AUD$100 million to Wuhan which has been impacted by Covid-19.  This shows a company that is so much more than an online retailer. 

Lai points out that “The Alibaba ecosystem keeps delivering new sources of value to shareholders.  Amid the Covid-19 lock down in China, Alibaba’s new enterprise communication app, DingTalk, has achieved new prominence.  Alibaba introduced a new digital health check in feature on DingTalk, which as at February 2020, had recorded more than 150 million daily health check ins.”

While currently investors are obsessing over Covid-19, Alibaba management said “17 years ago, the ecommerce business experienced tremendous growth after SARS.  We believe the adversity will be followed by changes in behaviour among consumers and enterprises and bring ensuing opportunities.  We have observed more and more consumers getting comfortable with taking care of their daily living needs and working requirements through digital means.” 

With the huge growth in China’s middle class and online commerce in coming years, combined with Alibaba’s dominance across retail, financial and computing businesses it’s clear to see why the company is in Platinum and Baillie Gifford portfolios.  Investors can of course buy Alibaba directly either on the Hong Kong or US exchange and can also gain access to it through managed global funds.

 

This article appeared in the Australian Financial Review during March 2020 - written by Mark Draper GEM Capital

The investment team from Montgomery's are pleased to bring you their latest edition of "Best of the Best".

 

In this edition they discuss:

 

  • Have low interest rates made assets too expensive?
  • Why Infigen should profit from our decabonising economy
  • What should we expect from the big 4 banks in 2020?

 

Download your copy by clicking on the report below.

 

Article written by Shane Oliver - Chief Economist AMP Capital

Coronavirus continues to rattle investment markets as the number of new cases outside China continues to rise posing increasing uncertainty over the impact on economic activity. And its impact has intensified following the collapse of OPEC discipline causing a further plunge in oil prices raising concerns about debt servicing for oil producers. From their highs global shares and Australian shares have had a fall of around 20%.

Source: PRC National Health Commission, Bloomberg, AMP Capital
Given the extreme uncertainty this note looks at various scenarios in relation to global and Australian economic growth and what signposts to look at in relation to how it may unfold.

Much ado about nothing or a major global catastrophe

It seems there are two extreme views on coronavirus. Some see it as just a bad flu and can’t see what the fuss is all about. Others think that it will trigger a major humanitarian and economic catastrophe killing millions and triggering a major global recession as excessive leverage is finally exposed. The optimist in me wants to lean to the former:

  • So far over 114,000 people are reported to have contracted the virus of which nearly 4000 have died. Of course, this number is still growing but in China where the number of new cases has collapsed (see the first chart) the number is 80,754 cases and 3136 deaths. In the 2017-18 US flu season alone 44.8m Americans got sick and 61,099 died.
  • The actual death rate from Covid-19 may be 1% or lower, rather than the currently reported rate of 3.5% because many of those who get the virus don’t get sick enough to seek medical help and so won’t be included in the case count. The Diamond Princess episode may provide a rough guide – all 3711 passengers and crew have been tested with 705 contracting the virus of which seven have died and most of those are believed to have been over 70. This would suggest a death rate of around 1% which is only just above that for regular flu for those over 65.
  • It appears to be less contagious than regular flu.
  • China’s experience shows it can be contained. Maybe this is due to extreme containment measures in Hubei that are not possible in other countries. But the case count in the rest of China has also been contained with less extreme measures and Singapore and Hong Kong have had some success in slowing new cases without extreme quarantining.
Source: PRC National Health Commission, Bloomberg, AMP Capital
  • Alternatively, at some point authorities outside China may just conclude that containment is impossible and, as the death rate is not apocalyptic, shift from containment to just treating those who get very sick. This could enable life to return to normal, albeit with a change in behaviour - less handshaking, frequent handwashing and wearing a mask. 

But I also must concede I just don’t know. There is much that is unknown about the virus itself and how long it will continue to spread. And even if there is a switch to just treating the very sick it’s unclear there will be enough hospital beds. And there is also the human or behavioural overlay which is intensifying the economic impact. Just look at the toilet paper frenzy to see that this can have a real economic effect even before the virus has really taken hold in Australia. While there may be a boom in demand for hand sanitisers, toilet paper and long-life food, this will be a temporary boost as the spread of the virus globally and the disruption that containment measures are causing is continuing to increase the risk of a longer and deeper hit to economic activity. And there is a risk of secondary effects as the short-term disruption risks leading to business failures and households defaulting on their debts if they can’t keep up their payments and so causing a deeper impact on economic activity. The secondary effects of the coronavirus outbreak and its flow on is highlighted by the 45% collapse in oil prices since mid-January. Ultimately lower petrol prices will be a good thing as this will boost consumer spending when the virus goes away but for now all the focus is on the downside of lower oil prices – debt problems and less business investment by producers.

Base case versus global recession and beyond

Given all these uncertainties it’s still too early to say that shares, commodity prices and bond yields have bottomed. The following charts present three scenarios for the global economy: 

  • How we saw global growth panning out prior to the virus. Basically, we were expecting a mild pick-up in growth.
  • A sharp downturn centred around the March quarter as the Chinese economy contracts sharply but rebounds in the June quarter offsetting recessions in developed countries including in the US. This is our base case.
  • A worse case downturn that sees global growth contract in the March quarter (led by a sharp contraction in China) and the June quarter as (as developed countries get badly hit) resulting in a global recession to be then followed by a rebound as life returns to normal led by China.

Note: the scenarios show quarterly annualised growth. The key is to focus on the pattern of growth rather than the precise level.

Source: Bloomberg, AMP Capital
 
The next chart shows three scenarios for Australian growth:
  • How we saw global growth panning out prior to the virus.
  • Mild downturns in the March and June quarters driven initially by the lockdown in the China and then the coronavirus flow on to the rest of the world and Australia, followed by a second-half rebound. This is our base case.
  • A worse case downturn that sees deeper downturns in the March and June quarters then followed by a rebound as life returns to normal.
Source: Bloomberg, AMP Capital
 
Last week we moved to forecasting a recession for the Australian economy in our weekly report. We were already expecting a negative March quarter on the back of the bushfires and the hit to tourism, education exports and commodity exports from the slump in China. But the spread of coronavirus globally and in Australia has made it likely that we will also see a contraction in the June quarter too. As with the global outlook this should really be “a disruption” that will pass once the virus runs its course - hopefully at least as the Northern Hemisphere heads toward summer. The worse case scenarios would likely see a deeper decline in shares and bond yields.

What to watch?

Shares will bottom when there is confidence that the worst is over in terms of the economic impact from the virus and its largely factored in. So, the debate is largely now about how big the hit to growth will be and this relates to how long the virus will weigh on global growth and any secondary effects it may cause. In this regard the key things to watch are as follows:

  • A peak in the number of new cases – as per the first chart.
  • News of successful vaccines or anti-virals.
  • Whether governments switch from containment.
  • Timely economic indicators, eg, jobless claims and weekly consumer confidence data in the US and Australia.
  • Measures of corporate stress, eg, spreads between corporate bond yields and government bond yields. 
  • Measures of household stress, eg, unemployment and non-performing loans.
  • Measures of market stress, eg, bank funding costs as measured by the gap between 3-month rates and central bank rates. These have risen but are well below GFC levels.
Source: Bloomberg, AMP Capital

  • The monetary and fiscal policy response – this will be critical in terms of minimising the impact on vulnerable businesses and households from the coronavirus disruption, ensuring financial markets remain liquid and driving a quick recovery once the threat from the virus is over. So far so good with policy makers moving in the right direction (rapidly so in Australia it seems) – but there is a fair way to go. 

What does it all mean for investors?

The rapidity of the fall in share market has been scary. In our view the key things for investors to bear in mind are as follows: 

  • periodic sharp falls in share markets are healthy and normal. With the long-term trend ultimately remaining up & providing higher returns than other more stable assets. 
  • selling shares or switching to a more conservative investment strategy after a major fall just locks in a loss. 
  • when shares fall, they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities the pullback provides. It’s impossible to time the bottom but one way to do it is to average in over time.
  • while shares have fallen, dividends from the market haven’t. Companies like to smooth their dividends over time – they never go up as much as earnings in the good times and so rarely fall as much in the bad times. 
  • shares and other related assets bottom at the point of maximum bearishness, ie, just when you feel most negative towards them. 
  • the best way to stick to an appropriate long-term investment strategy, let alone see the opportunities that are thrown up in rough times, is to turn down the noise.  
Page 1 of 28