18 Mar 2020

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Four criteria we are considering before buying shares in this market

With the Australian market in freefall, readers and clients alike have asked us where we are looking to invest. While we continue to monitor the fluid situation closely, we have established some key criteria that we would look to satisfy in anticipation of a potential recovery.

Over the past few weeks, the term “coronavirus” has well and truly entered the world’s lexicon, devastating populations, exposing weaknesses in health systems and global supply chains, and putting a halt to broader economic activity. The equity market has for the large part reflected the uncertainty faced by investors, with some of the most significant one-day falls and intra-day swings we have experienced in the history of financial markets (-8 per cent to +4 per cent on Friday, 13 March comes to mind).

While The Montgomery Fund has not been immune, we have held a significant cash balance in the fund on the potential for a less benign coronavirus outcome than investors initially anticipated – which it would now be fair to say is worse than our initial, more cautious assessment.

However, with the Australian market down approximately 30 per cent from its recent peak at time of writing, many of the questions we are fielding from investors are focused around what we are looking to buy (which may be a sign that wide-spread capitulation has yet to occur!). While not exhaustive or prescriptive in nature, the following categories are the types of businesses that we are presently focused on, with a view to investing on a 12-18 month time-frame:

  1. Quality companies with strong business fundamentals without structural impairment due to coronavirus – that is, the slowdown represents missed or delayed earnings, rather than impaired earnings
  2. Asset backed companies with latent capacity that will recover over the course of time – many of these have balance sheet leverage, but we expect banks to prioritise high quality assets with significant moats in their financing decisions over other weaker businesses
  3. Companies where competitors may / will suffer from a prolonged shutdown, providing medium term opportunity for these companies to capitalise on weakness
  4. Companies that will survive the downturn and should be well positioned in a recovery – these businesses are either economic sensitive, or more impacted as a feedback loop, but given the fall now appear more attractive on medium term return expectations

While it remains very early days in the evolving coronavirus crisis, the sharp falls in equity markets suggest investors are starting to price in the disruption to the economy. Financial system stability will remain top of mind in the short term, but it is our view we are yet to see significant second-order impacts to the economy, with first-order impacts – that is travel, education, hospitality bearing the initial brunt of changes to human behaviour.

However, we continue to seek quality opportunities that meet the above criteria should selling become indiscriminate given the potential for these businesses as the world “returns to normal”.

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