Against a rapidly evolving macro backdrop, we thought it would be prudent to provide investors with a brief update on how the Montgomery Small Companies Fund (MSCF) has positioned itself and to share our thoughts on the risks and opportunities that we see ahead of us.
Our view on COVID-19
The COVID-19 pandemic has forced many countries to take unprecedented measures designed to flatten the outbreak curve and relieve pressure on their healthcare systems, such as closing borders and shutting down many non-essential activities. This shutdown could last for a protracted period, perhaps 6 months or even more, and will most likely tip the global economy into recession and result in widespread job losses. The key questions from here will be how deep and for how long? A V-shaped rebound looks off the table with a U-shaped recovery increasingly more plausible. Credit markets will be closely watched for signs of freezing over.
In response, Central Banks are slashing rates and providing liquidity to cushion the blow while Governments’ near-term efforts remain focused on fiscal stimulus packages aimed to support those industries most impacted and maintain employment. This way, economies will be shielded to some extent and hopefully best placed to participate in the upturn when it comes, as it will.
The situation is fast moving, with a rapidly escalating case detection rate in large Western economies. As governments increase COVID-19 testing cadence in response to the growing case burden, we expect the scale of the infection cases to grow. At this early stage what has become clear to us is that the more you look, the more you find.
The burden of health systems consequently becomes more apparent, lifting angst and fear levels within populations. Recent Government announcements appear to be preparing their citizens for this. Governments are, however, mobilising now, some faster than others, and are marshalling impressive resources to mitigate the virus impact on populations and its economic impact.
Montgomery Small Companies Fund Positioning
As small cap investors, our job is to identify the best investment opportunities we see in front of us and to manage risk appropriately, which includes preserving capital. Although we expect the recent sharp sell-off to present some outstanding money-making opportunities over the medium-term, for now we have positioned the portfolio relatively defensively.
In late February, we became alarmed that the US was downplaying the risks of a COVID-19 pandemic, despite what was happening in Europe. Consequently, we began to prepare our portfolio defences, first by lifting cash levels, exiting February at 16.9 per cent. We sold out of stocks in sectors we considered to have primary or first order exposure to virus impacts, like travel and international education. By early last week, we had moved up to 30 per cent cash. We got there by removing or reducing stocks we regarded as the next level of direct exposures, such as retail, media, businesses requiring financial market funding or those with weaker balance sheet positions. We also cut our exposure to smaller, less liquid companies to improve the overall liquidity of the portfolio.
Today we hold roughly 35 per cent cash and we believe the portfolio is relatively well positioned to manage the downturn as we see it today. More than 30 per cent of the portfolio is invested in companies with market caps in excess of $1 billion and another 20 per cent above $500 million (only 2 per cent in sub $250 million market cap bracket).
We will continue to make changes on a dynamic basis as you would expect us to. We will undoubtedly have investments that will have problems that we haven’t foreseen, but overall, we feel the portfolio is now positioned to take advantage of the many opportunities that are now presenting themselves. We have the cash firepower and flexibility to make those decisions when the time comes on terms which we ultimately expect to be beneficial for the fund.
Some of the significant investment exposures include:
Although we are defensively positioned today, we are constantly monitoring the news flow so we can best take advantage of the stock opportunities when they present themselves. We acknowledge that timing markets perfectly is very difficult. We don’t expect to get this exactly right.
Much internal research and deliberation is focussed on what signposts will ultimately guide our decision to redeploy capital, into the best risk-reward opportunities . Some of these signposts include COVID-19 case, fatality and recovery rates and evidence that the shutdown measures have managed to effectively slowdown the virus, as well as the success of fiscal and monetary policies in stabilising economies.
We are also working on a shopping list of stocks we want to own when the outlook improves. There will be some great opportunities to buy high quality growth companies at really attractive valuations. Select global growers will likely maintain a strong earnings growth trajectory and will also benefit from a weaker Aussie dollar. The next level of opportunity will be the beaten-up cyclicals with strong competitive positions and improving outlooks as the cycle recovers – mining services and retail comes to mind, and eventually the surviving travel and tourism stocks will recover. Then there will potentially be opportunities to participate in deeply discounted recapitalisations of good businesses which were caught out with over levered balance sheets. Finally, as risk sentiment improves, some of the earlier stage companies will present really attractive investment prospects.
The portfolio is structured for capital preservation today and to provide flexibility to take advantage of opportunities to come. We don’t know what will happen tomorrow but expect every one of our portfolio companies to be able to operate under the conditions ahead.
We will continue to keep you updated over the days and weeks ahead in what have been very challenging times for all investors. Wishing you good health.
Dominic Rose & Gary Rollo.