M O N T G O M E RY IN V ES T M E NT MA NAGE M E NT

I nvesting in pandemic
markets
It’s obvious to say we are living through unprecedented times. It’s perhaps less obvious
that while the circumstances might be different, the human response in investment
markets is surprisingly similar, and some situations even a little predictable. To begin with,
forecasting a virus would be the pin that ultimately popped the bubble in asset markets –
no one predicted that.

In this note, I will discuss the factors that led us to being out of step with the market and
raise cash in our portfolios. And perhaps with a little pride, I will also discuss the thought-
leading research that our team has been conducting and their in-depth analysis of the
spread of COVID-19. Our thinking should help our investors navigate and prosper
through the recovery.

By Roger Montgomery
Montgomery Investment Management
April 2020
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We did spend a great deal of time last year warning In point of fact, the Coronavirus pandemic struck at the
that asset markets were stretched, very late in their cycle time of the second most overvalued U.S. stock market
and seemed disengaged from reality. Unfortunately, ever.
while it is our sincere hope that investors heeded those
warnings, we did look very out of step with the roaring In Australia, the story was very similar. The S&P/
prices at the time. ASX 200 Industrials Index, excluding financials was
trading on a record earnings multiple of almost 27
Stuck with the one per cent returns on cash balances, times. On its own, that may not have been a problem,
investors migrated to equities for their superior yields remembering that interest rates had declined steeply
and hoped-for capital gains. What was forgotten in the to record low levels. The issue was consensus earnings
mad dash for a better return, was that ‘one per cent is estimates were in decline.
better than minus twenty’.
Meanwhile, and since June 2019, one-year forward
earnings per share estimates for the ASX 300 had been
To be fair, the conundrum declining. In the absence of a resurgence in economic
for investors last year was that growth, the combination of rising prices and falling
earnings has rarely ended well. In 2019 and in early
cash had been so painfully 2020 investors were paying more for many companies
(both high and low quality), and failed to appreciate
poor at generating a return their fear of missing out caused them to adopt more
risk.
that's acceptable, many felt
forced to take on more risk. We didn't predict COVID-19. Although we were aware
of it in mid-January. My family and I returned from
To our minds however, overseas in mid-January wearing face masks but were
the only Australians on the flight doing so, nobody was
investors hadn't really talking about it at that time. When we were discussing
appreciated the extent of the all the scenarios that might pop the bubble, we didn't
know it would be COVID-19.
risks they were adopting. The basic ingredients of a bubble were in place
Markets were expensive with investors betting on ‘potential’ rather than
‘proof.’ The US market was irrationally expensive
To begin with the U.S. market had been extremely and we saw extreme valuations here in Australia,
expensive for some time. As Figure 1 demonstrates, the along with declining earnings. We were witness to a
US S&P500 index was trading on a Cyclically-Adjusted retail recession in Australia as well as a collapse of
Price to Earnings Ratio (CAPE) of more than 32 times residential construction activity. Then, in Australia, we
in January 2020. To put this in perspective, an investor experienced the personal devastation the bushfires and
could look all the way back to the year 1870 and find subsequent floods wrought.
only one instance when the market was even more
expensive, and that was during the Tech Bubble of
1999-2000.

Figure 1. S&P500 CAPE RATIO 1870 – 2020

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Private Equity – a nail in the coffin Figure 3. Boom in Private Equity dwarfs even
stretched public markets
Whenever you see an already-established industry
growing at rates much faster than the broader economy
or the population, it is relatively safe to assume that
pace of growth is unsustainable. Growth simply cannot
continue at rates well in excess of the underlying
economy or population, lest the industry becomes the
economy.

When one observes sustained accelerated growth, it is

reasonable to ask whether a bubble exists.

Since the Global Financial Crisis, we observed the

same unsustainable global expansion in the number
of Private Equity firms hanging up their shingle. Of
course, once the shingle is hung, ‘private equiteers’
need to raise money, and once they raise said money,
that money needs to be deployed. The consequence
has been a rising number of deals as shown in Figure Source: World Bank; Preqin
2. And thanks to the rising competition from the
boom in Private Equity firm numbers, those deals were One might ask, why a bubble in global private equity
conducted at an ever-increasing multiple. should be a concern for Australian equity investors? As
we outlined last year in The Australian, there were two
Figure 2. Private Equity boom – number of firms expensive issues; first, the belief that all private equity-
and number of deals backed companies, especially the 83 per cent that
lost money, are worth owning because they will all be
winners, is a flawed proposition that has defined many
past bubbles. And the second was that private equity is
an illiquid asset class. Consequently, if a high net worth
investor, a super fund, a sovereign wealth fund or an
endowment fund, invests in private equity, a rapid exit is
unlikely if, for whatever reason, one decided to do so.

We were unable to predict

what might trigger a broad
desire to exit asset markets,
but an investor wanting to
take risk off the table, and
unable to redeem from their
private equity investments,
would have to turn to more
liquid markets to do so.
In turn, the massive collective investments in Private
Source: World Bank; Preqin Equity’s hands, meant that any amplified desire for
liquidity would put pressure on public markets. I believe
The boom in private equity firms coincided with, and some of the extreme volatility we are witnessing is a
was a consequence of, ultra-low interest rates on cash function of both an information ‘vacuum’ and
that nobody wanted. As more private equity firms an alternative for the very heavy investment
incorporated, and more deals were conducted, the accumulated in less liquid markets over the last
rising multiples begot more inflows and a self-fulfilling decade.
spiral up began. The result has been that while US
public equity markets have, on average, tripled since
2002, net assets in private equity hands have risen
eight-fold (Figure 3).

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 The response have always been found. Those focused on quality
and value find that opportunities are therefore greatest
Our response to the above concerns, was threefold: when that which is temporary is treated as permanent.
This too will pass.
• First, maintain ‘quality’ as a priority and avoid the
highest risk companies – those with prices reflecting In today’s crisis we observe that a government can
‘potential’ rather than ‘proof’. ‘stimulate’ their way out when citizens are worried
• Second, actively move to reduce the beta, or the merely about the economy. When investors or
measurable ‘riskiness’, of the equity portion of consumers are worried about their health however,
the portfolio. Reducing the beta of the portfolio no financial incentive can encourage people to
involves moving out of riskier and more volatile spend and take risk with their wellbeing. Queues of
companies and into companies perceived as more people awaiting social security payments will rekindle
stable or defensive within our Quality, Value and memories of depressions and instil even more fear but
Prospects framework. these too are common to recessions.
• And finally, we also raised the proportion of cash
in the portfolio. At the beginning of 2020, The
Montgomery Fund held almost 20 per cent cash, Today, it is the market’s
and as the issues around Coronavirus became
more serious, The Fund moved to more than 30
realisation that concerns
per cent cash. At the time of writing (31/03) The
Montgomery Fund holds approximately 33 per cent
about health can have more
in cash. serious and potentially
As an aside, and coincidentally, this is a similar level lasting consequences for
to the cash held and disclosed recently on the balance
sheet of Warren Buffett’s Berkshire Hathaway.
the economy, that have
Our process, built on the back of our combined
exacerbated the market’s
experience of previous market dislocations, resulted in declines.
the avoidance of the higher-risk WAAAX growth stocks,
and their peers, in 2018 and 2019. This correction is therefore different to the Global
Financial Crisis, different to the TechWreck of 2000,
While this decision put us out of step with the market, and it's different to the corporate debt-inspired crash of
out of step with investors and left The Montgomery 1987. But in many respects, it is the same. It is a crash.
Fund’s performance lagging, it has since rewarded the Importantly, several of us here at the Montgomery office
patient. Value investing has worked for decades and have invested through those periods, and we know that
we expect in the future it will again journey through the long-term reality is not as frightening as the short-
scorn, contempt and derision but patience is all that term panic inspires. Humans, it should be remembered
is required to demonstrate its handiness. Frequently are adaptable and resilient. As I said a moment ago,
and somewhat predictably, investors forget how far the this too will pass.
shares of a company with no earnings can fall. This is
especially true when over a decade has elapsed since One Australian fund manager, and a friend of mine,
the last serious correction. Ignoring the unbridled noted, "We're likely to see a near total shutdown of
enthusiasm and euphoria has however helped shield the world." It sounds really, really frightening. But as a
our investors wealth from the worst of the recent value investor such sentiments should be welcomed.
declines. Yes, it does inspire fear, and losses mount as people
panic, but those declines in share prices also provide
Is this correction different? the opportunity for those with cash.

Invariably, different triggers and nuances accompany A few reminders

each crisis and market dislocation, but each is
ultimately accompanied by an information vacuum that Remember cash is most valuable when nobody else has
produces a correction. Importantly, every correction any.
is also fed by a fear that no solution will emerge,
that capitalism or even humanity is at risk. Truthfully, In reality, there won't be a total shutdown of the world.
there are equities that benefited from a misallocation Let's remember that China and many Asian economies
of capital during the preceding boom, when the are operating, re-scaling their operations and
aforementioned potential was valued more highly than economies again. While liberal Western democracies
the proof. For investors in many of those companies, a are only just entering a period of rapid detection
permanent loss of capital will be experienced. But it is rates and fatalities, and while markets are surprised,
worth remembering that corrections tend to conclude remember again, this too will pass.
before a solution is broadly declared, and solutions

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China may already be showing us that steps can be "There is really nothing to worry about”, “More people
taken to contain the virus and stop its spread. Soon, die from the flu” and “not many people are dying – it’s
I expect countries currently experiencing parabolic not that bad” reflected misplaced security and simply
growth rates of infection to slow those growth rates. stemmed from a lack of testing.
Then the panic will abate.
We were confident, indeed almost certain, that delays
We always thought the panic would be worse than to testing and its subsequent scaling in Western liberal
the pandemic. It’s hard to be surprised by something democracies would reveal a surprising number of
expected. cases. We also believed that Western sensibilities might
prevent, or at least delay, the draconian but effective
As Figure 4. illustrates, The Montgomery Fund has lockdowns seen in the East.
done a very good job of capturing more of the upside
in months where the market has risen, and far less South Korea obviously, has been the poster child for
of the downside in months where the market has testing and controlling this disease.
declined.
Figure 5 is what we refer to as The Government
In fact, since inception, The Montgomery Fund has Competence Index. It illustrates the amount of testing
captured an average of 81 per cent of the gain in being conducted per capita in each country as at
months the market has risen, and just 64 per cent of March 31, 2020.
the declines in months when the market has fallen.
That is a function of the lower beta of the equity part What really worried us or what did worry us the most in
of the portfolio, and also the fact that we've had the February and early March is, the very little testing that
flexibility to hold cash. had been conducted in the United States. More on that
in just a moment.
Figure 4. The Montgomery Fund Upside-
Downside Capture Figure 5. Covid-19 Government Competence
Index

Source: Morningstar Source: The COVID Tracking Project, Montgomery

Coronavirus and COVID-19 South Korea

I'm very proud of the work our team at Montgomery Table 1. South Korea Experience (data to 01 April
have conducted on the spread of the virus and its 2020)
likely impact on markets. While many other investors,
early in the Coronavirus outbreak, were focused on Tests 404,962
fatality and detection rates, we actually went one step
further than that, and we were following testing rates. Cases 9,887
Testing rates are most important. If testing isn’t being Deaths 165
conducted, cases won’t be found.
Test per mn of population 7,899
What we found early explained why investors were Detection rate 2.44%
so relaxed. The West wasn’t scaling up testing and
consequently wasn’t discovering many positive cases. Current fatality rate 1.67%
And where testing was being conducted at scale,
such as in Wuhan and South Korea, Western financial
markets were less concerned. Comments such as;

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 South Korea were very successful in controlling the The outbreak in Italy wasn’t surprising. Nor are we
outbreak. And the reason why is, they started testing surprised to find that the detection rate was so much
very early. That in turn was probably a function of their higher than South Korea. The reason for that is very
geographic proximity to China. They also had a death simple; Italy took a long time to start testing and that
cult spreading the disease. And so it was relatively gave time for the virus to spread. Italy only commenced
obvious to them that they needed to get onto it quickly. testing in earnest in mid-February. As of 31 March
2020 the country had conducted 506,968 tests. Italy’s
Moreover, South Korea tracked everyone's mobile cumulative detection rate is now almost 21 per cent,
phones. Once a COVID-19 positive case was found and the fatality rate is 11.7 per cent. Consequently,
the country was able to take information from the Italy is in a much worse predicament than South Korea.
individual’s mobile phone and find out precisely, using And we believe Italy’s experience may be reflected in
GPS, how many other mobile phones were in close the United States.
proximity and where over the previous 24 hours. Within
24 hours, employing the military, South Korea had not United States
only quarantined the person who presented as unwell,
but every other person that person was in contact with. Our most shocking discovery in the very early days
of February was that despite the United States having
As of 1 April 2020 South Korea, a country of a population of 330 million people, they were only
approximately 50 million people, had conducted conducting an average of 40 tests per day, on average,
404,962 tests, with 9,887 tests returned positive. through January.
And because testing commenced early, only 2.4 per
cent of all tests conducted returned positive results. In February, they lifted that to an average of 92 tests per
Of the 9,887 confirmed positive cases, while it's day. I'm not joking, this was the total number of tests
tragic that 165 people have actually passed away, being conducted in the United States for COVID-19,
it's encouraging that it's less than two per cent of all out of 330 million people.
positive cases.
Our thesis was a pretty simple one. The United States
Testing early and testing hard worked. That is not would eventually ramp up their testing and when they
something we expected from Western liberal countries did, as they late as they did, they would be shocked by
who were apathetic and unprepared. their detection rates – the number of people confirmed
as positive – and also their fatality rates. The market
Italy was blissfully unaware of this in early February.

Table 2. Italy’s Experience (data to 31 March As of 31 March 2020 the US is witness to 17.6 per cent
2020) detection rates and the market now fears that rate is
going to rise materially, in coming weeks.
Tests 506,968
As Figure 6 demonstrates, the U. S’s handling of
Cases 105,792 Covid-19 can only be described an abject failure.
Deaths 12,428
Figure 6. United States – growing fast from a low
Test per mn of population 7,468 base and a very late start
Detection rate 20.87%
Current fatality rate 11.75%

Italy was always going to be the poster child for

Western liberal democracies and ultimately fed into
our understanding of what would happen in the United
States, which in turn, would drive markets globally.

That's why we wanted to follow Italy when the virus

broke. And why did it break out in Italy? Italy, and
in particular the Lombardy region, has a very high
concentration of Chinese manufacturing firms with
Chinese workers pursuing that coveted ‘Made in
Italy’ label. Consequently, there's a lot of Wuhanese
businessmen and women moving between China to Source: The COVID Tracking Project, Montgomery
Italy.

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Will hot temperatures help?
Holding cash when everyone else wants cash but
One lingering hope is that warm temperatures in the doesn’t have any is when opportunities can be taken
summertime will slow down the spread. advantage of. Comments about the world ending or
this being Armageddon or a great depression, feeds
A simple way to test this theory is to plot growth rates into that vacuum pushing prices down even further.
against temperatures.
Stage Two
In Figure 7. below we plot growth rates against the
Earth’s latitude. Latitude on the horizontal axis, and Stage Two, sees a little more rationality appear at
growth on the left-hand side of the virus. You can see the same time companies start raising money and
Malaysia and Singapore very close to the equator, pulling their guidance. In Australia, toilet rolls may
hot countries, and still very high growth rates for start appearing back on supermarket shelves and
Coronavirus, slower than some of the Nordic countries, remain there. The hoarding slows and the financial
but nevertheless still growing. So, it might not stop out market panic eases along with the volatility. Once the
of the spread of the virus. market realises humanity will survive, a more rational
assessment of the impact on the economy starts to
Figure 7. Equatorial temperatures and COVID- occur. Obviously, we're going to see revenues cut
19’s growth rate deeply. We know that even for high-quality companies
we like, their earnings and revenue will be impacted for
the 2020 calendar year.

Assume revenues of zero. Modelling will remain difficult

for many months but we are less concerned about very
short-term revenue and earnings because our investing
time horizon is much longer.

We are going to be targeting those companies that

have sufficiently strong balance sheets, can endure a
year of zero revenue, and don't need to recapitalise
their balance sheets.

We might even look at companies that do need to

recapitalize, but only at deeply discounted prices. As
an aside, one of the observations we can make is
that market bottoms often coincide with a round of
Source: The COVID Tracking Project companies engaging in deeply discounted rights issues.
We have already seen Webjet, Flight Centre and Ooh
You can follow our latest COVID-19 testing Media approach the market for capital. The longer
analysis and tracking via our website and deeper the economic slow-down the more we are
and the range of commentary posted at: going to see capital raisings and bail-outs.
rogermontgomery.com
Stage 3 and the Reserve Bank of Australia
Opportunities
Stage Three, could be steep and deep or relatively
So what are the possible opportunities? What's the path benign. The magnitude of the third stage depends on
forward from here? the extent of the recession and the degree to which
credit supply for corporates is impacted. In times of
Stage One crisis, liquidity is everything.

Firstly, let's think about a framework for a crash. Stage We saw the Reserve Bank of Australia (RBA) throw
One is almost complete, and that is accompanied by everything it had at markets reassuring participants that
an unwinding of the growth premium that was built into liquidity in Australia is not going to be an issue.
prices prior to the correction commencing and reflected
in those WAAAX stocks referred to earlier. The RBA cut its target cash rate to 0.25 per cent to
encourage banks to further drop borrowing rates for
Also accompanying Stage One is the market being businesses and households. The RBA also commenced
shocked by the extent of the infection. We think there's purchases of Australian Government Bonds to maintain
some of that to go in the United States. Markets are a three-year government bond yield of only 0.25 per
currently in an information vacuum, and when investors cent, and reducing the cost of longer-term, fixed-rate
don't know how serious the situation could become, business and household loans (which are partly priced
that's when asset prices overreact. off three-year government bond yields).

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The RBA is also reported to have offered banks a There will come a point in the future, where the World
longer-term funding facility of a minimum A$90 Health Organisation announces that the Coronavirus
billion on a three-year basis at 0.25 per cent. Finance danger is over. There's also the very real possibility of a
for individuals and companies will remain cheaply vaccine. And when those things happen, there's going
available. Finally, the RBA, along with the Australian to be a lot of pent up demand for travel. Sydney Airport
Office of Financial Management (AOFM) will launch should be a beneficiary. And we have seen the Federal
an AOFM-managed A$15 billion direct investment Government propose a funding package to help
program in residential mortgage-backed securities second tier airlines. Clearly, they don't want Qantas to
(RMBS) and asset-backed securities (ABS) helping to be a monopoly airline in Australia. That's not good for
ensure functioning liquid markets. consumers. And two domestic carriers are very useful
for Sydney Airport.
The Montgomery Fund portfolio positioning
Now, in terms of where we've decreased our
In terms of our positioning, we have a high cash weightings, we reduced our holding in Aristocrat.
weighting and we are delighted that we've entered Obviously, there's going to be fewer people attending
this period with all of that cash. That's certainly casinos because of the bans on them, particularly in
helping to protect on the downside. But perhaps Australia, and the United States.
more importantly, for new investors in our fund, it
means that we're going to be able to deploy that cash We've also reduced our holding in Westpac and
into new opportunities at lower prices. And keep in in Macquarie bank as well, simply because we're
mind, that for The Montgomery Fund, because we've a little concerned about the impact of financial
underperformed for a period of time by sitting out the market stress on liquidity for now. While the RBA/
bull run, we've got to catch up that under performance APRA announcements alleviate some of concerns
before there's a performance fee to be paid. domestically, we want to obtain a little more comfort
about global developments.
In terms of sectoral exposures, we note the banks
make up 27 per cent of the index, and The In closing
Montgomery Fund currently has approximately five per
cent of the portfolio exposed to the banks. We believe In conclusion, this crisis will pass like all others before
this will change in the future however we need to be it. At Montgomery, we’ve not only been dynamic with
confident that credit and market liquidity concerns will our cash holdings, we've also been very dynamic with
abate. adjusting the beta of the equity part of the portfolio.
Prior to the outbreak of Coronavirus, we'd been
We also have very low exposure to consumer reducing the beta of the portfolio by increasing the
discretionary, and low exposure to consumer staples. portfolio's exposure to larger stalwarts and reducing
The retail recession in Australia has been something exposure to relatively higher beta stocks. You can
we anticipated since our analysis suggested a collapse expect that to reverse in the future as we seek to gain
in residential housing construction led by a precipitous exposure to, and leverage, the recovery.
drop in approvals last year.
At precisely the same time that everybody else thinks it’s
We've recently increased our weighting to CSL. CSL time to bail out, we’d like to be ‘bailing in.’
is a high-quality global franchise, has a superb
balance sheet and people are still going to need We’d like our supporters to be thinking likewise and
plasma. Indeed, plasma could actually be a source speaking with their clients about adding to their
of assistance for COVID-19 patients if antibodies are investment in Montgomery.
harvested from survivors.
My sincere best wishes for the next year or two.
Telstra is one of our largest positions. The internet is Navigating it well will set up portfolios and wealth
likely to be the last service that people will cut off, if outcomes for the next decade.
they're required to work from home or self-isolate. And
there is a longer-term thesis for Telstra, and that's 5G.

We have recently added Sydney Airport to the

portfolio. It is thick in the COVID-19 crisis and
investors might be concerned but the company owns
a monopoly asset. Yes, Sydney Airport will suffer a
hit to revenue and earnings, there's no doubt about
that – let’s assume zero. We however anticipate that
its capacity will be filled very quickly in a recovery. We
think travel will bounce back reasonably quickly thanks
to pent up demand from a still ageing population.
Many families separated by the virus will rush to
reunite.
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Do you want to get in contact with the team at Montgomery?

Private Clients: Please call David Buckland or Toby Roberts on 02 8046 5000 or visit our website www.
montinvest.com

Advisers/ Researchers/ Consultants: Please call Scott Phillips (NSW) on 02 8046 5005
or David Denby (VIC, TAS, SA) on 0455 086 484 or Michael Gallagher (QLD) on 0409 771 306 or Dean
Curnow (NSW, ACT, WA) on 0405 033 849.

Important Information
This document has been prepared by Montgomery Investment Management Pty Ltd (ABN 73 139 161 701) (AFSL 354 564)
(Montgomery).
The information provided in this document does not take into account your investment objectives, financial situation or particular
needs. You should consider your own investment objectives, financial situation and particular needs before acting upon any
information provided and consider seeking advice from a financial advisor if necessary.
Future investment performance can vary from past performance. You should not base an investment decision simply on past
performance. Past performance is not an indicator of future performance. Investment returns reviewed in this document are not
guaranteed, and the value of an investment may rise or fall.
This document is based on information obtained from sources believed to be reliable as at the time of compilation. However, no
warranty is made as to the accuracy, reliability or completeness of this information. Recipients should not regard this document as
a substitute for the exercise of their own judgement or for seeking specific financial and investment advice. Any opinions expressed
in this document are subject to change without notice and Montgomery is not under any obligation to update or keep current the
information contained in this document.
To the maximum extent permitted by law, neither Montgomery, nor any of its related bodies corporate nor any of their respective
directors, of cers and agents accepts any liability or responsibility whatsoever for any direct or indirect loss or damage of any
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