Adjectives used to describe the past 12 months are losing their meaning; unprecedented, tragic, volatile, worrisome, and so on. Throw in some comments about the extraordinary levels of monetary and fiscal stimulus and there you have 99% of the commentary that will review this amazing period.

We do not know what the future looks like but we are optimistic. Worst-case health and economic scenarios, forecast by some, have not eventuated in Australia. Let’s hope that continues.

Rather than making vague prognostications on what the future holds or predicting how stock markets will react, we wanted to share some insights from our investment experience and outline how this shapes our process and, ultimately, our portfolios especially with the current covid-19 backdrop.

Management and capital allocation

It has been said that we only get to judge the quality of management decisions made during the good times after the cycle turns and the ‘tide goes out’. The tide certainly went out over the early part of this year. Whether it be the need to write down acquisitions purchased at the top of the cycle, repair balance sheets with dilutive equity raisings and dividend cuts, or jettisoning assets that are now ‘non core’, the recent market dislocations have shone the spotlight on management decisions made over the past cycle.

Assessing the quality of management teams is a central component of the Airlie investment process. There are many factors we use to do this but, ultimately, we look to invest the money of our clients in companies run by executives who we trust and view as highly competent. Furthermore, we think that management teams can influence the creation of shareholder value through their decisions on capital allocation.

Below we present two examples that illustrate the shareholder wealth management teams can create when they allocate capital with skill and insight.

It doesn’t matter until it matters… and it has really mattered this year so far!

Not only did Wesfarmers management adeptly capitalise on the final stages of the bull market to sell assets at good prices, it built resiliency and optionality into the balance sheet heading into the downturn. This contrasts with how the Wesfarmers balance sheet was positioned during the global financial crisis and should bode well for the company’s ability to make value-accretive transactions at attractive prices.

This focus on the balance sheet and a company’s financial strength is another central component of the Airlie investment process. It helps us identify both opportunities such as Wesfarmers, and avoid 'value traps' whereby valuations may seem appealing but, with the wrong level of debt for the business model, a company is unable to consistently generate adequate cash flow and returns for shareholders.

Corporate debt levels haven’t seemed to matter to the market over the last few years and some management teams have been lured by cheap debt to fund buy-backs or increase dividend payouts. The economic impacts of the covid-19 health crisis have quickly changed the market's view on the importance of financial strength. Figure 4 shows the outperformance of those stocks in the ASX 200 Industrials index with low financial leverage in March and April 2020. Our focus on financial strength has helped our portfolio through this period.

Figure 4: Outperformance of stocks with low financial leverage in March and April 2020

ASX 200 Industrials Total Return by Net Debt to EBITDA

Source: MST Marquee, Airlie Funds Management

As a result of the economic impacts of the covid-19 crisis and the market's renewed focus on financial strength, we have seen over A$20 billion of equity capital raised on the ASX in the past four months to repair balance sheets. However, we believe that it is not only in the short term that financial strength matters. Over the long term, companies that are able to fund their operations, including growth, from internally generated cash flows tend to outperform those that repeatedly need to come to the market to raise equity. This collection of companies that repeatedly require new equity capital, or 'equitisers', have underperformed by 9% p.a. relative to low equitisers on the ASX over the past 20 years. These decisions about how to fund the business tie back to management decisions on capital allocation.

Figure 5: Long-term outperformance of companies with low levels of 'equitisation'

Source: MST Marquee, Airlie Funds Management

We are ultimately optimistic, even though we are unable to predict the future. The government and community response in Australia has kept us in relatively good shape. We are mindful that in the very short term, government policy responses will be key to both the health and economic outlook. Currently in Australia the Job Keeper/Job Seeker fiscal programs are due to be removed later this year, and from our discussions with company executives there is caution on the ramifications for employment and consumer spending from the removal of these programs. While the near-term outlook is uncertain we have confidence in our investment process; it is robust and has been tested through multiple cycles over two decades. We continue to expect those companies with high-quality management teams and strong balance sheets to do well over the medium to long term and we remain disciplined in our investment approach as we navigate the current uncertainty.