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Rudi’s View: Bear Market Observations

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Apr 03 2020

This story features COCHLEAR LIMITED, and other companies. For more info SHARE ANALYSIS: COH

Dear time-poor investor: better prepare for significant dividend reductions, and more negative news from oil, covid-19 and the USA

In Today's Rudi's View:

-Records Will Be Broken
-When Giants Are Wrong
-The Strong Will Be Stronger
-Banks Will Cut Dividends
-Oil Producers Under The Pump
-Infraboom, Infra-Kaboom?

-The Data Crunch

By Rudi Filapek-Vandyck, Editor FNArena

Records Will Be Broken

It was one of the easiest predictions to make when I predicted in mid-March: expect a lot more negative news from the USA.

That was not a political statement. It was simply an assessment that the world's largest economy was ill-equipped and unprepared for what was yet to unfold, with the covid-19 pandemic about to hit its exponential trajectory on American soil.

The situation on the ground has turned a lot worse since, and there still is no clear vision as to when the unfolding human tragedy, and economic damage, might end. Don't automatically assume that when this unfolding tragedy hits its peak life can quickly move to normal again.

If governments learned one thing from the Spanish flu pandemic more than one hundred years ago, it is that opening up too soon will simply trigger the next wave of infections. Already reports are out this is now the problem some Chinese regions are struggling with.

In the meantime, the 2020 pandemic & Bear Market are breaking all kinds of records, already recording the most rapid collapse of markets in the shortest time frame. Excessive volatility is likely setting another record as well.

Meanwhile, in the real world, central banks have unleashed the largest support programs -ever!- to make sure the world's credit system does not freeze or collapse, leading to the largest increases ever recorded to central bank balance sheets, while official cash rates and bond yields have equally set new all-time low records.

Still to come: the largest drop in economic activity inside one quarter plus the quickest increase in unemployment numbers, ever. Finally, the magnitude of what exactly is happening is dawning on governments, economists and others.

The largest government stimulus programs -ever!- are still likely to be enlarged further, and they will need to be in order to stave off all-time records in terms of personal and business bankruptcies, and to prevent setting new all-time records again later in all of the above.

Yet to follow: gigantic sums to prevent entire industries from collapsing. (A lot more than what is being publicly discussed at the moment). The old joke about privatising the profits but socialising the losses will dominate the picture in most economies in the months ahead. When I wrote "this is the Bear Market that changes the world" in March, some responses from readers suggested I was being alarmist.

Pretty confident that by the time all this is over, the general consensus will be that I wasn't nearly hyperbolic enough in my description and predictions. Regarding the latter, I'll happily repeat what I wrote last month:

But let there be no mistake: the answer to the question of how do we ever get out of this mess is still the same: with more money. Loads of more money.

This time governments around the world will join in with central banks. This is why this Bear Market is changing the world in front of our eyes.

All of us ain't seen nothing yet.

When Giants Are Wrong

When a giant among investment experts like Howard Marks discovers he was a bit too quick in assuming the quickest sell-off in equities -ever- had created an abundance in opportunities for longer-term oriented investors, he changes his mind. What else is he supposed to do?

Howard Marks' latest update to investors can be accessed here:

The Strong Will Be Stronger

Economic recessions and related Bear Markets are nature's way to separate the wheat from the chaff, which is a fancy way for saying when this crisis has been dealt with, the strong will be even stronger vis-a-vis the weaker players in each market.

This does not by definition imply corporate failures. Companies who face a recession as fierce as this one, while not being in the most healthy condition, can suffer so much damage to their financial situation it might take many years to salvage.

In the meantime, the strong and healthy competitor is able to launch new products, add extra services, invest in future growth, build out a wider moat, and grab some extra market share and leadership too.

The benefits from being the most solid, highest quality operator is something that might not always be apparent during the good times, but it will show up during and after this year's recession. No doubt about it.

The first such analysis I have come across in recent weeks was released by Wilsons, following Cochlear's ((COH)) surprise equity raising at $140/share.

Not only will the extra capital assist the world's leading cochlear implant manufacturer from successfully navigating this very tricky period, when no elective surgeries are being conducted in order to free up as much space in hospitals as possible to cope with covid-19 patients, Wilsons is equally convinced Cochlear will emerge in a much stronger competitive position.

This assessment is based upon the fact that major competitor Advanced Bionics has the added disadvantage of reputational set-back following the recall of its HiREs Ultra/3D product. Two other competitors, Sonova and Demant, have exposure to the retail audiology channel, which in the current context translates into exacerbated covid-19 impact.

This is why Wilsons, despite heavy downgrades to forecasts, retains its positive Overweight rating alongside a valuation of $213.15 for Cochlear shares. It's not about what is happening right now, it's about what is likely to unfold in the aftermath.

Banks Will Cut Dividends

Prime minister Scott Morrison has indicated the Federal government is not asking the banks should sit on their cash this year and not pay out any dividend to shareholders, but investors better not draw false confidence from the PM's statement. Australian banks will cut their dividend this year, and next. That's what happens during economic recessions.

Don't shoot the messenger, please.

Australian investors, and I know many of you are in that very same position, have been relying on banks, and other equities, plus real estate to generate income from since the aftermath of the GFC changed the world of interest rates and income generating assets, but this year in particular the damage will be pronounced.

Outside the share market, we see rent relief, mortgage support, eviction moratoria and other forms of financial relief to which all banks have agreed to fully cooperate in a wonderful display of Team Australia, together we can do this. But someone will have to pick up the tab and in the current scenario that someone will be the banks.

Any stress in commercial property equally leads to the banks. As does the stress in residential where people in general are carrying too much debt, are losing their job, and won't be collecting any rent for a while. The Big Elephant not to be mentioned right now, but it will be just you wait, is when banks can conceivably start foreclosures and calling in loans to zombie companies?

This is why investors should not be naive about what follows after this crisis. It'll be an extended period -"era" might be a more suitable term- of subdued conditions for consumer spending. There will be a whole lot less income from the local share market as large numbers of companies will not only cut, defer or scrap their dividend this year and next, boards will feel compelled to adopt more conservative policies, meaning after the onslaught, the recovery in dividends will be much slower too.

Anyone looking for another all-time record, watch what happens to the retreat in dividends paid out in Australia this year.

Look no further than Transurban's ((TCL)) market update this week, for the seeds for lower dividend payouts are already being planted. You can see the experts in the corporate credit market smiling right now, because they are certain their customers will get paid on the corporate loans they hold.

How all this is going to play out exactly for bank shareholders is anyone's guess. Sector analysts have to make a lot of assumptions when trying to map the sector's outlook under the given circumstances, but maybe Morgan Stanley's recent update can provide investors with some guidance into what might unfold from here.

The largest cut among the Big Four seems to be reserved for owners of shares in Westpac ((WBC)) with Morgan Stanley's DPS estimate shifting to 115c for the current financial year (from 174c last year), followed by 100c next year, which will not be raised in FY22.

Westpac is expected to be hit the hardest, but the pattern for all four looks pretty similar in that total dividends in FY22 will be below dividends paid out last financial year for each of the Big Four.

The numbers put forward by Morgan Stanley imply Westpac's dividend will be cut by -30% this year, and by a further -13% in the following year, with no increase expected in FY22.

The last time Westpac only paid out $1 in total dividend over a full financial year was in FY06, before GFC.

Oil Producers Under The Pump

Energy markets have quickly become the world's hot spot for negative news and baring a true and genuine miracle (not impossible, this is the oil market after all), investors should be expecting a lot more negative news to come out the world of oil and gas producers, explorers and sector services providers.

Forget about the abandonment of the Saudi-Russia supply agreement, closing down international tourism and whole cities around the world is having such a devastating impact on the demand side, soon there will be no storage room left for the excess that is being pumped out of the earth. Where will it all go?

Sector analysts are suggesting the logical market response will be an even lower oil price. Production must be squeezed out of this market. Given the end of armistice between OPEC and Russia, and the plunge in demand, this has all the hallmarks of becoming a very, very ugly situation indeed.

Shares in oil producers on the ASX enjoyed a fierce rally this week. Go figure. You simply cannot put a lid on animal spirits, in particular not when the US President himself seems to be working on a Grand Deal that should keep global production in check, but what about the demand side?

No doubt shareholders in Santos ((STO)) and Origin Energy ((ORG)) still remember what happened to these companies' balance sheet and share prices last time the world was facing a similar ugly situation for crude oil markets.

This time around, most balance sheets in Australia are in much better condition, but this still doesn't mean businesses plans, operational cost levels and investment intentions won't have to adjust to the renewed reality of a much lower price for oil.

The graphic below is from a recent attempt by energy analysts at Morgan Stanley to illustrate what the current situation means for producers in Australia. The example below is for Santos whose fixed costs, including maintenance capex, requires oil to be priced above US$30/bbl.

What did the French say again when in a similar situation?

M'aidez! M'aidez!

Infraboom, Infra-Kaboom?

Is the current infrastructure boom a phantom in Australia? It increasingly looks like this will be the case for many a contractor and engineering services provider with industry insiders suggesting many are but one disappointment away from major disaster, all thanks to paper thin operating margins.

The now Chinese owned John Holland recently made the claim the industry in Australia is "teetering on the brink of collapse", claiming many a contractor is operating close to insolvency. Covid-19 might claim a few casualties then. Shareholders be warned.

Sector analysts at Bell Potter have been concerned for a while as yet. In February, in the midst of the local reporting season, they warned their clientele to be picky when selecting exposure. All is not well when margins are thin and projects complex and costly.

This sector has generated major bloopers during the best of times. RCR Tomlinson springs to mind, as well as Forge Group. While each of CIMIC Group ((CIM)), Lendlease ((LLC)) and Downer EDI ((DOW)) had their own misadventures throughout the years, to name but a few. Now energy producers are deferring new projects, scaling back spending and cutting costs.

Bell Potter warns investors better avoid those contractors in a net debt position, as well as those that don't seem to have good cash flow and growing profits. The point is highlighted, once again, that it only took one single contract to reduce Decmil Group's ((DCG)) interim result by -$49m.

A major chunk of the operational risks relate to the fact many were aggressively bidding for new contracts 12-24 months ago, and these projects are coming up for conclusion now. Risk for cost blow-outs is on the rise thus, even without covid-19 potentially disrupting work.

To properly assess the risks involved, Bell Potter analysts point out simply analysing the balance sheet is never sufficient for this industry.

Many more factors need to be taken into account, including "a company's historical success at converting earnings to cash; the degree of any potential impact of the coronavirus on their specific operations; their historical ability to weather economic storms; the expected collectability of current receivables balances; and the use of alternative financing arrangements such as reverse factoring."

Bell Potter's sector favourites are Monadelphous ((MND)) and Service Stream ((SSM)). Others seen under a positive light include Lycopodium ((LYL)) and Southern Cross Electrical Engineering ((SXE)).

The Data Crunch

With the whole world focused on daily data updates in the hope the global curve of covid-19 infections is starting to plateau, it's probably wise to point out none of the statistics gathered reflect an accurate picture of the situation on the ground. And authorities would be well aware of this.

Why so? Because the largest contingent in any population is most likely showing no symptoms and thus won't turn up in any of the statistics. Don't take my word for it. There are plenty of virologists being interviewed and quoted in media, and they are saying exactly that.

So we are sort of watching Chinese economic data. We know they are not an accurate statistic, but it's all we've got.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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