The Most Volatile 12 Months in the Last 10 Years - How Did Active Managers Fare?

Australian Fund Monitors

25 February 2021

The 12 months through the end of January marks one of the most volatile periods for equity markets in the last 10 years.

• In March 2020 the ASX 200 Total Return Index recorded its largest single monthly fall in 10 years falling -20.65%, while February 2020 it fell by -7.96%, the 3^rd largest fall in 10 years.
• Fortunately for investors, the last 12 months also included the 2 largest single month gains over the last 10 years with the ASX 200 Total Return Index bouncing back in April by 8.78%, and again in November by 10.21%.
• For all that volatility - or perhaps because of it - the ASX200 Total Return Index fell by -3.11% over the 12 months.

While not quite as volatile, global markets returned similar statistics.

• In 2020 AFM's Global Equity Index had 10-year record monthly loss in March of -8.07%, and -5.57% in February.
• As expected, the Global Index also bounced back in April by 4.15%, and then had the second-best month in the last 10 years in November.

The bulk of investors in Australia get exposure to these 2 markets via both passive and active fund managers. The outcome for passive equity investments is shown in the points above - in other words investors in a "passive" ETF will broadly match the index, after allowing for fees, but how did Active Managers both globally and domestically perform through this period? Looking at Long Only Managers we note the following points:

• 79 of the 97 or 81% of Australian Equity Funds beat the index through the 12 months, and all but 11 of these funds beat the index over the last 3 years, showing they have been able to sustain outperformance through the cycle.
• 23 Australian Equity funds lost more than 25% in March 2020, but 18 of these went on to record an outperformance over the index over 12 months.
• The defining statistic for those Australian Equity funds that outperformed was their "Up-Capture Ratio" which measures their cumulative performance during the market's positive months. The average Up-Capture Ratio for the top 20 performers was 193.6 (any number over 100 shows outperformance, so 193.6 means they rose at almost double the rate of the market, confirming significant value can be derived from active management.
• Global funds found the going far more difficult with 36 out of 53 funds outperforming the global market (68%). However, one third of the funds that outperformed in the last 12 months failed to beat the benchmark in the previous 3 years.
• As with Australian Equities, many Global funds - 33 in total - underperformed in March, while only 22 of these went on to outperform over the full 12 months.
• One of the key statistics for Global funds that did outperform was their Down-Capture Ratio, which measures their cumulative return when the market is falling. Unlike Australian Equity Funds, their most successful Global peers were those that gained against the market during the negative months. The average Down Capture Ratio for the 15 best performing funds was just 43.4 showing that these funds on average only fell less than half as much as the index when markets were negative.

The data shows that volatility can be a friend for Australian Equity funds, although that volatility may test the mettle of many investors. For Global fund investors it may be useful to note the quote from Warren Buffett - "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1".

Of course, we all know that's easier said than done. However, one way to reduce volatility, or avoid large losses, is to ensure diversification across markets, strategies and asset classes, and ensuring that the correlation of those diversified funds is as low as possible.

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Robert Swift from Delft Partners about the Delft Global High Conviction Strategy. Since inception in August 2011, the Strategy has risen +14.93% p.a. with an annualised volatility of 11.78%. Over that period, the Strategy has achieved Sharpe and Sortino ratios of 1.08 and 1.97 respectively, highlighting its capacity to achieve good risk-adjusted returns while avoiding the market's downside volatility.

Longlead was founded in 2014 and is a specialist long/short equity manager with a core focus on Asia & Australia. The team at Longlead have recently released and Australian Domiciled Wholesale Unit Trust based on their existing Longlead Absolute Return Fund.

The Longlead Absolute Return Fund was started in July 2017 and has returned 29.24% per annum since inception. For most investors the proof of an absolute return manager is in their performance during down markets, and Longlead have provided investors with a positive return 64% of the time when Asian Pacific markets are negative, generating significant outperformance.

Bubble, bubble, toil and no trouble!

Montgomery Investment Management

February 2021

There are a number of arguments being advanced to suggest the stock market is in a gigantic bubble that is at risk of bursting imminently. Some of the arguments relate to broad overvaluation, the tidal wave of overpriced IPOs that double on listing, and the observation that interest rates remaining low forever is tantamount to the unrealistic, and previously unrealised, expectation of high rates of earnings growth being sustained forever.

For this article however I want to look at the market's valuation compared to bond yields to help understand the extent of any euphoria in markets that may cause them to be at risk of imminent collapse.

Australian ten-year bonds have traded almost in lockstep with their global peers over recent decades, and since the early to mid 1980's bond yields have been in inexorable decline.

Source: Tradingeconomics

According to Bloomberg, the ten-year Australian bond yield is 1.17 per cent. The bond yield will move independently of short-term cash rates set by the Reserve Bank of Australia, so while the RBA Governor Philip Lowe has made it clear that the overnight cash rate of 0.1 per cent will not be moving for some years or until inflation is "sustainably" in the target band of 2-3 per cent, that does not mean the yield curve cannot steepen with ten-year bond yields rising.

Nevertheless, the starting point for one method of assessing equity market valuation is the ten-year bond yield. To that yield we add an equity market risk premium. On this number there is much conjecture. The equity market risk premium is the average return that investors require over the risk-free rate (ten-year treasury bonds for example) for accepting the higher variability in returns that are typical of equity investments. In other words, the Equity Market Risk Premium reflects a minimum threshold that motivates investors to invest.

Investors and academics have long debated this number, which of course changes over time. Turning to the RBA again, and its June 2019 Finance Bulletin - The Australian Equity Market over the Past Century[1], reveals the following:

"Using the updated dividends data, the new historical series (extended with available data for more recent time periods) imply that the total nominal return on equities (i.e. the sum of capital gains and dividends) has been around 10 per cent, per year over the past 100 years (based on a geometric average which allows for compounding over time). In real terms - i.e. after accounting for inflation - the average annual return was about 6 per cent. There have not been material differences in returns across sectors over this time, although of course there have been periods in which sectors have performed differently. Over the same period, the total nominal return on long-term government bonds has been around 6 per cent, implying an average equity risk premium (excess return of equities over safe assets) of around 4 per cent."

So, to the bond yield of 1.17 per cent, we should add four per cent for the equity market risk premium. The product of the two is of course 5.17 per cent. This is the theoretical fair value Earnings Yield for the market.

The Earnings Yield is of course merely the inverse of the Price Earnings ratio so, by dividing 100 by the earnings yield we can arrive at a theoretical fair PE for the market of 19.34 times earnings.

If the 1-year forward PE of the market is much higher than this, investors are willing to accept a narrower than reasonable future return above bonds, given the risk of investing in equities.

According to Bloomberg at 12.17 pm on 3 February 2021, the 1-year forward PE for the ASX200 (excluding loss making companies) is 19.26.  By including loss making companies the 1-year forward PE is 20.55 times suggesting there is only marginal enthusiasm for equities overall.

This picture of course changes throughout each day. As bond yields rise, the fair value of the market falls, and the reverse occurs when bond yields decline. If bonds yields do begin marching materially higher the risk for the market rises, even if the market itself does not rise. This is because the fair value PE would decline moving further below current levels.

Today, as it stands however, on this measure at least, it doesn't appear that the Australian stock market is in a bubble.

[1] https://www.rba.gov.au/publications/bulletin/2019/jun/the-australian-equity-market-over-the-past-century.html

Damen Purcell, COO of Australian Fund Monitors, speaks with Chris Wheldon, Portfolio Manager at Magellan Asset Management

The Magellan High Conviction Fund follows an unconstrained, highly concentrated long only strategy investing in global large cap stocks...with the fund investing in just 8-12 of Magellans best ideas. The fund also has the ability to take a cash exposure of up to 50%.

Cash rates locked, but dividends unshackled

Dr Don Hamson, Managing Director, Plato Investment Management

9 February 2021

We didn't get another "historic" rate cut from the RBA on February 2, but we did get some absolute confirmation of what we've been saying for quite some time - rates are staying lower for longer.

In his rate decision statement, Philip Lowe said, "The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest."

In short, Lowe's probably not going to even think about lifting the cash rate until at least 2024. The ramification of this statement for those investors still trying to make ends meet  from yield on term deposits and other cash-backed products is obvious.

But that's where the retirement income pessimism should stop - after a tough year for dividend income there's a break in the clouds.

We've entered 2021 with some positive news, which lays a strong foundation for what should result in a strong dividend recovery in the coming 12 months.

Bank dividends

The first piece of positive news, a capital management update from APRA in December. The regulatory authority repealed restrictions imposed on banks earlier in the year regarding dividend payout ratios. In April 2020, APRA initially warned against paying any level of dividend. In July, an update putting dividends back on the table, but the authority said they must not exceed more than 50% of earnings.

The December update put an end to the regulatory uncertainty with APRA noting further improvement in the economy and removing all hard restrictions on bank and insurance dividends.

Bank dividends cut an average of 60% in FY2020 so there is significant upside. While we don't expect them to go back to pre-COVID-19 levels for at least another two years, we do expect to see bank dividends begin to move toward more normal payout ratios of between 70 and 80 per cent over the next 12 months. Still a big improvement from what many were anticipating only a few months ago.

Franking is here to stay.

The second announcement was from Federal Labor Leader Anthony Albanese. Many readers of this article will remember myself and the Plato team campaigning against Labor's policy to scrap franking credits at the last federal election. This would have had a serious impact on retirement income. In fact, the policy was labelled the 'retiree tax' by many.

On January 2, 2020, Mr Albanese said in an online address to Labor party members, "I can confirm that Labor has heard that message clearly and that we will not be taking any changes to franking credits to the next election." 

Uncertainty surrounding franking credits has been an ongoing concern for retirees seeking to move into equities to generate income. It's been a common theme during my firm's regular investor Q&A's.

If you take Fortescue Metals (FMG) for example you can see why. For tax-exempt investors, the Iron Ore miner paid a gross yield including franking of 14.5% in 2020 - that's more than 4% from franking alone.

Dividend cut probability reduced

For more than a decade, the Plato Investment Management team has been using proprietary quantitative analysis to predict the likelihood of dividend cuts. Our latest modelling now shows a significant improvement in the outlook, with the probability of dividend cuts from Australian stocks now back to around the long-term average.  To us this signals that the big Covid-19 related dividend cuts are now behind us.

The income landscape

Buoyed by some of the aforementioned factors, we maintain an actively managed and well  diversified portfolio of dividend paying stocks is the most compelling income generating strategy, particular for Australian retirees.

Our latest 12-month income forecast shows equity income remains well above other major asset classes.

Whilst the big traditional Australian income stocks such as the banks have cut dividends and underperformed, on the upside we've been generating strong income for investors from miners such as Fortescue Metals, BHP and Rio Tinto in recent years and we expect this to remain consistent throughout the year.

We also expect strong yield from select retail businesses in the year ahead - the likes of Wesfarmers, Coles, Super Retail and JB Hi-Fi.

When it comes to the banks, the Commonwealth Bank maintains a strong balance sheet with excess capital. This raises the likelihood of a buyback in the coming years, which would benefit retirees particularly.

On the flip side, avoiding dividend traps is still important, although it would appear there are now less dividend traps in the market than there was in 2020. We would caution inflated historical yield figures in sectors such as Tourism and Leisure, Energy and Infrastructure and Retail REITs.

Finally, the only free lunch remains diversification. And for retirees, that lunch can get a little better if your portfolio is being managed to take advantage of franking credits and other tax-effective opportunities such as buybacks.

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Michael Frazis from Frazis Capital Partners about the Frazis Fund what drove the Fund's significant outperformance over the past 12 months. Michael also shares his thoughts on the current state of markets around the world.

The Frazis Fund has risen +109.74% over the past 12 months vs AFM's Global Equity Index's +2.59%. Since inception in July 2018, the Fund has returned +35.74% p.a. vs the Index's +10.54%.

Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds, discusses the market and performance of high grade bonds in January 2021.

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Chief Investment Officer, Steve Johnson, is joined by Alex Shevelev, Senior Analyst on the Australian Shares Fund, as they discuss the factors contributing to a strong start to the year for Australian retailers including JB Hi-Fi and Super Retail.

Forager Australian Shares Fund

Forager International Shares Fund

Transcript:

Steve

Hi everyone and welcome. It's Steve Johnson here, Chief Investment Officer at Forager Funds, bringing you our first video for 2021. I'm joined by Alex Shevelev, Senior Analyst on the Forager Australian Shares Fund. Hi Alex, how are you?

Alex

Hi Steve, hello everybody.

Steve

It's been a bumper start to the year for Australian retailers, lots of them out early in 2021 talking about some very buoyant Christmas trading. We saw JB Hi-Fi, Super Retail, a couple of stocks that we own small positions in our portfolios such as Shaver Shop and Michael Hill pretty consistent across the retail industry, making lots of money.

Alex

It's been a great time to be a retailer. All that money that we saw that's not going towards international travel and a lot of the money that's coming from government stimulus is ending up in the coffers of some of these businesses and the revenue growth has been absolutely staggering for what are already some pretty large businesses. Supercheap and JB Hi-Fi group grew 23% and 24% in total revenue and that's including the fact that some of these stores were shut down for a period during that half.

Steve

I remember doing an analysis of JB Hi-Fi probably 10 years ago, questioning whether it could ever get to $10 billion of sales given the amount they Australians spend on electronics. But we've seen through this past period, they just keep taking market share and also the market keeps growing. The big thing though, has been profit. You talk about sales up 20%, but profit numbers are up a lot more than that.

Alex

In some cases they're up 80% plus and the reason here is twofold. Firstly, we've got increasing gross margins. So the retailers have managed to tick up the sales prices of their products ever so slightly relative to their costs. That might only be a couple of percentage points and you may not see it necessarily in your purchases but for a retailer that makes maybe a high single digit margin that is a really big change.

Secondary to that, you've then got all those extra sales, all that extra gross margin coming through and the operating costs of these businesses have stayed largely similar. So you're getting a double benefit there.

Steve

I think as a well-run retailer, you might be talking sort of 6% to 8% margins at the bottom line. So as you can add 2% at the gross margin level, that's having a fairly dramatic impact on your profit. Maybe a bit counter-intuitively retailers are talking about it being difficult to get goods into the country, from China in particular, with lots of capacity constraints in shipping. It's probably been a good thing net for them because there's less competition and lots of demand and it's enabled them to put those gross margins up a little bit. Now the share price reactions have been muted using profit here up 80% and 90% on stocks that were not trading on crazy multiples to start with.

Yet we've seen share prices, maybe up 5% or a bit more on the day and retracting a bit over the days after that. What's going on with the bumper results coming out way above everyone's expectations and share prices not really moving?

Alex

These retailers had run up to some extent already. There was already an expectation that there was going to be more revenue flowing in. However, it is higher than people expected, but that increase is limited, or appears to be limited in investor's minds, to this first half of the year and potentially subsequent couple of months. These businesses are not necessarily getting credit for this level of profitability continuing.

We're going to really get to see that in the first half of next financial year, how these businesses end up relative to the half they've just had.

Steve

I'd probably say we agree with that. That's a sensible reaction from the market to say this is clearly unsustainable, both at a sales level, people are going to start spending money on travel and other things again, towards the back end of next year. Probably most importantly, you would assume these to come back to something more normal eventually.

Alex

That's right. There are some things that have changed though for some of these retailers and Shaver Shop is a good example of this. There has been a transition to online and the businesses that have really been able to seize the opportunity in online and transition some of their offline sales to online should be better positioned for that come next year.

Shaver Shop for example, has seen its online sales percentage tick up from 10%, two years ago, closer to 30%. Now that's a big change for a business like that.

Steve

Yeah and I think you've seen some of these businesses manage that transition well. Shaver Shop is up to more than a third of its sales through its own website online. They're delivering those through the store network. But it says to me that all of that brand awareness they have, when you think I want to buy a shaver, where do you go? The money that's been spent on that over all these years is worth something. As long as you can get your offering right online, you're not actually seeing the likes of Amazon kill these businesses. In fact, they're doing quite well online.

Alex

That's not the only thing that's happening though. There's a secondary aspect of it and that is that this period has really been a shake up for a lot of these industries.

So you've got, for example in the jewellery space, some competitors that might struggle more than the listed player Michael Hill. In that situation you might be taking sales off competitors. Eventually, like we had seen with someone like Baby Bunting, over a long period of time those competitors might fold and you might capture more of those sales.

In other situations that shake up has really been a COVID affected shakeup, but with implication over a long period. So personal travel on motorcycles for example, is likely to be a bigger feature going forward as people remain a little bit hesitant of public transport, and that's really feeding into a Motorcycle Holdings result, which probably is not going to be quite as good as our bumper first half of 2021, but has a good chance of being better than the prior years as that industry is really shaken up.

Steve

I think people are actually underestimating how difficult the environment was for the three years leading into this COVID meltdown. Retail in Australia has been really hard. You've had costs marching up slowly while revenue has not been growing at all across the whole sector and this leakage to online going on at the same time. I think you've seen some of those businesses do a great job of consolidating in their industries and I don't think we're going back to 2019 levels of profitability.

There's no doubt that this year is going to be an anomaly on the high side. But I think people are looking back and saying, well I'm going to apply a multiple of 2019 earnings. In my view, that might be a bit too conservative given where share prices are at the moment. So still some really interesting opportunities out there in the space and still a meaningful part of our portfolio.

We're looking forward to hearing those and other companies give us further updates through February as our Australian portfolio reports results. Thanks for tuning in, and we'll be back with some regular updates over the next month as we get all of those results.