Wednesday 15th April 2020
Stress testing supply chains
Our underlying companies in the Legg Mason Martin Currie Global Long Term Unconstrained Fund have shown resilience in terms of balance sheet strength and relative share price performance. However, given the unprecedented nature of the exogenous shock, and the recessionary environment we are going through near term, we have identified a limited number of risks, which we have been focusing our research on. These are notably concentrated in our Industrial and Consumer holdings.
Autos – low supplier inventories could disrupt manufacturers
The auto industry is an area of notable exposure to supply chain risk, supply chains are tightly integrated and lean, with fragmented suppliers that are at risk of cash flow deterioration. Inventories in this segment are generally low, and therefore there is a higher risk of the rapid spread of disruption along the supply chain and onto the car manufacturers. In terms of our portfolio holdings, Ferrari looks the most vulnerable, its entire manufacturing base being in Italy. However, the company is able to shift some of its production base around the different models, notably its limited-edition models, to ensure that capacity gets managed efficiently. This is testimony to the company’s pricing power and unique product offering, which should help it get through the short-term volatility in better shape than the rest of the sector.
Consumer – inventory dislocation and wholesale impact
On the consumer front, there are some disruptions in productive capacity in some parts of Europe – Italy particularly. The most noticeable disruption will be with the ultimate end markets – department stores and duty-free operators. They are all clearly impacted by the marked reduction in the volume of customers. This, in turn, is likely to bring substantial inventory dislocation over the coming quarters, leading to opportunities for consumers and discount retailers but pressuring the margins of the wider retail sector.
Companies with more wholesale exposure will be more at risk. More established brands with stronger balance sheets will be more able to withstand the inventory dislocation issue, in particular thanks to better access to outlet stores. Our Italian retailer Moncler, is a good example of this resilience, given its limited wholesale exposure and strong inventory control, it benefits from strong pricing power over the long term.
Healthcare – high-quality management teams can navigate the turbulence
In healthcare, we are monitoring the situation in the plasma collection centres, where there could be at some point a risk of diminishing inventories as blood donations get impacted by a lower number of donors visiting collection centres. At this stage, we are not concerned about the situation and would see stocks in that industry being relatively defensive as a result.
We are monitoring our holdings in MedTech and Life Sciences, such as Coloplast, Mettler Toledo and Masimo where the impact on the supply chain is more likely to come from consolidated manufacturing facilities or single-source component suppliers being temporarily disrupted. In general, these are high-quality businesses stewarded by experienced management teams and as such we are confident in their ability to navigate turbulent operating environments, borne out in their recent relative performance.
Semiconductors – supply side more immune to disruption
Semiconductors are very sensitive to the demand side of the equation, whilst the supply side has limited exposure to exogenous shocks. The supply side is effectively a short chain that is highly automated. Instead, supply-side adjustments are purely related to CAPEX savings measures that companies put in place, and of course, consumer end market slow down. We hold supply-side firm ASML, a supplier of production tools. We believe they are relatively immune from any COVID-19-related temporary effects, given the long order book and lead time for leading-edge EUV machines. This leads to a lower risk of order cancellations from semiconductors makers this year.
Our structured risk assessment helps build resilient portfolios
Our structured analytical framework is based on the fundamental analysis of supply chains and their risk assessment helps ensure that we are prepared for events like COVID-19. Such a framework helps us when we need to rapidly assess risk exposures and stress test portfolios.
Importantly, it showcases the significance of being ‘crisis-ready’ by knowing our portfolio fundamental risk exposures in such a precise way, and consistently assessing risk from different angles to ensure that we don’t have any unintended exposures.
