Fires, floods, pandemic, war - what comes next?

Fires, floods, pandemic, war – what comes next?

In a recent blog post, Joseph Koh, portfolio manager of the Schroder’s Australian Equities Long-Short strategy, compared the current market environment to the Four Horsemen of the apocalypse. Titled ‘The Dark Horse Cometh’, Koh highlighted the impact that fires, floods, a pandemic and war have had on markets, but suggest this is only the beginning.

“They may not be done just yet” he says referring to the four horsemen, with death the next horseman to hit; likely referring to the cash-flow-negative “zombie companies” that have dominated market-cap gains and momentum for the last few years.

While it took a war to create the inflation that central banks around the world failed to achieve for 20 years, “no-one could have predicted the pandemic which turbo-charged central bank efforts” that have ultimately been central to the explosion in valuations of companies of lesser quality, but also to the dispersion in valuations between ‘growth’ and all others.

Reflecting on the days of “free money,” Koh says “the greatest multiple dispersion seen in Australian listed company history has started to converge,” with high P/E firms trading on multiples of 30 to 50 times, and remaining above DotCom-bubble levels despite the recent selloff. The selloff in Australian tech has been more akin to the Nasdaq collapse, “reflecting the poor cash-flow generation of most of the listed Australian high-multiple stocks.”

This correct is “still nascent,” according to Koh, who believes overvaluations remain prevalent in various corners of the market. “It is one thing for a business to not report a profit and produce free cashflow because it chooses not to,” – think Amazon – but we are now in an environment where it has “every incentive to do so.” “For those that cannot or do not do so, and we suspect there may be more of these than may currently be imagined, the consequences may be dire.”

The valuation rotation has only just begun on a broad basis, but there are also exceptional mispricing opportunities within sectors, potentially offering alpha for those able to deal on the long and short side of the market; the caveat here is to be nimble. For instance, ANZ offers a 40 per cent “relative performance prize” compared to the leaders in NAB and CBA, if ANZ is able to get its business processes back in order.  It is a similar story for commodities, ranging from oil to iron ore and copper.

On the outlook for the next few months, Koh suggests “deflationary forces” from falling equity markets and higher interest rates won’t impact energy prices; hence we are likely staring at a stagflationary environment. He believes another  “large correction” in the multiples of expensive stocks is likely, and suggests the best form of defence is the same as in previous cycles: it’s “sustainable cash flow.”

Drew Meredith

Drew is editor of The Inside Network's publications and a principal adviser at Wattle Partners.