In recent weeks, Yarra’s investment team has been scouring its investment universe to prepare for the rebound. Katie Hudson, Portfolio Manager for the UBS Australian Small Companies Fund, details some of the guiding principles that her team has developed in order to capture opportunities in the months ahead, when COVID-19 restrictions are eased and business activity resumes:

1. A hard stop doesn’t necessarily mean a hard start

The revenue “hard stop” experienced by many companies is, in our view, unlikely to be followed by a widespread “hard start” as activity resumes. This will be particularly the case for consumer facing businesses where demand is likely to be muted (e.g. travel, retail, education and tourism businesses), meaning we are being very selective in this space.

2. Understand “demand lost” vs. “demand deferred”

While lost demand is gone forever, “deferred” demand is likely pent up and is well placed to rebound quickly in a range of sectors. As a result we maintain a strong preference for the latter. Examples in our portfolios include radiology and pathology service providers, who could potentially see higher run rate revenue over the next 6-12 months than before the shutdown as deferred activity is layered on top of normal activity levels.

3. Earnings rebuilds will differ significantly

Understanding cost structures has been critical in the shutdown, since it speaks to cash burn and, ultimately, balance sheet strength. As we move into the recovery, understanding how earnings will rebuild is equally important.

One example is the international travel sector: while we expect activity will rebuild very slowly, travel companies will see all their costs quickly return (e.g. rent, labour) which means cash burn may extend beyond what the market is expecting. By contrast, airports such as Auckland Airport, which own their hard assets, have an extremely low fixed cost structure, meaning cash burn is minimised and profits rebuild more quickly. While both are exposed to the same demand dynamics, we have a clear preference for owning the airport.

4. Some companies will see long-term earnings power diluted

While the short-term hit to earnings from moderating activity is reasonably clear, the extent to which the shutdown impacts a company’s long-term earnings power can be far more opaque.

For shopping malls there has been permanent erosion of earnings, reflecting the combination of likely higher vacancies and rent resets. The shift in power between mall owners and tenants has never been more stark, with even listed retailers openly declaring they will not pay rent during the shutdown (despite a clear contractual obligation). While arguably this is an acceleration of a trend already underway, in our view the long-term earnings power has been clearly diminished.

As active investors with a long-term focus, we are adding to holdings in those smaller cap companies where short-term earnings pressure has been confused with longer-term viability. Companies where the longer term earnings power remains in place – and for some market leaders it has improved – are helping to build the foundations for longer term outperformance.

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