The COVID-19 virus has had a devastating impact around the world. More than 2.5 million people have died, including more than 500,000 in the US, more than 120,000 in the UK, and 909 in Australia. The Institute of International Finance estimates that government support packages and other measures to combat the pandemic have added $24 trillion to global debt over the past year.

However, we believe an end to the pandemic is in sight. Several vaccine candidates have reported positive phase 3 trial results, including Pfizer, Moderna and AstraZeneca. These vaccines are now being rolled out across the globe, with (at the time of writing) more than 271 million doses administered across 108 countries, which now exceeds the 115 million confirmed COVID-19 cases globally.

The race for herd immunity

The speed of the rollout since the first dose was given in December is impressive, but with a global population of 7.8 billion – and estimates by US Chief Medical Adviser Dr Anthony Fauci that 70-90% of the global population needs to be immunised before the world achieves herd immunity – there is clearly a long way to go. In this regard, some countries are doing better than others with the vaccination rollout. Israel is leading the charge, with 53% of the population having had one dose and 39% having had the second dose. By comparison, 16% of the US population, 32% of the UK population and a miserly 5% of the EU population has had the first dose. Australia’s rollout of the Pfizer vaccine has just begun, with the first dose administered to around 61,000 people – largely quarantine and border workers, frontline healthcare workers and aged care residents and staff.

We are closely following events in Israel, and the signs are promising. Israel’s health ministry recently announced a real-world study in the country that showed the Pfizer vaccine was 98.9% effective at preventing COVID-19 deaths and 99.2% effective at preventing serious symptoms developing. Case numbers in the US and UK are also falling.

Australia is targeting 13 million vaccinations by mid-year, with the country fully vaccinated by October 2021. Flight Centre believes it is possible that low risk international travel could resume in the second half of 2021. Qantas expects to be at 60% of pre-COVID domestic capacity by Q3 this year, and 80% by Q4.

Not everyone is as pessimistic as Dr Anthony Fauci around the timing of herd immunity, with McKinsey estimating it could be achieved in the US and UK in the second half of 2021.

We share that optimism, and stocks that benefit from a re- opening scenario dominate our portfolio. Key holdings currently include Flight Centre, Pointsbet, Vicinity Centres, Virgin Money UK and Xero.

Up goes the yield curve

While we expect the world to move into a recovery phase, the astonishing level of debt left in the aftermath of the COVID- 19 pandemic is presenting real challenges for global governments. Quite possibly the only realistic policy outcome is a long period of above normal inflation (2.5%), which inflates away the world’s debt. Eventually, a prolonged period of inflation may be the least painful way of dealing with future debt costs.

The US Federal Reserve is on record stating that it will hold rates low until full employment is reached and the rate of inflation exceeds the 2% target for some time. Should the Fed hold this line while growth and inflation expectations accelerate, the yield curve (10-year bonds less 2-year bonds) will likely steepen further than it already has. Most of 2021’s Treasury asset purchases are being done on the short end of the curve. With the short end of the curve suppressed and the long end of the curve rising, the curve will steepen.

History suggests Price to Earnings multiples will contract when the yield curve steepens and inflation moves above 2.5%. Of course the present value of cashflows discounted at 2% is much higher than those discounted by 4%, but it’s not always clear what changes in forward rates mean for asset valuations.

Goldman Sachs has identified three periods in recent history where the curve steepened dramatically, but in each case a sell-off in stocks was not sustained. 2013 saw the most dramatic steepening in the yield curve, which widened to 2.5% (versus the current 1.5%); however, the market still managed to achieve strong returns with growth stocks still outperforming value. While returns in 2015 were mixed, 2016 also generated strong returns.

Source: Goldman Sachs Research, FactSet

So now is not the time to throw the baby out of the bathtub..

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

One of the things that differentiates the Kardinia Absolute Return Fund from long only funds is its ability to generate a return or hedge the portfolio by short selling stocks.

Short sellers are often criticised for preying on the weak and taking advantage of misfortune. Napoleon is said to have called them ‘enemies of the state’. Whenever the market falls sharply, it is short sellers who often come in for criticism, with calls for increased regulation or a banning of the practice.

Contrary to some opinions, however, we don’t operate in packs and short well-run businesses. Instead, we tend to look for poorly-run businesses whose management teams often resort to accounting tricks to give an overly optimistic assessment of their business.

What is short selling?

Anyone with a cursory interest in the share market has heard of short sellers, but many don’t really understand how it works. Let’s start with a simple example.

Imagine for a moment you are a farmer. You don’t own any sheep, and you believe they’re overpriced. So you look over the fence and ask your neighbour if you can borrow their sheep and pay them interest over the holding period. Since sheep are broadly homogeneous, your neighbour is happy to do so as long as the correct number of sheep are returned when requested.

Off you go to market to sell the sheep for $100. Your instinct about the price was correct, and the price per sheep subsequently falls to $65. You buy the sheep back at the lower price, return them to the neighbour and profit $35. Borrowing something which is not yours, taking it to the market, and selling it with the belief you can buy it back cheaper – that’s shorting.

Once we’ve made a decision to short a company, we contact a broker to borrow the shares. We make sure the borrowing costs aren’t prohibitive and then sell the shares on market like any other sale. The stock is monitored like any other stock in our portfolio. Once the trade has played out we purchase the shorted shares and return the stock we bought to the lender and stop paying the borrow fee.

What makes a good short?

We approach our short book exactly the same way as our long book. The only difference between us and a long only manager is that when analysing a company and discovering too many red flags, a long only manager will place their pen down; but we can continue to work and then make money off the idea by going ‘short’ the stock.

When it comes to shorting, we’re looking for as many of the following ‘loser attributes’ as possible.

• Weak balance sheet
• Poor earnings quality/cash flows
• Low returns
• Small potential market
• Industry headwinds

It’s a difficult business, and you’re fighting against many factors. Markets tend to go up, broking houses tend to publish supportive research, management are always talking up their stories – so you need a healthy serve of patience to see the investment thesis play out.

One of our most successful shorts has been our position in Bendigo Bank. With a weak capital position, we believed a raising was highly likely, resulting in a further dilution to earnings – which we eventually saw in February 2020. Earnings quality has been consistently poor, with a heavy reliance on Homesafe given the reliance on revaluations to drive profits (home owners sell a share of the future sale value of their homes). Returns remain bottom quartile as the company battles to restructure the underlying business, with heavy spending through to 2022 growing to $80m. Its cost outcome continues to be flattered by capitalised software charges that continue to run in excess of amortisation. Dividends have recently been cut, revenue downgraded and costs blown out.

The competitive advantage from shorting experience

One of the side benefits of shorting is that we find the knowledge and experience gained from shorting poor-quality businesses provides us with a competitive advantage when it comes to picking stocks for our long book. We’re aware of the short positioning in a stock, the availability of borrow, the cost of that borrow and other factors involved in shorting a stock, which provides valuable market intelligence with respect to market positioning in a stock and helps us to identify heavily shorted stocks, or ‘crowded shorts’.

When a stock is heavily shorted and reports reasonable news, there are few headwinds to the stock moving higher, as market participants are unable to short any more stock and often buy the stock on market to cover their short position. We take advantage of this knowledge when we have a more bullish assessment of a company’s prospects, particularly during reporting season when crowded shorts can rally significantly (‘short squeeze’) – even on a poor result.

One of the biggest short squeezes of all time occurred during the attempted takeover of Volkswagen by Porsche in 2008, when the share price of Volkswagen skyrocketed 400% in the space of two trading days – from €200 to €1000.

In March 2008, Porsche owned 31% of Volkswagen. Hedge funds had shorted Volkswagen partially due to concerns over auto demand during the GFC. But in October 2008 Porsche announced it had increased its stake in Volkswagen to 43% and it owned call options over a further 31% of Volkswagen shares – giving Porsche an effective interest in the company of 74%.

At that time, around 12% of the issued shares in Volkswagen were net short. Normally when a company is in play, short sellers need to buy shares on market to deliver back to the entity who lent them the shares in the first place. The issue for the short sellers in this case was the company’s share register: Porsche controlled 74% of the shares and Lower Saxony owned 20%, and neither were sellers. What followed was an aggressive short squeeze as shorters covered their positions by pushing the share price ever higher. In doing so, the shorters briefly made Volkswagen the biggest company in the world, with a market capitalisation of more than $350 billion. In the end, Porsche failed to stump up the cash to exercise the options, and was itself bailed out by none other than – Volkswagen.

Making the shorts work

While a takeover of a short position is always a risk, we at Kardinia minimise this risk by taking smaller position sizes in our short book and utilising its market intelligence with respect to market positioning of all short positions. Some of the most heavily shorted stocks currently in the Australian market include Webjet, Z1P Co and Pro Medicus.

We also try to avoid shorting companies that have assets that might be attractive to an acquirer. Break-up valuations take on more prominence in our investment process when analysing potential short positions – meaning we typically avoid a Porsche/Volkswagen scenario.

At Kardinia, the short book has been a consistent positive contributor to our strategy’s performance since its inception 14 years ago. In the COVID-induced market drawdown of February/March 2020, the short book made a significant positive contribution to performance and helped ensure that we protected investors’ capital (Kardinia -3.93%, market – 36.17%)*.

* Full performance history is available on our website

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

When America sneezes, the world catches a –

After looking dubious for some months, President Trump’s chances of winning the next election are roaring back, with his campaign focusing on law and order and re-opening the US economy.

With riots continuing to spring up across the US, law and order has become a powerful platform (particularly among female voters). Added to this, elections are often won or lost on the economy – and there is a growing desire in the US for the economy to open and for workers to return to their jobs. This becomes a stark choice for those idle workers voting to reopen versus remaining in lockdown.

We believe the mainstream polls underestimate Trump’s support. The bipartisan divide in the US is strong, and many voters are unwilling to publicly admit their support for the President.

A K-shaped recovery?

Another factor likely to have an impact on the election outcome is, of course, COVID-19. All US deaths relating to the virus have dropped materially from a peak weekly count of 17,000 (according to the CDC data) to 5,000 for the week ending 15 August. It is a little surprising to see that the media has not focused on this statistic, instead preferring to focus on the infection rate – although this too has been falling, with average new cases per day falling from above 60,000 in July to around 40,000 in early September.

We are not sure COVID-19 infection rates will ever hit zero, but maybe they don’t need to. If we can learn to live with COVID-19 while opening up business, we believe the economy – including ours in Australia – has a good chance of continuing its recovery. The discussion about the ‘shape’ of this continues – will it be a V, W, or U? Perhaps it will be a K – that is, good for some and bad for others. It is difficult to imagine a more conducive environment for e-commerce businesses, with large numbers of people confined to their homes for business, consumption and leisure. This has, therefore, created an enormous inequality between those businesses that are leveraged to e-commerce and those that are not.

Changes afoot at the Fed

The other key support for markets is US monetary policy, with the US Federal Reserve recently announcing a new framework. It’s yet another evolution in thinking for the Fed, which has proven increasingly willing to use the tools at its disposal to engineer a recovery in the economy.

The framework suggests that monetary policy during economic expansions should aim for inflation moderately above 2% for some time, providing a boost to employment and economic growth. This contrasts to the Fed under Paul Volcker in the early 1980s, when interest rates were quickly raised to record highs to crush runaway inflation (which was running above 12%) and euphoric commodity, housing and bond markets. This current shift in policy towards a greater tolerance of inflation suggests lower rates will persist for some time, with no pre-emptive tightening; which should support gold, commodities and other inflation-benefiting stocks, as well as equity markets in general.

If history is any guide, when the Fed makes a change of this magnitude it’s worth paying attention. We have long believed that during periods of market dislocation, the actions of central banks are the key drivers of market returns. If a deal on a fiscal stimulus plan cannot be agreed between the Republicans and Democrats, it is likely that the Fed will continue to do the heavy lifting. Watch this space.

‘Unprecedented’ indeed

In February and March, COVID-19 and the subsequent economic shutdown spooked investors so much that they sent the market vertically down for a total drawdown of 36%. To be fair, no-one living today has experienced a pandemic on this scale.

As time has marched on, however, it is looking increasingly likely that the pandemic was more akin to an exogenous shock than a structural downturn – a black swan event which may see the economy recover faster than most expect.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

With winter in full swing, investors are going on a yield hunt. Central banks are increasingly controlling volumes and prices as they attempt to set the shape of yield curves.

In the US, investment grade 10-year corporate bonds typically offer more than a 2% yield, significantly higher than the 10-year Treasury yield of approximately 70bps. It was therefore a curious move by the US Federal Reserve to target corporate bonds. What is the Fed seeing that spooked it to take such action? Restoring liquidity to credit markets was one cited reason, but regardless of the motivation the end outcome is clear – corporate bond yields are going to fall, potentially closing off an additional asset class offering income to ever-hungry investors.

It’s a similar theme at home, where the Reserve Bank of Australia (RBA) has pushed interest rates so low that as an asset class, term deposits are no longer an option for investors requiring income.

In response to COVID-19, on 19 March 2020 the RBA announced a cut in the overnight cash rate target to a record low of 0.25%. In fact, the RBA went one step further and announced it would also target a yield on three-year Australian Government bonds of 0.25%, purchasing across the yield curve to achieve the target.

This unconventional measure is set to remain in place until progress is made towards the RBA’s goals of full employment and the inflation target (2-3% on average, over time).

Given the spike in unemployment due to COVID-19 and the risks of further increases once the government’s stimulus measures (JobKeeper and JobSeeker) are wound back, as well as the RBA undershooting its 2-3% inflation target for more than four years, this does not appear likely anytime soon. In fact, at the ANU Crawford Leadership Forum on 22 June 2020, RBA Governor Philip Lowe said that due to the pandemic and an excess of global savings relative to investments, interest rates would remain at their current record lows for years to come.

To us at Kardinia, yield-producing equities are increasingly looking like the last asset class standing. We believe investors will continue to move capital into equities to chase yield in a world seemingly devoid of such opportunities. The need for income is a powerful force – particularly for those transitioning to or already in retirement. At some point, we believe this need will tip bond investors into the equities market. Consequently, we have increased our exposure to this thematic.

Share trading at an all-time high

At a time when investors are grappling with unprecedented uncertainty, a new phenomenon is taking hold in equity markets which is causing quite a stir. Retail investors are setting up accounts and trading securities with enormous enthusiasm. A range of online trading platforms, such as Robinhood, are being embraced by a new generation of retail investors and the impact on markets has been noted.

Populist investment forums are encouraging investors to participate and with a lack of sport, gambling and other entertainment options available, combined with increased free time, many have turned to share trading. The Australian Securities and Investment Commission’s recent report, Retail investor trading during COVID-19 volatility, highlights the doubling of average daily securities market turnover by retail brokers; between 24 February 2020 (the first trading day after the market peak) and 3 April 2020, it rose from $1.6 billion to $3.3 billion.

Whether this retail trend has truly divorced fundaments from asset prices, or whether the professional investment community is clutching at explanations for the recent market moves, is open to much debate. Either way, Kardinia believes central bank actions remain the most powerful driving force behind market returns.

Kardinia’s strategy

Since inception over 14 years ago, Kardinia has deliberately restricted its maximum net exposure to the market (that is, long positions minus short positions) at 75%. This ceiling has proven itself time and time again in its ability to limit the drawdown of the fund. This has been the case again this year during the COVID-19 pandemic, when the fund’s drawdown was 3.93% versus the market drawdown of 36.17%.

The true value of this key structural element of the Kardinia fund comes to fruition when markets fall. Drawdowns of more than 5% in the Australian market tend to occur at least once every year, and our capital protection is invaluable during these periods. As the current swift rally in the market takes hold, the chances of a sell off will only increase with time. With volatility likely to remain elevated, we truly believe the Kardinia fund is a strategy for the times.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

In reality it’s only a few weeks since we wrote our last update, but – as you are no doubt feeling too – in many ways it feels like months ago.

The Kardinia Long Short Fund has generated a positive return of 0.71% for the year to date, while the ASX300 accumulation index has fallen 21% (figures at 22 April 2020). In line with our aim of minimising our investors’ exposure to market weakness, we achieved this by owning high quality companies with strong balance sheets; maintaining a sizeable short book of poor quality companies with poor outlooks; and operating a disciplined risk management process, including a stop loss policy.

Implications for China from COVID-19

We have been focused on the short-term impacts of COVID- 19 on the economy and share prices, but are now turning our attention to some of the longer-term ramifications for markets. As we said in early March, we believe that in time, COVID-19 will be seen as a catalyst which quickly evolves into a crisis of solvency, trade relations and financial markets. The virus itself is not the main event.

Evidence is starting to emerge that the risks of concentrated production in any one location are being acknowledged. Japan has earmarked $2.2bn of its stimulus to shift Japanese manufacturers out of China. According to a recently released survey by the US National Association of Manufacturers, more than half of all manufacturers are planning changes to their supply chains in the coming months as a result of the pandemic. Larry Kudlow, Director of the United States National Economic Council, recently publicly stated that the government should compensate every US firm wanting to move out of China.

We believe the grounds are shifting into terms of trade relations and geopolitics, which over the medium to longer term have the potential to affect global financial markets. This is certainly worth watching as the situation evolves. It could be the case that costs are permanently higher and margins lower, and trade skirmishes the norm rather than the exception.

Recapitalisations

Our economic system is not set up for companies earning zero revenue for three months. Corporate Australia needs to recapitalise, and the process has started.

We are actively focused on high quality companies looking for balance sheet repair, and we have recently taken placements in companies including Reece, Ramsay and IDP Education. It should be noted that more recent raisings have not performed as well as the early deals, which may offer an early signal of investor fatigue.

Where to from here

Global strategists are forecasting a 30-50% collapse in global earnings over 2020. Stock analysts clearly need to catch up, with earnings downgrades to date suggesting a fall in earnings of only 10%. Widespread central bank and Government fiscal stimulus has excited the market for now, but we believe the weight of downgrades will prevail in the end. Markets tend to move with underlying earnings with a lag. Should earnings collapse to the extent of the forecast 30- 50% over the coming 12 months, the ASX would trade on a PE of over 20x. This is too high, and we believe a multiple in the 15x-16x range is more appropriate given the risks.

What everyone wants to know, of course, is whether the ASX close of 4500 on 23 March is the bottom in this bear market.

The market fell 36% from its peak on 20 February 2020, and has seen a bounce driven by large Government stimulus programs and emergency central bank easing measures. Our view is this bounce is unsustainable and the market will resume its downward trajectory in time, so our positioning remains cautious. However, we are mindful that this thinking has become consensus, so we are wary of pushing our net exposure to the market too low in the short term.

Furthermore, the full economic impact of the COVID-19 restrictions could take months to play out, and rallies during these times can be violent. We currently hold a conservative net long position. Most importantly, we hope you and your family are keeping well in this unprecedented time.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.