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The last six weeks have seen some wild fluctuations in the share prices of many US tech stocks, which appear to have impacted the ASX’s tech sector. In August Apple (+22%), Facebook (+14%), Tesla (+74%), and ASX AfterPay (+33%) had strong months with share price gains significantly higher than the index. However, September has seen these high-flying companies come back to earth, falling between 10-20% over the past 15 days.

One reason why markets rise sharply is that when are more buyers than sellers. However, sometimes it is difficult (as it was in August) to determine a reason why individual stocks post strong gains, especially when a company has not provided new news.  

Last month we saw the financial press clutch at straws trying to find the reason behind steep price movements that were markedly different from both the underlying index and the overall market. However, in the last week, it has been revealed that a large options trade from Japan’s Softbank, in combination with retail trader exuberance, seems to have prompted outsized gains in these prominent tech names. In this week’s piece, we are going to look at how relatively small trades in derivatives can have a large impact on underlying share prices. 

Setting the Scene

2020 has seen a dramatic increase in the numbers of retail investors entering equity markets for the first time, typically opening brokerage accounts with the zero-cost platforms such as Robinhood in the USA and Commsec in Australia. Many of these new investors are stuck at home with stimulus payments, no sports to bet on, and uncertain economic prospects, so have gravitated towards investing in shares. Naturally, many of these often millennial investors have invested in tech stocks with which they are familiar. These stocks also have the appeal of delivering earnings growth in an uncertain environment. Therefore we have seen tech stocks globally gain sharply in 2020, trading on valuation measures that defy conventional logic. An example is the loss-making APT, trading on 44x revenue.

Institutional investors have also been forced to buy these growth companies. As these stocks become a larger part of the index they must be included in index funds. Active managers concerned about underperformance – and often ignoring valuations – buy them for fear of missing out.

Magnifying gains through options

Facing uncertain economic prospects and observing that the FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks only seem to go upwards, an increasingly large number of investors have sought to magnify their gains by investing in call options rather than physical shares. Additionally, with companies such as Tesla sitting at a share price of US$2,200 (pre-stock split) and Amazon at US$3,100, buying call options for a fraction of the cost is seen as a cheaper way to participate in the rally.

Call options are financial derivatives that give their holders the right to buy a specific asset by a particular time at a given price. For example, in early June Apple (AAPL) was trading at $80 per share; a three-month call option for/with August expiry with a $100 strike price was trading at $3.50 for one contract for 100 shares. So, for an initial outlay of only $3,500 – which buys 10 Apple call options – the investor has exposure to the movement for the next three months of $80,000 worth of Apple shares. If AAPL finishes August below $99, the investor loses the $3,500 premium paid in May; if, however, the price increases to $110, the investor makes a profit of $6,500 (after subtracting the price initially paid for the call premium).

As APPL finished August at $129 per share, the actual profit was much higher at $25,000, a significant gain for an initial outlay of $3,500.

From the above table, you can see that buying “out of the money” call options (options that have a settlement price far higher than the underlying stock’s current share price) in late May generated a substantially larger profit than the $2,144 that would have been gained from simply buying the AAPL shares at $80 and selling at $129 in late August. Though if AAPL had increased from $80 to $99, the holder of the $100 call option would have lost the $3,500 paid for option in early June.

Higher returns attract new entrants

Purchases of call options surged going into August in the USA. Small day traders spent around US$40 billion on call premiums according to data from the Options Clearing Corp. The options buying was concentrated in the popular tech sector names such as Apple, Facebook, Amazon, Netflix, Alphabet, and Microsoft. Most of these companies had a record amount of call options outstanding in August, and upward momentum in their underlying share prices generally.

Into this heated market, Japan’s Softbank reportedly paid $4 billion to buy short-dated out of the money call options with a notional value of $30 billion, with the counterparty’s major investment banks. This very large options position likely exacerbated the tech rally in August and then fuelled the fall in September as it was unwound.

Delta Hedging

In an options trade, Softbank’s counterparty would buy a certain amount of stock to hedge their potential losses based on the sold call option’s delta. This is done to prevent significant losses in the event that the option finishes in the money and the counterparty has to deliver the stock to the option holder.

An option’s delta expresses the change in price a derivative is likely to see based on the price of the underlying company’s share price. The delta varies according to the distance between the current share price and the price at which the option can be exercised, as well as the time left in the option contract.

Take the above example of Apple $100 August call options. In late May with Apple’s share price trading at $80, the delta on these options was 0.2. SoftBank’s assumed purchase of AAPL options (along with the outstanding retail) for $750 million would have resulted in the counterparty selling Softbank the call options initially buying $525 million of AAPL stock to hedge their exposure.

However, as AAPL gained sharply through July and in particular in August, in our example SoftBank’s counterparty would have been forced to buy more AAPL stock in the market to delta hedge their exposure. As the delta of the options approached 0.95, in this example the counterparty bank would have needed to purchase around $1.8 billion in AAPL stock, putting upward pressure on the share price. On average the value of AAPL shares traded per day is around $1billion, and this increased to above $3 billion in August. It is likely that the “melt-up” of AAPLs share price was due to the forced buying of AAPL stock by investment banks looking to hedge their exposures to the derivatives contracts sold both the the NASDAQ Whale and the legions of retail investors.

Our take

Share price movements typically reflect the balance between the number of buyers versus sellers of stock on a particular day. However often the reasons behind price movements can be quite opaque. The August gains in tech stocks in the USA which probably had an influence on the ASX’s tech stocks such as AfterPay were likely influenced by the forced buying of tech names such as AAPL, due to the delta hedging activities of the investment banks that sold call options. Similarly, the falls in September are likely to be due to these positions being unwound. For example, Softbank almost certainly did not want to take delivery of $38 billion worth of AAPL stock in late August, preferring a cash settlement from the banks that sold them the options.

From these observations, one could take the view that buying out of the money call options is a sound investment strategy. However, around 80% of call options expire worthless with the seller collecting the premium. As a regular seller of call options in the Atlas High Income Property Fund, this has been our experience over many years. We find that buyers are generally too optimistic with regard to the expected near-term share price gains. Indeed, all of the options that we sold at the end of June, for expiry last Thursday on the 17th September, expired out of the money. This earned Atlas extra income that helps us pay our 7% yield.

• In August most listed companies in Australia reported their profit results for the six months ending in June. This period has arguably been the most challenging for real estate ever. At no stage during the 1992 recession or the GFC were large sections of the economy closed by the government and Australia’s borders effectively sealed. While the shopping centre trusts saw significant declines in earnings, many other property trusts were far less impacted from CV-19 than was feared during the dark days of March.
• The Atlas High Income Property Fund gained by +5.3% in August, a pleasing outcome as many companies in the Fund reported stable earnings, paid distributions and were quietly optimistic for 2021. A common theme from reporting season was that business conditions have continued to improve since June, with tenants paying rent and new leasing deals being signed.  
• In an environment where interest rates are close to zero, we see that in the near future, the market will re-rate property trusts that can deliver a stable stream of dividends to investors. What the August reporting season demonstrated was that real estate is not a homogenous asset, with some landlords seeing a minimal impact from CV-19.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2020.

Lessons from reporting season

Nathan Bell, head of research and portfolio management at Investsmart, highlights the travel sector which saw airlines and travel retailers at the epicentre of the COVID-19 storm. “You could hear the desperation in Alan Joyce’s voice as he pleaded for state borders to reopen after announcing a $4 billion loss”.

The August 2020 reporting season was always going to be very unusual, dominated not by company-specific factors, but instead by rising political tensions, unprecedented fiscal stimulus plans, travel bans and government-mandated shutdowns. The impact of COVID-19 on our society over the past six months almost surely was outside of the disaster planning scenarios of both companies and investors alike.

Against this challenging background, markets were expecting horrific financial results and large losses as we enter this reporting season. Outside of travel-related companies, corporate results ended better than expected. In this week’s piece, we look at key themes coming out of the August 2020 reporting season.

More information than usual

Despite the uncertainty, many ASX-listed companies have improved communications with their shareholders, with some companies including Transurban and Sydney Airport giving monthly updates on operating performance which looked very dramatic in April and May. On the positive side of the ledger JB Hi-Fi, Coles and Wesfarmers provided out of cycle updates, highlighting sharp increases in revenue during lock-downs. Traditionally, Australian corporates may only offer a relatively bland update in May between presenting their first-half profit results in February and their full-year results in August.

Additionally, most companies are “in blackout” and don’t communicate with investors between late May and reporting results in August, a state of events that were different in 2020. This quiet time has been instituted to avoid giving institutional investors an advantage over retail investors, as being able to ask a CEO questions in private while their company’s financial reports are being compiled could provide reliable and profitable clues as to whether a company is likely to outperform or underperform expectations on results day. In the August 2020 reporting season, there have been fewer surprises (especially negative ones) than usual due to the higher levels of investor communication brought on by Covid-19.

Bad News out of the Way Early

A key theme in 2020 has been companies first introducing bad news in June and July and then delivering positive news flow on results day in August. This theme was seen in QBE, Worley Parsons and Coca-Cola’s results, all of which provided gloomy predictions and asset impairments in July and June. In August, these companies saw a strong rebound in their share prices as their financial results offered some positives and the company paid a dividend that was higher than the market had expected.

Minimal Guidance

Against this background of uncertainty, 70% of the companies that have reported in August 2020 have either not issued earnings guidance or have withdrawn profit guidance for the upcoming year. With increasing class-action lawsuits challenging listed company continuous disclosure reporting requirements, the refusal to provide earnings guidance during heightened economic uncertainty is understandable.

When a company reports an adverse event that results in a steep fall in share price, it is now common practice for lawyers to seek damages on behalf of investors, arguing that losses were solely due to the failure of the company to keep the market appraised of adverse events. The class action funder then takes a percentage of the settlement, which can reach as high as 45% of the total award if the case reaches a courtroom. For example, in 2018 Woolworths faced a $100 million lawsuit, alleging that the company was in breach of its continuous disclosure obligations. In early 2015, Woolworths’ shares fell after management informed the market that profit growth for the year would be below the previous guidance of between +4 and +7% growth over the previous year. This change was attributed to a management decision to lower prices to win market share back of Aldi and Coles, rather than maximise short-term profit.

In recent years Australia has become one of the most favourable jurisdictions in the world for shareholder class actions, attracting both domestic and foreign litigation funders and raising reporting guidance anxiety for locally listed corporates. In late May the government responded to the elevated uncertainty of COVID-19 by relaxing the continuous disclosure obligations under the Corporations Act 2001 for six months. However, the raft of outstanding lawsuits, rising insurance costs for company Directors and Officers and the expiry of the shield in November must surely have made companies wary of issuing guidance.

The Haves and Have Nots

The CV-19 pandemic has not been uniformly bad for all Australian companies. In contrast to travel-related companies (including Sydney Airport, Flight Centre and Qantas) and listed property trusts with shopping centre assets (Vicinity Centres) that have seen significant revenue and share price declines over the past six months, a range of companies have performed well ahead of expectations in 2020. Electrical retailer JB Hi-Fi, hardware and office retailer Wesfarmers, AfterPay and Domino’s Pizza all saw record profits over the past six months, benefiting from elevated online spending and consumers staying at home over the lockdown period.

Government Handouts

Cash handouts from the government have been a significant feature of the August results season, although generally not openly discussed. Programs such as JobKeeper and higher JobSeeker payments have assisted consumer plays such as JB Hi-Fi and AfterPay, as cash payments from the government have supported retail sales, despite the significant rise in the unemployment rate. Premier Investments’ result attracted a large amount of commentary in the press after reporting a record profit on the back of strong online sales, maximising JobKeeper subsidies and rent waivers. However many other companies Including Crown, Sydney Airport, Tabcorp, Carsales.com and Cochlear, have also benefited from stimulus plans in 2020 without receiving the same level of media attention.

Best and Worst

Over the month, the best results were delivered by JB Hi-Fi, Amcor, WiseTech and CSL; all of which reported strong earnings growth in a highly challenging macroeconomic background. Reliance Worldwide, Flight Centre, Stockland, Star Entertainment and QBE Insurance all saw strong share price performance after the release of their results, down substantially on 2019 results by better than low expectations.

On the negative side of the ledger Challenger, Telstra, Seek, Bendigo Bank and AGL Energy all saw weak share price performance over August. The common themes amongst this group were the profit results weaker than expectations combined with bearish management commentary for the coming year, mainly due to the inability to reduce costs in line with revenue falls.

Treasury Wine’s share price also fell in August, not due to their results which were quite solid, but rather on news that China’s Ministry of Commerce has launched an investigation into “dumping practices” of Australian wine producers into China. Wine is now expected to join beef and barley on the 2020 list of Australian goods attracting tariffs when imported into China, a material event for Treasury Wines that derives 40% of their profits from the Chinese market.

Our take

In aggregate the August results season was better than expected, with a number of companies in the Atlas Portfolio delivering profits ahead of estimates and a few companies paying unexpected dividends. What was clear from the August financial reporting season was that the CV-19 pandemic had impacted Australian companies to varying degrees. This contrasted to the dark days of March 2020 with the median return for the 200 companies comprising the ASX 200 was down -23%, on investor fears that CV-19 would be very damaging for all companies, irrespective of their business model or industry. Indeed, some of the apparent winners from COVID-19 such as JB Hi-Fi and AfterPay were sold down heavily in March.