COVID-19 viewpoint: James de Uphaugh
Markets are working through social and economic stress, which may lead to a period of extreme corporate Darwinism.
While our thoughts are naturally with those most deeply affected by this pandemic, we recognise that our day job is to steward our client assets through this challenging period.
The equity market has been hit by a one-two: first, the COVID-19 virus turning from what was generally perceived as a local Chinese issue to a global pandemic, and then the OPEC plus cartel having a bust up that undermines the already shaky economics of the US shale industry and with it a chunk of US high yield credit.
Most developed equity markets have fallen 25% to 30% and VIX, a measure of volatility used in risk models, has done a moonshot; what was initially viewed as more of a threat to supply became a massive threat to demand as the impact of rolling lock downs on discretionary consumption began to impact revenues. As the Next CEO said on Thursday, 19 March, “People do not buy a new outfit to stay at home.” Put simply, if private consumption is 60% or more of GDP and it falls approximately 20% for a quarter or so then something needs to take up the slack or there will be a problem. Hence the logic behind the UK Government’s fiscal package being equivalent to 15% of GDP. Most developed market governments are putting forward packages of similar magnitude. Moral hazard, or being seen to bail out the ‘bad actors’, is not an issue this time round. In the Global Financial Crisis (GFC) of 2007-08 the banks had overreached themselves. Here, no one is to blame: it is a biological event. Governments have learnt from the GFC and have gone early and large.
Simple financial theory says that a share price should be the sum of its cash flows over time discounted back. Now obviously it depends what type of share you are looking at but for most UK shares the year 2020 accounts for roughly 10% of the value. Yet markets have fallen more than double that and many shares have been hammered.
We are not naïve to the reality that corporate trading is going to be worse than abysmal over the next few quarters, but it is important not to extrapolate the near term too far forward. Many dividends will be cut, cancelled or deferred, and yes, there will be equity placings from some to get from A to B. But for those companies that have not swallowed the efficient balance sheet textbook and are well financed to get from A to B, they will enter a competitive landscape radically different: make no mistake this will be corporate Darwinism on steroids.
It is also heartening to see companies prioritise other stakeholders at this time of need: the major food retailers are a good example of this as the ‘Big 4’ step up to the plate to feed the nation. We had a post-results call with WM Morrison on Thursday 19 March and they understand this to a humbling degree. They are the epitome of Responsible Capitalism. Government recognises the strategic importance of such retail distribution conduits and has granted a twelve-month reprise on business rates that will be difficult to taper off too sharply.
At this time of gut wrenching uncertainty, with the Financial Times running headlines such as ‘Sterling hammered as London prepares to go into lockdown’*, and stock market volatility (70 stocks in the FTSE 350 Ex Investment Trusts had intraday moves of above 20% on Thursday; others were even more extreme**), it is easy to become myopic and forget that as the economy stabilises the recovery is likely to be powerful with oil low, rates next to zero, massive fiscal support and several months of pent up demand. Remember, investors find value when the headlines are bad, not good.
Much of our analytical work has been focused less on attempting to determine precise estimates for this year’s earnings, and more on scenario planning around liquidity, gearing and other measures of financial robustness. So long as balance sheets and business models are strong enough to withstand this period of unprecedented disruption, we expect the bulk of shareholder value to remain intact and companies to be able to capitalise on the environment as we emerge on the other side. It is at times like this that deep fundamental analysis really counts.
*Source: the FT, print version, 18 March; the online headline for this article has since been tempered https://www.ft.com/content/e836f372-693e-11ea-800d-da70cff6e4d3
**Source: Bloomberg and Majedie 19 March 2020