26 March 2020
Earnings recession together with an economic recession
US stocks have lost more than a quarter of their peak values in February. While this is less than the 50 per cent fall seen during the financial crisis of 2008-2009, the current market correction has been swifter and more dramatic. Volatility has been exacerbated by the short-selling bans in Europe, hedge funds deleveraging and risk parity strategies cutting equity exposure. This has resulted in some puzzling market distortions where some of the poorer quality companies that were shorted by hedge funds have fared well, while some of the stronger companies that were hedge fund long positions have fallen in value.
Jeremy Podger, Portfolio Manager, Global Equities, notes: “This is what happens in highly volatile periods of the market – few movements can be justified by fundamentals, and nearly everything can be explained by positioning and forced actions by participants who cannot or choose not to hold their ground.”
We believe that certain stocks look cheap compared to their long-term value. For investors, the key is to understand how resilient companies are in balance sheet and cash flow terms, in order to survive the current crisis, and to judge their long-term franchise value. Companies with high leverage have been sold off across the board, understandably in some cases, where liquidity is tight and operational gearing is high. There are situations, however, where debt is high but debt maturities are well-managed, liquidity is strong and management teams are doing all the right things to mitigate the effects of the crisis.
And while it’s difficult to place absolute valuations on some of the companies that have suffered most - in some cases falling by 50 per cent in this month alone - we believe some of these names are trading very close to trough levels. From a price-to-book or price-to-sales perspective, these stocks now offer compelling value.
Angel Agudo, Portfolio Manager, US Equities, says: “The current macro scenario forced by Covid-19 is like nothing we have seen in recent history. Revenues of some sectors will go to zero. This is brutal for the short-term financials of every company in that situation. However, it will have little lasting impact on the value of a company if it can weather the months ahead.”
Opportunities in specific sectors
We see opportunities to add to some of the less economically sensitive stocks that have been hit by indiscriminate selling. These include technology, consumer staples, food retailing, pharmacies, healthcare and e-commerce.
Valuation spreads between similar companies in technology, insurance and healthcare are at record levels and this clearly presents an opportunity.
Many discretionary sectors such as hotels, cruise lines, airlines, restaurants have shut down almost completely. Many of these companies have a big fixed cost base and are priced as at risk of default. However, not all are the same and some will have sufficient liquidity, no imminent debt calls and experienced management teams. These will be able to survive and possibly thrive after this crisis, which will see at least a part of the competition eliminated.
Utilities stocks have also underperformed significantly in the sell-off, falling 34 per cent at one stage compared to a 25 per cent drop in the S&P 500. In many cases, the balance sheets and liquidity positions of these companies are healthy, and some of these names are now trading at multiples of 15 times price-to-earnings compared to 20 times at the start of the year. Stable earnings and cash flows make them an attractive bet in an uncertain economic environment.
Finally, some Japan and China-related companies are now approaching 2008 valuations. With expectations that Asia will emerge from this crisis earlier than the rest of the world - and with a massive fiscal boost, we see opportunities in some retailers, rail operators and leisure companies that have been severely sold off.
“I feel much more confident that the downturn is discounted when I see price-to-book ratios getting close to Lehman levels, particularly small-caps which have moved very quickly,” says Nicholas Price, Portfolio Manager, Japanese Equities.
Roadmap to recovery
Unlike previous crises such as the Asian currency collapse or the US tech bubble, the coronavirus pandemic’s effect on markets is truly global. This creates an environment in which investors are forced to reduce risk as markets fall, leading to periodic waves of panic selling. The real positive for Western markets is there is a roadmap to recovery in the form of China’s example.
Once the dust settles, we believe that companies that can survive the current crisis and are oversold, will recover sharply. Already this week, markets rallied on the back of the $2 trillion US stimulus bill and unlimited quantitative easing unleashed by the Federal Reserve, with sectors such airlines reversing some of their steep falls.
The road ahead is unlikely to be smooth, but long-term investors can embrace the volatility and look for new opportunities that arise from it, while continuing to ask themselves whether the companies in which they invest have the right characteristics to endure this difficult period.
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