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Tuesday, 8th December 2020 16:49 - by David Harbage
Festive city lunches are likely to be more subdued affairs this season, but we’ll try to get into the party spirit with a quiz question: "which year did the Queen proclaim to be an 'annus horribilis'?" Answer can be found at the end of this blog, award yourself a pat on the back if you come within two years of the correct date.
2020 has been an eventful one, dominated by Covid-19. With the first case of the coronavirus being documented in Wuhan on 31 December 2019, it subsequently became a pandemic. Never has our health been so closely scrutinised – as the previous year’s domestic news focus on Brexit switched to the infection - and the nation’s financial health has also been tested with UK bank, commonly known as base, rate cut to 0.25% and then to 0.1% on the 11th and 19 March.
Beyond the overnight offering, longer term interest rates (in the form of either HM government-backed or company-issued bond yields) have also fallen. In addition, other assets – traditionally chosen for their longer term merits, but necessarily featuring higher inherent higher risk-reward and volatility – have also made investors reassess the merits and suitability of each investment, as well as their own evolving comfort zones. For the record, the risk-free rate of a ten year UK government stock has fallen from 0.85% on 1 January to an all-time low 0.08% in August, before the yield on such gilt recovered to almost 0.3% by the end of 2020. For those with appetite for more risk, company bonds pay a little more: up to 2% yield to redemption, if perusing the investment grade universe.
What of equity returns? The rationale for owning a stake in successful businesses – to share in the anticipated growth in profits, dividends and asset appreciation over the longer term – was jettisoned by many who could not stomach the prospect of a seemingly unlimited drawdown in the worth of their equity investments. The shutting down of many parts of the economy, along with massive government intervention to support livelihoods and businesses, has provided plenty of headaches for both institutional and private investors, to say nothing of traders focused on shorter term returns.
With the benefit of hindsight, stockmarkets’ initial response to the potential calamity of corporate failure resulting from the suspension of normal economic life was overstated – as, almost without exception, equity bourses have bounced back from their lows in late March with several (notably Wall Street, but also Japan and Germany’s) scaling new heights. The announcement of success in the search to find an effective vaccine for Covid on November 9 was a positive catalyst to lift ‘animal spirits’ and prompted a 13% rally in the FTSE100 for the month. Having jumped from 5,520 to reach 6,270 last month, the index has continued to strengthen – even as the Chancellor warned of tough economic times ahead and appraised us of the nation’s increasingly indebted public finances.
So, what does 2021 hold for investors? Considerably less uncertainty than we faced six months ago – as the US election is behind us, a Brexit trade deal (or not) will be in the ‘rear view mirror’ and the prospect of waning Covid-19 induced economic disruption. Undoubtedly, difficult times lie ahead for much of the world’s population – both economically and health-wise – and the authorities (central bankers, politicians, regulators) will have to be careful to maintain financial stability as we try to return to normal. Are company shares fairly pricing in the risks or are they overvalued?
In an arithmetic calculation, most of the present day value of a company’s equity capital is represented by an assessment of its longer term earnings or dividend income stream – while a relatively small portion of its current price is attributed to its near term (say next two years’) income. Clearly individual businesses vary in terms of making such judgements – in terms of their maturity (from ‘start-up’ to distributing the bulk of profits), through to variable enterprise worth (equity-loan capital mix) – with asset duration varying substantially. Bottom line is that while analysts would be loath to forecast beyond a two year time horizon, investors necessarily make decisions based on their perception of a business’ much longer term prospects.
Looking back over the past year and forward to 2021, one can expect central banks to keep interest rates (both short and longer term) low – with any pick-up in inflation largely ignored – and governments to continue to support ailing essential industries and issue huge stimulus packages (yesterday’s announcement from Japan of Yen73.6bn, equates to US$700bn, is set to be dwarfed by the US in the next month or so). One could endlessly debate the relationship between a central bank and a government, in terms of where debt resides, how imbalances are serviced and when – or indeed, if - reconciliation or redemption occurs. “Kicking the can down the road” seems too flippant an observation for such a serious subject, but for the foreseeable future it would seem that real assets – such as property, equity and scarce commodities – represent clear beneficiaries of such ‘print money’ exercises.
2021 is likely to feature a lot of corporate casualties, and probably more than that seen in the current year, as supportive measures are eased back and many faltering businesses fold. As Covid-19 infections subside, media headlines will probably focus on the magnitude and efficacy of economic shutdowns – possibly concluding that, with the benefit of hindsight, action taken by the authorities was overly harsh on private liberty and business. By contrast, equity investors will be wondering what 2021 has in store.
The acceleration of the digital age is obvious when looking at the winners and losers amongst listed company shares in 2020; technology-driven, often internet-facilitated businesses dominate the world’s largest. By market capitalisation as at 1 April 2020, these companies were worth in excess of US$300bn: Saudi Arabian Oil (Saudi Aramco) $1685bn, Microsoft $1359bn, Apple $1285bn, Amazon $1233bn, Alphabet (Google) $919bn, Facebook $584bn, Alibaba $545bn, Tencent Holdings $509bn, Berkshire Hathaway $455bn, Johnson & Johnson $395bn, Visa $384bn, Walmart $344bn and Nestle $304bn. Since then, the advance of technology driven businesses, like electric motor vehicle manufacturer Tesla, has only deepened investor focus on the likely beneficiaries of a post-Covid world.
As a consequence, we should not be surprised to see equity indices reflecting this move away from traditional industries - some of which may be side-lined, if not replaced, by new ways of living and working. In the UK, whose stock market is rather a lightweight in technology businesses, it is perhaps not surprising that we have lagged the rebound in share prices that has occurred in the US or globally. In addition, investors with a global perspective have probably chosen to give the FTSE100 index - which began 2020 close to its all-time high, at 7,560, but is currently 1,000 points lower – a ‘wide berth’ with Brexit in mind. Featuring more ‘old pre-Covid world’, rather than ‘digital age’ businesses, one might anticipate further investor neglect of the UK if it were not for the valuation argument. The price of UK equity relative to the US market – based on projected earnings in 2021 for both (using the FTSE100 and the S&P500 indices – is attractive, at a near 40% discount.
More particularly, Britain’s smaller and medium sized stock market listed companies – found within the AIM, FTSE Small Cap and FTSE250 indices – feature a higher proportion of technology businesses than the FTSE100’s near dearth. For instance, technology makes up 11% of the FTSE250 and more than 13% of the remaining London listed smaller segment, including AIM listed companies. The valuation of these businesses, by reference to profits, asset backing and balance sheet gearing (level of debt) appears particularly attractive as compared to larger FTSE100 peers or their own history. Intuitively one might expect smaller firms to be more nimble and flexible in difficult circumstances or changeable market conditions – as well as in pursuing new opportunities, as they present themselves. Based on company announcements over the past couple of months, this expectation would seem to have been borne out by the experience of 2020 as management have taken swift action to preserve cash and adapt to the unusual economic closures.
Another reason for expecting medium and smaller size UK companies to perform well, going forward, is an expectation of further merger & acquisition activity. Aided often by a favourable currency (relative to sterling), overseas predators have not been slow to recognise the apparent value residing in domestic businesses across many listed industries. The last three months has seen a marked pick-up in takeover and bid activity – both in the listed and private sectors – with motor insurer Hastings Group acquired for £1.1bn last month and £850m being paid by RWS Holdings for SDL. Further corporate activity, which will include industry consolidation - where a marketplace is overcrowded or expected to shrink in the difficult times ahead - is confidently expected in 2021.
Following the release and this month’s approval (in the UK, at least) of a vaccine, ‘light’ has appeared at the end of the Covid ‘tunnel’ and the writer has joined the market consensus opinion in taking a more benign view of the outlook for equity markets. However, global and domestic economic output is set to be sluggish and potential investors in individual companies must be diligent in assessing the balance sheet strength and the prospects for sustainable earnings – in the knowledge that many will not survive. Against such a backdrop and looking into 2021, preferring to own collective investments to gain diversification (reduce the risk of individual company disappointment) and active portfolio management (from an experienced specialist fund manager), the following assets continue to have appeal for this particular observer:
Gold – both physical metal (i shares ETC) and the producers (i shares ETF and the actively managed Golden Prospects investment trust) - as mentioned in the previous blog (written the day before Pfizer’s vaccine announcement), the limited supply precious metal should benefit as fiat currency expands (from governments’ stimulus packages).
Global equity – with a focus on either defensive business activities (Scottish investment trust) or high quality growth companies (Smithson investment trust), large, technology focused industries (Scottish Mortgage investment trust) or medium sized technology firms (Edinburgh Worldwide investment trust) or an attractive discount to underlying net asset value (Brunner investment trust).
UK smaller and medium sized companies – in expectation of M&A activity and appreciation of their growing ownership of technology assets (JP Morgan Smaller Companies, JP Morgan Mid Cap and Schroder UK Mid Cap investment trusts).
Private equity – often with a bias to the digital or internet-facilitated age, also set to make acquisitions at distressed prices in weak economic conditions, priced on significant attractive discounts to net asset value (via global managers: Harbourvest Global Private Equity, Standard Life Private Equity and Pantheon investment trusts or technology-rich Oakley Capital and ICG Enterprise investment trusts).
Flexible - multi asset manager, with a focus on real, inflation-proof capital preservation on an attractive discount to NAV (Caledonia investment trust)
Specialist – industrial warehouse property (Tritax Big Box investment trust), global infrastructure spend (Ecofin Global Utilities & Infrastructure investment trust) or an attractive discount to net asset value (Picton Property Income investment trust)
Finally, as ever, please note that the above mentioned investments are not a recommendation; readers must carry out their own due diligence.
P.S. the Queen said her AH was 1992, when three royal marriages collapsed and fire destroyed much of Windsor castle.
The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.