A view on financial markets - At the crossroads

Thursday, 7th May 2020 07:55 - by David Harbage

Investors have experienced a turbulent and very uncomfortable 2020 to date, with the COVID-19 pandemic surprising us all and inducing a level of uncertainty rarely seen in our lifetimes. If dear reader, it feels as if you have been living through a disaster movie at worst or a surreal chapter of a book at best, you are not alone. Many of you, torn between wanting to invest for the long term but worried about deterioration in the immediate outlook, have requested an update in the writer’s current thinking.

Both ebullient economists and seasoned fund managers are proving to be uncharacteristically reticent about making short term predictions for either the global economy or most financial assets. After the dramatic fall in listed equity (company share) prices and a subsequent rapid 20%+ bounce-back, technically it could be said that we have experienced bull, bear and another bull market in 2020 to date. This volatility, chronicled in the writer’s 2 April blog ‘March Winds’, continued throughout April – but, while daily moves of 3% or more became commonplace, the FTSE100 index (of the one hundred largest UK stock market listed businesses) has struggled to move decisively one way or the other.

It could be said that the market is at a crossroads and cannot decide which way to go. All eyes are on the pandemic and its impact on the economy, with other issues such as global trade agreements, the US Presidential elections and Brexit negotiations relegated to sideshows. The prognosis for the COVID-19 virus remains unclear and the outlook for economic health, public ‘purses’ and the financial system is even more opaque.

Perceived wisdom seems to fluctuate from day to day, with emotive forces often overriding factual evidence. One day features optimism that the virus’ power is receding, enabling authorities to ease the ‘shut down’; a rapid ‘V’-shaped economic recovery is possible (with government stimulus aiding the bounce-back) and a belief that share prices can experience the shortest ever bear market. On another day pessimism dominates, as fears of a second wave of the virus next winter prompts governments to ‘err on the side of caution’, reinforcing social distancing which prevents many businesses  from operating profitably and paves the way for a protracted ‘U’ or bath shaped depression.

While financial markets have an impressive record of ‘looking through’ or discounting immediate news to focus on the medium or longer term prospects, current economic (unemployment claims), public finance (solvency of PIGS – Portugal, Italy, Greece & Spain) and corporate (dividend cuts) announcements will test the capability of that  ‘barometer’. In particular, the fact that health is clearly a high profile and a personal issue - probably prompting politicians to make ‘heart’ over ‘head’ decisions - cannot be overstated and suggests, from a stock market investor’s perspective, a lag in smart strategies to address the current economic situation and therefore a more protracted recovery in economic and corporate health.         

We shall, of course, be wise with the benefit of hindsight as regards how the COVID-19 virus and its economic consequences pan out but, in terms of answering the question of “should one be invested in the stock market?” a binary No or Yes cannot apply. Rather, against the backdrop of increased uncertainty, featuring a widening of prospective outcomes (as measured both by economic GDP and companies’ earnings), it is important to ensure that equity is a suitable asset (and owned to an appropriate extent) within an individual’s long term savings.

Subject to a positive response, re-consideration of how one might invest is prudent - given the dramatic moves in overall market and individual company valuation over the past three months. Depending on appetite for risk and potential reward, one could choose industries or businesses with resilient defensive business activities - such as household goods group Reckitt Benckiser which produces health, hygiene and home products – as does Unilever in addition to its well-known food and beverage offering. The share prices of these FTSE100 index multinationals have held up reasonably well, with Reckitt‘s shares actually appreciating in 2020.

The brave might try to benefit from a bounce-back in more economically sensitive cyclical stocks, which have fallen much further than the overall UK equity market’s 22% (based on the FTSE100 in the year to date). However, in the absence of visibility on company earnings in 2020 and 2021 (analysts have been encouraged to dispense with forecasts given the current uncertainty, evidenced by widespread dividend cancellations); one has to address two particular issues: will the business survive and secondly can it thrive in an economy that is potentially changing. Ensuring that a balance sheet is not carrying too much debt – relative to expected revenue and tangible, realisable assets – and having confidence in the business model (culminating in profitability) requires diligent investigation of pricing power, costs and operating margins, to say nothing of the experience of management. Essentially the prospective investor must understand how the firm makes money, have confidence that the business can be sustained in the current hiatus and has a bright future.

The pace of change in the world means that investors must constantly assess demand for a firm’s products or services, alongside other demographic developments. The COVID-19 pandemic will undoubtedly accelerate or change some short or longer term expectations. For instance, the technology or facilitators of remote working appear beneficiaries of our recent experience – playing to environmentalists seeking a reduced footprint as an aside – ranging from telecommunication infrastructure through to client relationship management software and cyber security capabilities. There are few UK listed cyber security businesses available for investors’ consideration, but one worthy of investigation is GB Group.

A £1.3bn market capitalised business with low net debt (£35m), its impressive track record of global growth has resulted in a rich rating – notably, a price to earnings ratio of 36 and a negligible yield of 0.4%. Growth is set to pause in the current accounting year to 31 March 2021 but should resume on any stabilisation in economic activity. The broking community like the business, but are wary of the City’s high expectations – as reflected in the valuation – two research houses suggest the shares are a Buy, but the remaining six published views are neutral. Investors should also be mindful that GB Group is listed on the Alternative Investment Market (AIM), which requires lower levels of corporate disclosure than would apply to a fully or premium listing on the London Stock Exchange. There is usually a ‘loser’ to any major change in society and owners of office property – such as the FTSE100 real estate giants British Land or Land Securities - which own significant office blocks in London may be on the wrong side of such shifting work patterns.

The retail experience, which has been changing for more than a decade away from High Street shopping to online ordering and delivery, appears set to accelerate further – notably in food, both grocery and take-away meals - as well as in most other general products. Establishing a price-competitive operation can be both complex and expensive (evidenced by Marks & Spencer‘s belated entry into online delivery of its food proposition), retailers must clearly possess a robust technological platform to maintain a place in an industry whose profit margins appear set to remain thin. Next, at one time dwarfed by M&S, is a good example of a business that has managed the difficult task of remaining relevant in the ever-changing fashion industry – and communicated its expectations, incidentally, to investors – commendably.  

Other industries appear particularly problematic in the short term, requiring an end to social distancing before seeing any prospect of profitable operation. These include public transport and many leisure activities or hospitality venues; the viability of air travel, restaurants and pubs appears especially difficult or uncertain – each activity will no doubt continue, but stock market listed firms in these areas are probably best avoided in the short term. After a period of abstinence, pent-up demand can be expected in a number of areas – from ‘low ticket’ pub meals, through domestic hotel holidays to the wish to purchase a motor car or for an expanding family to move home.

The reader will have their own personal take on whether their health concerns would inhibit a visit to a pub or guest house (your author would be keen, countering a recent nationwide opinion poll indicating reluctance). Based on a consensus of 12 brokers’ views, earnings forecasts have halved over the past three months for pub group J D Wetherspoon in respect of their accounting year to 31 July 2021 (from 78.1p to 38.8p per share). Analysts of the pub (and, more recently, hotel) group have divided views on ‘Spoons’ prospects: 6 say Buy, 3 suggest a Hold and 3 recommend Sell. The industry has a lot to contend with, not least an inflation-busting increase in the living/minimum wage, and prospect of growth in the ‘drink at home’ trade.

Motor manufacturing and retailing is another low profit margin business which is facing obvious headwinds – beyond the current ‘lockdown’, that has reduced UK road traffic to levels not seen since 1946 - in the form of uncertainty surrounding government policy and deadlines on favoured fuel (petrol powered and even hybrid vehicles following diesel to the exit, to make way for electric cars). On an individual basis, most stock market listed motor retailers carry significant financial gearing and this is prompting the sale of less profitable garages, further industry consolidation – per Pendragon and Lookers‘ conversations disclosed this week – or could include a move by management to delist. By contrast with dormant new vehicle sales, the used car market and servicing & parts (the ‘shovels & spades’ of the industry) typically provide a higher and more reliable return on capital. As with air travel, it is difficult to envisage a world without the motor (if electric) car – but investing in the current listed motor opportunities is probably not for ‘widows & orphans’.

While commenting on the vehicle-related subject, Halfords provided a reasonably reassuring update this week. Deemed by HMG to be an essential product retailer, and therefore allowed to remain open for business over the past month or so, the group focuses on vehicle spares and servicing, along with a leisure division featuring bicycles and accessories. However, as a ‘brick & mortar’ retailer, the Redditch-based group has had to cut costs and focus its scarce cash resources. Six weeks ago Halfords announced the closure of its Cycle Republic and the Boardman Performance Centre, along with the transfer of Pure Scooters, as management addressed its less profitable divisions. Profit expectations for the firm’s accounting year to 31 March 2022 have fallen by a third - as compared to that expected just three month ago – but the five research houses publishing a view are typically positive.

By contrast, another cyclical industry appears in much better financial health – based on an inspection of the house builders’ balance sheets – boasting net cash (rather than debt). Foremost in this regard are Persimmon (featuring £844m more cash than debt), Taylor Wimpey (546m net cash) and Barratt Developments (427m net cash), although FTSE250 constituents Bellway, Crest Nicholson, MJ Gleeson, McCarthy & Stone, Redrow and Vistry also have no net debt. Although house prices are expected to ease as unemployment rises, the cost of build (notably labour expense) is falling and profit margins are relatively high by historical standards (EBIT average 21%). The prospect of the Chancellor extending ‘Help to Buy’ (which encourages first time buyers to acquire a newly built home) and reducing stamp duty – as a means of stimulating the wider housing market activity – represents another positive, which underpins (please excuse the pun) this blogger’s appreciation of the sector at this level. Profit expectations have been reduced by circa 25% for next year’s earnings, while share prices have been marked down by as much as 40% despite most builders announcing plans to reinstate work on most sites this month.

Accordingly, prospective investors can choose between the less economically sensitive sectors of commerce – which include food retailing, telecommunication operators, electricity generators or distributors, water providers, pharmaceuticals, healthcare and perhaps tobacco – or the apparently cheaper but more cyclical segments of business activity, which have more to fear from a protracted recession, locally in the UK or globally. Based on some belief in the efficiency of markets to correctly price future returns (discounted by to their present day worth) and the risks (both up and downside) to a central-case prospect, one could decide to own the whole stock exchange listed equity market – which will feature the relatively loved, the neglected and the despised industries and companies (and therefore the highly valued as well as the apparently lowly priced businesses).

As previously mentioned in this blog, the use of exchange traded funds (ETFs) can be employed as a low cost means of owning the whole market or a particular segment of a stock market. For instance, the i share or Vanguard FTSE100 or the FTSE250 ETF enables the investor to replicate those underlying indices (with their inherent diversification) at a cost of 0.07% or 0.1% per annum. One could similarly buy overseas equity markets (or segments, based on the underlying size or business sector)  as well as other asset types - such as government or corporate bonds, commodities or property, private equity or absolute return hedge funds -  to broaden the spread of one’s investment.

As an example of a different asset class, the i share Physical Gold exchange traded commodity (ETC) fund is worthy of special mention – given the current outlook for currencies and, in particular, the stress on central banks and public finances. As most readers will know, there have been massive injections of liquidity or money into the financial system in order to support the economies of the US, Europe and most developed countries – along with interest rate reductions, to a commonplace near 0%, in order to reduce strain on the indebted. With cash paying negative real (after inflation) returns and printing presses set to increase money supply around the world, the prospect of owning a limited-supply, safe haven ‘store of value’ like Gold or another precious metal has increasing appeal.

Projected increases in money supply (in circulation and borrowed) to satisfy government deficits and stimulate economic activity is likely to ultimately produce a pick-up in asset prices and inflation, even while real  economic growth (as measured by GDP) might be negative or at best sluggish. Gold has historically performed well in such a climate of financial distress and still appears undervalued, at its current US$1,700 per ounce, by at least 10% – if only by comparison with its previous peak ($1,921 in 2011), which followed the recession prompted by the Banking crisis of 2008/09. By all accounts the recession that we are about to face is likely to be deeper – although, hopefully, not so long lasting.          

The investor may prefer, in these exceptionally uncertain times, to place their trust in an actively managed investment vehicle – perhaps having to pay a higher annual management fee, but having the comfort that their chosen manager would make selections in accordance with a specific remit (rather than replicating ll the constituents within an index). For instance, one could take the view that possessing strong technology has great appeal in a world which may be moving ever more towards internet-facilitated business. Certainly the tech-rich NASDAQ index has outperformed (albeit, by not falling as far as) other American equity. As an example, the £850m Herald investment trust combines a focus on smaller companies (worth less than US$2bn) in technology, communications and multimedia across the world, but with a bias towards the UK 52% (where the manager believes more attractively valued opportunities typically reside) and North America 23%. Managed by Katie Potts since 1994, Herald has outperformed its peer group over the last 1, 3 & 5 years and currently the shares are priced on a 17% discount to their net asset value (NAV), where they offer an income yield of 3.5%.

In conclusion, we may be at a crossroads in the sense that the market is pausing for breath – awaiting a new catalyst - before deciding which way to proceed. No doubt, when the news flow prompts, the market will move quickly as volatility remains high. Please make long term decisions, so that you are not overly influenced by short term momentum (or market movement), perhaps recording your views and expectations as a sanity check.

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.