Two key risks the market is ignoring – Part 1: Balance sheet risk

Balance-sheet strength is a quality that has thus far been significantly underappreciated in the recent market sell-off as investors overly focus on short-term earnings – but that state of affairs is likely to change

27/04/2020
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Authors

Liam Nunn
Fund Manager, Equity Value
Simon Adler
Fund Manager, Equity Value

Given the dramatic price falls we have all had to endure of late, it might seem redundant to sound a warning on investment risk. And yet, here on The Value Perspective, we believe the wider market is largely neglecting – and thus failing to price properly – two key sources of equity risk. If we are correct in our analysis, this would mean both the present situation and recent market trends are inherently unsustainable.

This pair of crucial considerations are balance sheet risk, which we will look at today, and valuation risk, which we will discuss in Two key risks – Part 2. The bull market we have witnessed over the last decade has in many ways been characterised by the gradual erosion of respect for these two risks, which history shows are hugely significant for equity investors.

Before we go any further, however, let’s briefly touch on what has happened over the last six weeks or so. Not only has the market’s reaction to the threat of the Covid-19 pandemic been dramatic, it has thus far also – as we shall see in a moment – been pretty one-dimensional. To illustrate the first point, the following chart shows all the 20%-plus and 30%-plus falls the US equity market has suffered since the 1920s.

280420pt1

 

Look down the list of dates in the left-hand column and you will find some epoch-defining market events – from the Wall Street crash in 1929 to, more recently, Black Monday, the bursting of the dotcom bubble and the great financial crisis. These are the sorts of traumatic episodes that people write books about – and yet, in terms of the sheer pace of market reaction, none of these falls was as dramatic as what we have just seen.

Unprecedented times

We are living through unprecedented times – and not just in the way everyone’s daily lives are being put on hold as the world battles the threat posed by this awful virus: from a purely financial market perspective, we are also in uncharted territory. As we mentioned at the start, though, the market’s reaction in recent weeks has not just been dramatic – as the next chart shows, it has also thus far been somewhat one-dimensional

280420pt2

Showing the eight best-performing sectors globally over the year to 25 March on the left and the eight worst performers on the right, it highlights where the pain has been concentrated up to now. Given the rout in oil prices, it is no surprise to see energy as the hardest-hit sector but, as you read across from the right – banks and consumer services, capital goods and materials and so on – a clear pattern emerges.

It is the cyclical areas of the market that have suffered the most – which is to say investors’ initial reaction has been to focus myopically on short-term earnings risk. The market has immediately marked down those names it sees as facing the most obvious near-term earnings impact from the widespread economic disruption. That  might, at first glance, seem reasonable enough but it is, we would argue, a deeply one-dimensional view.

Why? As we said at the start, the fate of companies’ earnings over the coming months is not the biggest risk investors face at this moment. Although, for some years now, it has largely paid to ignore businesses’ balance sheets and fundamental valuations in favour of earning growth, perceived quality, potential to disrupt and so forth, the market cannot afford to close its eyes indefinitely to these two crucial risks.

Cheap and easy debt

Let’s start with balance sheet risk – a consideration that, in a world of ultra-low interest rates, has faded to the back of many investors’ minds. With debt so cheap and easy to come by for most businesses over the last decade, it has becoming increasingly tempting for companies to decide it makes sense to gear up in order to buy back shares, carry out mergers and acquisitions and so on.

And generally speaking – particularly in the US but also to some extent in Europe – the market has rewarded this kind of behaviour. As a result, average levels of borrowing across developed markets are far higher today than they were heading into the global financial crisis in 2007 and 2008 – which means that many businesses are now significantly more vulnerable to an earnings shock than they might otherwise be.

The irony here is that many of the companies hit hardest in the initial round of selling – the ones in the right-hand sectors in the above chart – are not necessarily the ones who have been riding high on the wave of cheap debt. Our own holdings in mining, oil and gas and even, to some extent, banking are entering this crisis with far stronger balance sheets and far more conservative capital structures than at the peak of previous cycles.

And yet the market has apparently not been minded to give them any credit for that. Thus far, balance sheet risk does not seem to have entered the equation – but we do not believe that will last. Given the scale of the economic threat that is now unfolding, we would anticipate a lot of businesses will leave their equity investors vulnerable as a consequence of overly aggressive capital structures and excess leverage.

Balance sheet strength

Still, while the wider market may have been all too relaxed about balance sheets in this cycle, here on The Value Perspective, we have been anything but. One area we always put a huge amount of emphasis on when analysing companies is balance sheet strength. Indeed, it is one of our checklist of seven ‘Red’ questions we use to test the case for any potential investment, asking: How does its balance sheet stand up to stress?

We would never suggest our investments are completely immune to balance sheet risk – on the contrary, we will happily take on balance sheet risk if we feel we will be appropriately compensated in return. We do, however, strongly believe the companies in our portfolio are likely to have much better starting balance sheets than the average company in the global equity market.

It has felt very odd to be banging on about balance sheet risk through a long period when debt has effectively been free and hardly anyone has breached their debt covenants – but that state of affairs could now change all too easily. Here on The Value Perspective, we expect our long-term, disciplined approach to work very well as the market is forced to confront the reality that company balance sheet strength matters very much indeed.

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Authors

Liam Nunn
Fund Manager, Equity Value
Simon Adler
Fund Manager, Equity Value

Topics

Behavioural finance
Value
The Value Perspective
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