Life cycles – The features that make value investing work are present in all things
Equity investors can become so focused on the large listed companies on the screen in front of them they lose sight of the networks of smaller businesses that enable their investments to continue to function smoothly. One useful counter to this are the ‘Red Flag’ reports on corporate distress that are produced each quarter by leading UK insolvency practice Begbies Traynor.
Now, while we will endeavour to end this piece on a relatively upbeat note, there is no denying these reports can make for grim reading. Certainly the most recent instalment contains some stark numbers about the financial distress being suffered by the nation’s smaller companies – especially within a couple of industries.
So, for example, the number of food retailing businesses – here we are talking small, often family-owned local stores rather than the likes of Tesco – classed as being in significant financial distress was up by 58%. At the same time, the number of food and beverage manufacturers – again, smaller businesses producing food and drinks for supermarkets and other shops – thus afflicted was up 92%.
There are some obvious reasons for this. Under intense pressure both to cut prices and generate cash, the very largest players in the food retailing space are pushing that pain further down the chain, whether by demanding lower prices from their suppliers – and then taking longer to pay them – or by increasingly moving onto the turf of corner-shops and other local stores.
It is a similar story – and for similarly obvious reasons – in the oil and gas space, where a big drop in the oil price has seen the majors under pressure to rationalise costs and capital spending. Again the pain is being passed on to the smaller players, with companies in significant financial distress up by 69% in the sector as a whole and by 116% among oil services companies.
It was not exclusively bad news – in the construction sector, which has had a very bad time of it in recent years, significant financial distress had fallen by 30% – but clearly smaller companies are far more vulnerable than their larger counterparts to sectoral downturns. They are less diverse, have fewer reserves and are much more exposed on the working capital front should their own suppliers or customers demand different terms of trade.
Here on The Value Perspective, we often talk about the existence of cycles within the businesses we invest in and of course smaller companies are not immune to their influences. In fact, the ‘amplitude’ of the cycles they experience are greater – more simply, the peaks are higher and the troughs are lower – which is part of the reason investors in smaller businesses need to be looking for greater returns to compensate them for such risks.
But, while the ups and downs may be more pronounced, they are all still happening within a cycle. As the construction sector shows, the bad times do not last forever (nor of course do the good ones) and things tend to even out over time. The features that make value investing work – peaks and troughs, cycles and mean reversion – are not just features of quoted markets but are present in all aspects of economic life.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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