The long-term opportunity for patient value investors remains huge

Since markets crashed in March, we have maintained there are good grounds to believe the uncertain environment ushered in by the spread of Covid-19 ought to favour value stocks. We still do

13/07/2020

We have said it before and we will say it again – the moment you think something is certain in investment, you have lost your objectivity. So while we had good grounds to believe the uncertain market environment ushered in by the spread of Covid-19 ought to favour the sort of unloved businesses with solid finances we routinely target, here on The Value Perspective, we never took that as a foregone conclusion.

So at least we got that last bit spot-on. As for the rest ... well, maintaining a longer-term view, we still firmly believe we have good grounds to be hopeful for our portfolios – and here’s why. Back in what was only March but feels a lifetime ago, we expected pandemic-related concerns would lead to markets being beset by volatility and many businesses breaching covenants, requiring more equity or simply going bust.

As a result – as we explained in Why balance sheet strength matters – The Value Perspective team carried out an extraordinary amount of work, in very short order, to reappraise the financial strength of our holdings. In doing so, we gained comfort the work we do through our ‘Seven Red Questions’ investment process and the extra focus we have had on risk over the past few years meant our portfolios were in relatively good shape.

That being so, we expected the rest of the market to struggle while our portfolios held up relatively unscathed – but, as we all know, that has not happened. Almost inexplicably, the market has behaved as if it were on steroids – in the US, April and May were among the best-ever months on record while, in the UK, the same two months produced closer to four years’ worth of more normal returns.

Market darlings

Furthermore, over this time, the strength or weakness of a company’s balance sheet has played no part in the thinking of most investors. If the wider market likes a business, it has not mattered if it is expensively valued and enduring declining profits. The market darlings that were seen as the answer when the economy was strong are apparently still seen as the answer now the economy is weak.

That makes little sense. Take, for example, the aviation sector, where share prices are holding relatively steady and, in some cases, are even up – even though Covid-19 is asking some truly challenging questions of their economic models. There is a not insignificant chance a number of airlines will require recapitalising yet recent share-price behaviour really is not compensating for such a prospect.

If such businesses are the answer then, as the old joke goes, it must be a very silly question – so let’s set all emotion aside and, as we always do, focus on the numbers. At the start of June, the UK market stood at a higher level than for all but 4% of months going back to 1870. To put that another way, that leaves it in the top 5% of all valuations since Crazy Horse beat General Custer’s 7th Cavalry at the Battle of Little Bighorn.

True, the effects of inflation do make that sort of historical comparison unfair and yet, even after adjusting for inflation, the UK is still in the top quarter of all historical market levels. As for valuation, while some markets globally are still looking very expensive, the UK is not among them. As the following chart shows, its current CAPE of 13.2x is at a small premium to its long-term average but it well down on its average of recent years.

‘Worst in modern times’

As for the macroeconomic environment, you do not need us to tell you it is far from healthy. With the Bank of England and everyone else constantly revising their numbers, we will play safe and only echo the line that the drops in GDP and employment look set to be ‘the worst in modern times’. For its part, the OECD last month suggested the UK would suffer the worst economic damage from the Covid-19 crisis of any developed nation.

Not that it is by any means all doom and gloom. The government has stepped in to shoulder much of the burden – in particular, acting to shore up household income – with interest rates cut to 0.1% and a raft of initiatives including furlough schemes, statutory sick pay from the first day of claim, a relaxation of the minimum income floor for universal credit, three-month mortgage holidays and more.

When all is said and done, the UK government has been paying the salary for 8.9m workers and 2.6m self-employed. Out of a total workforce of 32.9 million people, then, more than one-third have had their wages covered by the government – more than one-third – and all this is being done to buy time during which a longer-term solution to Covid-19 might be found.

Under lockdown, infection numbers have declined significantly – and, again, that will buy time. What is more, we have seen unprecedented global support from governments, charities, universities, pharmaceuticals and biotech to find that solution – and rapidly. If they are successful – and if governments can fill the economic void in the meantime – there is little to worry about and markets are likely to continue upwards.

‘V-shaped’ recovery

And yet ... how worried should investors be that the market appears to be banking on just that outcome? The much hoped-for ‘V-shaped’ economic recovery – which would require some kind of medical solution – is all but priced in. It may well happen. Then again, it may well not. Nobody knows because any forecast would require an understanding of the evolution of a virus nobody knew anything about at the start of the year.

And, yes, the UK government currently pays for 35% of the workforce but the furlough scheme is gradually being unwound and employers are being asked to contribute more. In many instances, this is money employers simply do not have – what is more, the government does not have it either. Government borrowing is now forecast to hit 15% of the country’s GDP – a level not seen since the Second World War.

In the meantime, we are left waiting for a vaccine. As regular visitors to The Value Perspective will know, we are big believers in the triumph of experience over hope – that is to say, taking the ‘outside view’, focusing on ‘base rates’ and essentially giving greater weight to more general probabilities than to newer or more immediate information, which can often be a distraction.

So while, happily, legions of scientists are working day and night to discover a vaccine, legions of scientists have failed in similar endeavours in the past. Most viruses never see a usable vaccine. Of the usable vaccines that do exist, most take more than five years to develop. And when they are developed, they are often only partially successful. Sure, this time could be different – but all the other times were supposed to be too.

We are stockpickers

As you will have gathered by now, we are somewhat cautious about the overall market level – then again, here on The Value Perspective, we do not invest in the market and no-one really pays us to have a view on it. We are stockpickers and, within the UK market, we believe there are some areas of opportunity where that V-shaped recovery is not being priced in. Needless to say, we are looking closely at these areas.

The thing is, following the recent rally, opportunities within the market are few and far between. Companies now split broadly into two camps – those relatively unaffected by Covid-19, where valuations are unchanged; and those where valuations have fallen but risks have increased, more than offsetting the decline in valuations. As such, despite a prolific period of hunting for stocks, we are finding far fewer truly compelling investment ideas than we would expect in such an uncertain economic environment.

The good news, however, is that we do not actually need to find new ideas for our portfolios as the biggest opportunity in markets remains the disparity between growth and value. We have been saying this for a while now but only because it is true – however you choose to cut it, spreads between value and growth stocks are pretty much at 100% so, if we are at or near the market bottom, there is a lot of ground left to make up.

Value has seen a few too many false dawns over the last decade for us to be growing too excited just yet. Nevertheless, the long-term opportunity for patient value investors remains enormous.

Author

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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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