Value Perspective Quarterly Letter – Q1 2020
The world grapples with a very human tragedy
A very human tragedy is unfolding across the world as a result of the Covid-19 pandemic. While the world grapples with this crisis, it remains our job to do the best we can by those who choose to entrust their money to us.
Equity markets have been extremely volatile as investors react to the latest news-flow and assess the impact of the pandemic on end-consumer demand and companies. The speed of market movements have made it difficult for investors to accurately reflect the impact on companies, and therefore to make sensible pricing decisions. As such, there are many pricing anomalies where prices have moved far further than fair values, and similarly some prices which have not moved enough to reflect the new reality. Up to this point, the market’s focus has largely been on short-term profitability, and has not yet focused or distinguished between companies with differing balance sheet strength. This pattern is similar to what we’ve seen in previous panics, but longer term there is a difference and the market will almost inevitably discriminate in due course.
An indiscriminate sell-off is opportunity for discerning investors
There is an old expression that holds: “You make most of your money in a bear market – you just don’t realise it at the time.” If its meaning is not totally clear on first reading, the following chart starts to drill to the heart of its message. Running from the start of 1988 to the middle of last month, it shows the percentage of Global stocks that have fallen 50% from their seven-year high.
Value investing strives to take emotions out of the investment equation, enabling us to operate in markets gripped by investor euphoria and panic. In many respects, not least the near-vertical line on the right-hand side, this chart is a reflection of the latter and, while it does not say much about the magnitude of the potential opportunity, it says quite a lot about its breadth.
The sheer volume and number of stocks that have been beaten down in recent weeks demonstrates just how indiscriminate the market is being at present. Still to find its feet when it comes to differentiating between balance sheets, sectors and valuation, it is simply marking almost everything down. As such, while the above chart can be seen as reflecting panic, it is also a reflection of the opportunity set for value investors.
At most we buy perhaps one in 10 of all the stocks we analyse. In a strongly rising market, such as at the tail-end of a bull run, that can make life very difficult. As such, with value appearing in fewer and fewer sectors, our portfolios had become concentrated and turnover very low. The kind of market we are witnessing today, on the other hand, where there has been a broad-ranging and indiscriminate sell-off, is one we can – in a considered and discerning way – find more compelling opportunities for our clients.
Diversifying portfolio risk
The broad-based nature of the current sell-off means there is more opportunity to diversify out the risk in a portfolio than there was at the start of the year. Predictably cyclical-type businesses, such as airlines, are suffering in these markets – but so are traditionally more stable stocks, such as tobacco companies and utilities.
At this point, it is worth stressing that, in our deep-value Recovery portfolios, we will continue to be ‘the investor of last resort’. It is what we do and where we are offered the most attractive returns. In the downturn brought on by the 2008/09 global financial crisis, for example, we participated in rescue rights issues in the likes of Dixons, Inchcape and Taylor Wimpey and went on to make our investors many multiples of that original capital.
These were decent businesses with the wrong balance sheet at the wrong time but, we concluded, they were survivors and we should support them when no-one else would. Today, investors are generally not yet being compensated for taking that level of balance sheet or solvency risk but, while we wait for such opportunities, we can still pick up good companies at compelling prices and diversify the risk within our portfolios.
How will cyclical businesses fare in a downturn?
Irrespective of how it is defined, a recession is likely, which means that the profits for cyclical companies are likely to come under pressure. That does not, however, mean that share prices will inevitably decline. It is the stock market’s job to look through cyclical issues to see how the company may fare on the other side. The share price movements have already been severe, and in many cases already price in a significant economic contraction. For companies where the balance sheets are marginal, whether a recession is accurately priced in will depend on the size and shape of the downturn. However, for those companies where balance sheets are sound, we can be confident that, on the balance of probabilities, the odds of success are more favourable today than they were in the past and can begin to move forward prudently.
Many of the cyclicals we have been holding have already been discounting a much more negative economic scenario (which is one of the reasons we hold them). A major focus of our recent balance sheet work was to understand the robustness of the companies we hold if things turn out to be even worse than the market has been discounting. We are comfortable that the companies we own, whilst not immune to the effects of an economic rout, are well placed to weather the coming storm, allowing us to profit from future recovery.
Anglo American is a case in point. It is a business that will no doubt be meaningfully affected by an economic maelstrom, but it has learned its lesson from the last downturn and now scores extremely well across the multiple balance sheet stress tests that we put all of our businesses through. Not only do we believe Anglo American will survive what’s to come, but by virtue of its strong capital position, it may well be able to benefit by buying back its stock at hugely discounted levels. For example, we believe today this business could tender close to 30% of its shares in issue without putting the balance sheet in any peril. There is positive time arbitrage in many of the cyclicals we hold and we believe patience (and some bravery in buying more when attractive opportunities present themselves) will be rewarded.
What is the upside for UK investors?
Why are we asserting that, rather than running for the hills, now is the time to start thinking about increasing your equity exposure? It is because today is presenting a genuinely attractive opportunity to buy into equities – and not just in relative terms. This is no longer just about value versus growth: in absolute terms, the market is starting to look genuinely compelling.
The following is a scatter chart which shows UK equity market data going back to 1924. It plots both the dividend yield from the FTSE All-Share Index – along the horizontal axis – and, along the vertical axis, the subsequent five-year return recorded after investing at these various yield points. As you can see, the All-Share currently yields in excess of 6% – a level only surpassed in two other market episodes.
One was between 1974 and 1976 when, in one of the great market crashes of all time, the index lost nearly three-quarters of its value. This period saw the collapse of the post-war Bretton Woods financial and commercial system, the Nixon shock and the US dollar devaluation – a complete firestorm that resulted in some of the extreme data points you can see to the right-hand side of the above chart.
The market eventually ended up yielding nearly 9.5% over the winter of 1974 – and the only other time that runs it close came immediately after the fall of France, in 1940, just months after the evacuation of the British Army off the beaches of Dunkirk.
These were two very different times in history but, as we foreshadowed at the start, they do have one thing in common. In both instances, amid some of the worst fear and uncertainty they had experienced in a generation, investors were presented with an extraordinary buying opportunity before markets went on to rally hugely over the subsequent five years.
We do not know what the future holds today but we do know history is telling investors to be brave. Markets could well get worse before they get better but, if you are looking to invest on a five-year basis, now is the time to start rotating into UK equities. This is certainly not the time to be trying to call the exact bottom of the market but it is the time to start being brave.
What's next for UK dividends?
Equity income investors should brace themselves for what could potentially be only the second market-wide dividend cut in UK history. The likelihood of this increased when the Bank of England followed European regulators in calling for the suspension of capital distributions from UK banks in 2020
As many will remember very well, the UK’s only market-wide dividend cut to date came as part of the 2008/09 global financial crisis when financial stocks – which at the time comprised a fifth of the market’s total yield – all effectively cut dividends to zero over night.
In any normal market environment, the negative effect of one sector coming under pressure would be offset by growth elsewhere and the market’s overall dividend would continue to move forward. But 2008/09 was anything but normal and, with no companies actually increasing their pay-outs, the fall in financials’ dividends was accompanied by a decline of some 25% across the wider market.
The distinction between those that can’t pay, and those that should pay is crucial
Clearly markets today are also far from normal and it is now likely the decline in the overall UK dividend will be even larger than in 2008/9. However, it is important to make the distinction between businesses that are not paying a dividend because they are unable to, and those that are able to but, in the current environment, ought not to do so.
With other businesses also likely to cut pay-outs as they prioritise short-term liquidity, we have already modelled for a significant dividend cut in our income portfolio. We have considerable positions in sectors (such as materials and oil & gas) where earnings and cashflows that are highly sensitive to the broader economic environment in any given year.
We believe the majority of the businesses that we own in these sectors have very strong balance sheets (debt levels and upcoming refinancing risks are something we look at every time we analyse a company), and many of them have the financial capacity to maintain absolute dividends through a temporary profit dip. Whether or not they will elect to do so in the face of economic uncertainty is another matter, however.
If the global economy does experience a major recession as a result of this crisis, it is unfortunately highly likely that very cyclical businesses may well have to curtail distributions to shareholders in the near term. As long-term investors, we support this action. We would much rather see a business that we own protect its balance sheet in the face of a difficult-to-assess economic threat, rather than blindly pursue the maintenance of dividend targets that were set in a completely different environment. Making uneconomic decisions to maintain an unsustainable dividend will ultimately destroy shareholder value.
In the past, we have been willing to own businesses in income funds that have just cut their dividend if we believe the ‘recovered’ yield will be prodigious on the capital we’ve invested. We are very happy to be patient, with much faster growth opportunities from dividend cutters than those struggling to maintain their dividends.
This also holds true for businesses that we own in the portfolio today if they experience a cyclical downturn and have to temporarily reduce pay-outs. The overall impact on the intrinsic value of a business from a temporary dividend cut is extremely marginal, and at times like today it is important we don’t lose sight of that amid the short-term market noise.
A foundation for growth
There is no doubt that UK market-wide dividend cut will harm income in the short-term. We find this very difficult, as many retires and investors rely on equity income to cover their costs of living. While any cut in the UK Income fund’s distribution is disappointing, given the compound growth of 9% per annum over the past decade, the new base will still be high in the context of the fund’s long-term history and it should also provide a solid base upon which to build and grow the fund’s distribution over the next three to five years.
One final observation on the UK market overall, is that coming into this crisis the market yield was sufficiently high to whether a substantial cut and still among the most attractive income-based investments available to investors. For example, a market-wide cut of 30% would leave the UK market yield 4%, which is not far off the long-term average. From an equity perspective there will be few markets in the world that yield as much as the UK. And when you compare the UK market to gilts or any other income-generating alternative, the dividend yields of both the FTSE 100 and the FTSE All-Share remain relatively attractive in the context of global portfolios.
The Value Perspective 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.
They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.
This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.