Value Perspective Quarterly Letter – Q2 2020

28/07/2020

The Value Perspective team

This isn’t the second quarter that we expected

Back in what was only March but feels a lifetime ago, we expected pandemic-related concerns would lead to volatile markets with many businesses breaching covenants, requiring more equity or simply going bust.

We did an extraordinary amount of work, very quickly, on reappraising the balance sheets of our holdings, and gained comfort that the work we do through our Seven Red Questions process and the extra focus that we have had on risk over the past few years meant the portfolio was in relatively good shape. That being so, we expected the rest of the market to struggle and for our portfolio to hold up relatively unscathed.

However, the past three months did not unfold as expected. 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. By the end of June, Global equities have rallied 37% from the March lows and have to clawback only another 9% to return to February highs.

Turning to valuations, the following charts show that on a market sector basis valuation has not provided protection this year, far from it. The chart below shows which CAPE valuation bucket each of the Global sectors was in at the beginning of this year:

ou are looking to invest on a five-year basis, now is the t

ime 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.

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While the chart below shows the average return of the sectors in each of those buckets year-to-date:

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What was expensive has got more expensive, and what was cheaper has got cheaper. This is indicative of a market dislocation, and the opposite of what is true over the long-term.

The market continues to ignore balance sheet strength

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.

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 left-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.

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.

‘Worst in modern times’

As for the macroeconomic environment, you do not need us to tell you it is far from healthy. With central banks around the world 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’.

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Not that it is by any means all doom and gloom. The governments across the globe have stepped in to shoulder much of the burden – in particular, acting to shore up household income – cutting interest rates and a raft of initiatives including job retention schemes and credit repayment holidays.

 ‘V-shaped’ recovery?

And yet ... how worried should investors be that the market appears to be optimistic that a solution or vaccine will be found and markets can continue their upward climb? 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.

We are stock pickers

We are somewhat cautious about the level  of some  stock markets, it should be said that we do not invest in the market. We are stock pickers and although some areas are frothy once again, we believe there are other areas of opportunity where a V-shaped recovery is not being priced in and we are looking very closely at these areas.

The backdrop for broadening out the portfolio was new opportunities offered to us by the extreme volatility triggered by the COVID-19 pandemic.  

We have been able to increase the number of holdings significantly over the past few months; the backdrop for this broadening out the portfolio was new opportunities offered to us by the extreme volatility triggered by the COVID-19 pandemic. The businesses that we have found typically have robust balance sheets, impressive records of cash generation (or cash preservation in cyclical downturns) and, for income funds, attractive dividend yields, all coupled with compelling valuations.

Moreover, 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; whichever way 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.

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The blue line represents the value style of investing, as defined by a composite measure of price/earnings and price/book ratios and dividend yield. Simply put, that line hitting zero means the cheapest 20% of the global equity market has never been this cheap relative to the most expensive 20% at any point in the last 30 years. The market has arguably never – in modern history at least – been so blind to the underlying valuation of shares. It is no exaggeration, then, to suggest this is uncharted territory for value investing. To flip that point on its head and look at it from the other angle, the green line shows just how extreme the valuations applied to the highest growth areas of the market are today. At it’s 99th percentile, the premium the market is applying the growth factor is about as extreme as it has ever been. This means the long-term opportunity for patient value investors is enormous.

GLOBAL EQUITY YIELD AND GLOBAL EQUITY INCOME FUND ONLY :

Dividends

The market falls that followed the global spread of the Covid-19 pandemic ushered in a very difficult time for income-focused equity investors. We continue to update and re-assess our dividend forecasts for stocks held within the fund, and since March, have been modelling for a significant dividend cut for income/yield portfolios. In the first quarter fund updates, we said that many of the cyclical businesses we favour have strong balance sheets and therefore the financial capacity to maintain absolute dividends through a temporary profit dip. Whether or not they choose to do so in the face of economic uncertainty is, of course, another matter. In the past two months, a significant number of companies have elected to cut their pay-outs (or in the banks’ case, been told by the regulator not to pay them).

Clearly we were not the only ones to be so concerned so early into the crisis and, just a few weeks later, the Investment Association issued new guidelines covering the UK Equity Income and Global Equity Income fund groupings as it looked “to ensure that, in light of Covid-19, they can continue to function effectively in the best interests of savers and investors”.

Due to the pandemic, the trade body noted, many companies had reviewed their dividends, with some suspending or postponing payments, which in turn had impacted equity income funds. “This means some funds may be unable to meet the requirements to be included in these sectors, including two tests based on the annual and three-year rolling average yields of the FTSE All-Share and the MSCI World indices,” it added.

‘Short-term disruption’

Between them, the UK Equity Income and Global Equity Income sectors comprise almost 150 mutual funds that aim to provide a regular income for investors based on the dividend payments from the companies they are invested in. The new guidelines are designed to prevent any “short-term disruption” to these sectors, the Investment Association said, “so savers can continue to easily identify and compare equity income funds”.

“They will also enable fund managers to focus on long-term outcomes for savers, instead of potentially needing to make immediate changes to meet sector requirements,” it added. Or, to put it another way, the IA suspended its income criteria as it wanted to avoid a situation where fund managers fundamentally alter their approach, stretch for income and cause a spike in turnover – and thus a bubble in income-paying stocks.

As we have observed in a number of posts on our blog a month later, cuts to company pay-outs clearly do harm income in the short term.  We are working hard to offset the worst of this – as evidenced by the businesses with attractive income characteristics that we have added to the portfolio this quarter.

That said, a clear and consistent investment approach does not just help investors understand what they are buying into, it is the portfolio equivalent of DNA – and therefore something about which any fund manager should be fiercely protective. As the Investment Association has recognised, no-one who seeks to generate income from equities should have to consider compromising their principles in the short-term pursuit of higher dividends.

Author

The Value Perspective team

Important Information:

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.