Value Perspective Quarterly Letter – Q3 2021 - UK
We’re publishing three quarterly notes for Q3 2021 – one that looks at the UK, one for Europe and one that looks Globally.
What just happened?
As we write this quarter’s investment outlook the FTSE All Share index stands at 4,050 points. This is exactly the same level it was 2 years ago on the 13 September 2019. If you were an alien who only checked his UK portfolio once very two years you might be forgiven for thinking the UK stock market was a sleepy backwater and Earth the kind of place where almost nothing changes. And yet so much has changed.
The last 18 months have seen:
- The rise of one of the world’s deadliest pandemics
- The greatest fall in Global GDP in seven decades
- The largest and most coordinated Global stimulus package ever instigated
The extreme nature of what’s been going on was summed up by a recent cartoon we saw. A man is watching TV with yet another extreme headline emblazoned across the screen. The man turns to his partner and says “wouldn’t it be nice to live in precedented times again?”.
For many observers, this has felt like an environment where it’s taken a lot of hard work to go nowhere. But this isn’t true for most of the companies we meet. Yes they’ve had one of the hardest years work of their lives. But they haven’t sat around. In many cases, these companies are unrecognisable from the businesses we knew prior to the 2020 recession.
Operational improvements abound
There is an old expression “never waste a good crisis”. And few management team’s will not have seen a crisis as sharp or severe as the one we have experienced over the last 18 months. The best teams have used this challenging period to fundamentally restructure and reposition their businesses for the future. A good example is Rolls Royce.
Rolls Royce was a renowned UK engineering success story. Operating in the large, growing, market for air travel, Rolls Royce was one of only a handful of suppliers of Tier 1 jet engines. Barriers to entry in this market are extremely high. It’s not easy to replicate decades of expertise, huge amounts of investment in people and production and the long-term trust built up with global airlines. Rolls Royce operates a so-called “razor blade” model, where engines are supplied for low prices (and wafer-thin profit margins) but then provide a multi-decade stream of higher margin aftersales and servicing revenues. There was a lot to like about Rolls Royce.
Beneath the surface, however, Rolls was struggling with antiquated business practices, a fragmented production base and a huge legacy workforce. The Covid crisis and the impact on Rolls Royce has been severe, forcing them into a rights issue and to sell a number of non-core businesses. But on the flip side, it has also presented them with the opportunity to streamline their company for the future. Management have grabbed this opportunity with both hands. The fact that over the next 12 months Rolls Royce will reduce their production footprint from three factories to one, but still be able to produce the same number of engines is reveals just what they have been able to achieve.
The road ahead will be hard and there is still much work to be done. Moreover, their has been a considerable cost – financial and human terms as they have mad significant redundancies. However, these steps should allow them to be a better employer and more profitable steward of capital over the coming years.
Can shares in a 500 year old business go up 3 fold in a year?
Rolls Royce aren’t the only business using the crisis to make fundamental changes to their business model. Royal Mail has been a business under pressure for many years. A structural shift away from letters has put pressure on their revenues. A large, unionised, labour force made it hard to cut costs. And a universal service obligation necessitating when they deliver mail and at what price, made the business a political football with little pricing power. The light at the end of the tunnel has always been parcels. Online markets have been growing for a while now, but the onset of Covid saw an explosion in parcel growth rates; to which the constant ringing of our doorbells during our enforced work from home attests. This increased speed of transition – from letters to parcels – has fundamentally shifted the dynamics of Royal Mail in a more positive direction.
However, it’s the uncertainty and fear caused by Covid which has really allowed Royal Mail to change its future. Faced with an almost existential crisis, the management and unions have come together to work in a much more constructive way. This has allowed the company to alter it’s out-of-date businesses practices so they are fit for today’s new reality. Parcels do not need the same sorting machines, delivery patterns or post boxes as letters. But they do need other things which Royal Mail have in spades, such as a dense, highly evolved, final-mile logistics network.
As with Rolls Royce, there are many years of hard work ahead for the company and the path is unlikely to run smoothly. However, the very significant improvement in both near-term and long-term earnings expectations for this business have driven a very significant rally in the shares. It’s a measure of how cheap this business got, that despite a rise of nearly 300% from its trough, we still see considerable upside to fair value for the business today.
Rolls Royce and Royal Mail aren’t the only businesses in our portfolio where long-term profits expectations are improving and we’ve seen significant upgrades from a number of companies which have been struggling over recent years. M&S and Barclays are two such examples, however, more broadly we’ve been struck by how many of the companies held in portfolios are coming out of the downturn in much better shape.
Foreign interest in UK plc tells you its cheap, but don’t look for catalysts
It is perhaps not surprising therefore that we’ve started to see a pick up in M&A activity in the UK. The UK Aerospace and Defence sector has been a major beneficiary with Ultra Electronics, Meggitt and Senior (owned by the Value Team) all receiving approaches in the last 6 months. When it comes to the aerospace cycle, corporate buyers appear willing to take a longer-term view than many stock market investors. Outside of sectors with obvious potential for a cyclical rebound, we’ve also seen, and benefitted from, bid approaches in less exciting areas of the market.
The bidding war which has broken out between two rival private equity buyers for Morrisons plc has now pushed the price up nearly 65% in a matter of months. This is another great reminder why we don’t place huge value in looking for ‘catalysts’ when it comes to our investments. Put simply, the best investments, often by definition, don’t have clear catalysts, or they would not be cheap. But by buying undervalued companies with a decent long-term future, we still benefit as, in our experience, over our typical holding period of around 5 years, the value will out!
So what does the future hold from here? Will the FTSE All Share still be at 4,050 two more years from now? Sadly we don’t have a crystal ball. However, despite extended valuations in many markets around the world, such as the US, today’s UK market valuation look reasonably attractive in the context of history. More than that, many of the stocks that we own have taken advantage of the last 18 months to fundamentally put their houses in order. We remain cautious as we look at the world given the shock we have been through and the huge stimulus that is still ongoing. But we remain confident, when we look at your portfolio, that we can continue to generate positive longer term return for you, our clients.
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.
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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.