We believe that one of the most violent 50-day rallies in market history is quite difficult to comprehend unless viewed through the lens of significant policy action. This presents significant challenges for companies to navigate.
The US Federal Reserve Bank was buying more than US$1 million in financial assets every second during the peak panic phase of the COVID-19 crisis. But more importantly, the timing of liquidity stimulus matters almost as much as the magnitude. This was by far the fastest policy response ever to an economic downturn1 and it caught many people off guard.
We believe it's much harder to square the rally with the economic and corporate fallout, which is proving to be quite large, and a sustainable demand recovery is dependent upon health solutions rather than just fiscal and monetary policy.
As such, we remain somewhat sceptical as to whether the economy can launch a rapid pre-COVID-19 pandemic rebound as implied by consensus earnings and liquidity-induced market pricing- no matter how strong the policy response.
Importantly though as with all economic downturns, the impact will not be borne equally across industries and companies. We believe a few well-placed companies will see little to no profit erosion this year whilst many may rack up very large losses and potentially face painful rights issues, and some are even facing insolvency.
For some cyclical companies, the worst may be yet to come
While we sympathise with the policy-led market rally into cyclicals given the extent of the sell-off, we struggle to see the kind of earnings pull through that would justify a more sustained rotation. Even if demand were to recover, profitability may be more constrained and capital bases would have expanded through higher debt or equity recapitalisations.
We believe there are four main complex challenges which many companies now face.
- One such challenge is how to operate both safely and economically at the same time. For example, health and safety regulations and social distancing mean it is harder to get the same efficiencies from your factory floor. This may impact profit margins even once demand recovers.
- Businesses will also clearly need to develop more resilient supply and distribution systems as they place greater value on reliability and redundancy. That may also come at a cost.
- Some companies are very concerned with the geopolitical fallout, particularly with respect to China and the US, which is making it very difficult to plan capital expenditures in industries where it is already difficult to generate a positive return on capital.
- Many old economy or offline businesses now realise they need to have a full online offering. This will result in significant profit margin pressure as these companies become encumbered with dual cost structures associated with running a legacy store, or branch network, alongside supporting a growing online business. This may mean businesses may operate at a cost disadvantage versus those digitally native companies.
We prefer structural rather than cyclical exposures
As opposed to cyclical exposure, we prefer the relative safety and support of long-term structural trends that allow highly profitable companies to compound their cash flows at a higher-than-average rate over the long run, whatever the weather.
That is not to say that these trends are immune when the world stops but the long-term outlook remains definitively positive in our opinion. We remain confident in our belief that these growing end markets will continue to take share of the overall economic pie over the next five years and beyond.
Examples of long-term structural tailwinds that look set to continue, despite the COVID-19 crisis, include enterprise cloud deployments, investment into highly targeted biologics, factory automation, companion animal care, and semiconductor chip design.
The importance of fundamentals
Major one-time events like COVID-19 or bigger behavioural shifts like disruption, not only serve to widen the gap between new trends and old trends, but they can also forge a massive gap between new business models and old ones.
At a very basic level, winners in this environment need to first survive the current crisis and then thrive post the crisis and capitalise on the recovery when it arrives.
- Surviving means strong balance sheets and the ability to earn some cash flows to avoid depleting capital in a very challenging and highly restricted demand environment. We believe low return, highly-levered companies are much more exposed to these risks, particularly where demand for their products and services are more discretionary and cyclical in nature. We avoid investing in such companies at all stages of the cycle, preferring companies with stable end markets and strong customer relationships.
- The second stage that will characterise success is the ability for a company to thrive longer term, meaning to focus on companies that genuinely have the opportunity to expand their cashflows even in a background of impaired economic growth. We believe these companies are less economically sensitive and are still likely to take economic share over the long run as they are on the right side of their industry trends in terms of growth and business model.
So, while stock selection is always important, it is perhaps now more than usual. The second big takeaway is that we think investors need to focus on a long enough time horizon where the fundamentals can do the heavy lifting, providing the companies with the runway required to extract the value that resides within superior trends and business models.
Trying to second guess the short term is an impossible task and can tie investors up in knots. In the short term, we have seen that markets are driven by speculation with little connection to underlying fundamentals (such as earnings, dividends, cashflows). In our view, it’s hard to get an edge here.
In the long term it is very different. We believe that in the long-term it's the change in the fundamentals that explain the vast majority of total shareholder returns. In our view, over a period of 10 years, we expect between 80 and 110% of your total return would be explained by fundamentals, not by changes in valuation.
When we think long term as investors, the picture becomes much clearer. We believe investors that are prepared to look beyond short-term volatility and assess value over a longer timeframe than the average investor have an exploitable edge.
Our focus is on companies that can compound their cashflows at an attractive and above average rate for a very long period of time, whilst offering greater stability of cashflows, and this has served us well both in good times and bad times.
Subscribe below to Institutional Edition to receive my latest articlesAndy Gardner, Investment Manager Global Equities
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