The last few weeks have seen a massive sell-off in the equity market caused by the COVID-19 pandemic threat to the global economy and exacerbated by the oil price collapse.
Initially seen as a supply side problem for the global economy as China, the source of the outbreak and engine room of the global manufacturing supply chain, shut down to contain the virus. The issue has swiftly become an even more serious global demand side problem as the virus has spread to developed markets, with governments’ efforts to contain the disease severely disrupting economic activity. Indeed, anecdotal evidence from many companies we have spoken to suggests that, for the moment at least, the Chinese supply chain is pretty much back up and running.
Alongside the 1987 crash, the millennium dotcom bubble and the 2007/8 financial crisis, this is the fourth major equity market sell-off I have witnessed. They have all had different causes, addressing runaway inflation, a drastically overheated sector imploding and a credit crisis. In each instance, equities have sold off severely and every time they have provided major buying opportunities. This is my first medically driven crash. Just as we have recovered from previous crises it is hard to see why we should not rebound economically once the world has either found a cure for it or at least learnt how to live with it. In the short-term, the consequences are highly disruptive with democratic governments being unwilling to see their health services overwhelmed and large numbers of vulnerable people dying. The containment option they are having to adopt to slow its progress is highly debilitating to economic growth leaving many sectors, like the leisure industry with its high fixed cost base, severely exposed. Companies with high leverage are also vulnerable to a prolonged period of poor trading.
Coming into this crisis the Chelverton UK Equity Growth Fund was fortunate to be holding higher than normal cash thanks to heavy inflows after the Tory party election victory. As the crisis has evolved, we have taken a number of steps. Initially we reduced our holdings in companies that we felt were heavily reliant on Chinese manufactured goods, namely B&M European Value Retail (discount homewares) and IG Design (global giftware products). As we became concerned about tourism in London we reduced our holding in Rank Group (casinos, bingo and online gaming) after a very strong run. Finally we have been reducing holdings in some of our more highly rated stocks such as Blancco Technology, IMImobile and The Pebble Group, all after strong relative outperformance, feeling their valuations looked exposed as the tide went out, with a view to increasing our weightings again if and when they sell-off.
To date the sell-off has been pretty indiscriminate giving us the opportunity to top up holdings which we felt look over-sold, to start buying some old favourites, which until recently have not met our valuation criteria (like Electrocomponents and Bodycote) and finally to add some less economically correlated stocks like Qinetiq (defence), Augean (specialist waste) and Goco (the price comparison site), which hopefully will prove to be resilient in depressed economic conditions. Not knowing when the market will bottom out, we have been drip feeding money into the market as it sells off, all the while retaining much higher cash balances (of circa 8%-10% as opposed to the 3%-5% we would hold normally).
Earnings forecasts set earlier this year pre-Coronavirus can obviously no longer be relied on so we are reverting to our “EV/sales to maintainable margin“ methodology, which helps one understand how profitable a business should be and therefore how it might be valued in more normal economic circumstances, so we can identify when shares are massively oversold relative to their long-term value. Undoubtedly, we are seeing some exceptional buying opportunities, but that is of little consolation to unit holders when the market is in freefall. As a reminder, the Fund’s strategy is to invest in cash generative businesses with strong market positions and high levels of revenue visibility. Over 40% of the Fund is invested in companies with net cash. Just as in 1987 and 2008, without being able to call the bottom, I imagine that the current sell-off will be seen as one of the great equity investment opportunities in our lifetimes.
Just as in 1987 and 2008, without being able to call the bottom, I imagine that the current sell-off will be seen as one of the great equity investment opportunities in our lifetimes
As a footnote the oil price collapse seemed to add fuel to the fire causing the oil sector and, to some extent, the industrials to sell off sharply. The Funds exposure to the oil sector (currently around 3% of the portfolio) contains three producers, which are cash rich, and Diversified Gas and Oil, whose output is predominantly gas and is well hedged into 2021, leaving them well-placed to see out the downturn. From a global economy perspective with demand side issues, the low oil price should be supportive.
Tuesday 17th March 2020