After a remorseless three week sell-off commencing in the last week of February, equity markets bounced sharply last week, providing some evidence at last that they are not just one directional. Does this mean we are out of the woods, possibly not, but at least investors now know the market has the capacity to rally. However, any sustained rally is only likely to happen once investors are confident of when the current lockdown can end and governments are seen to be able to contain or cope with the virus, so some semblance of normal economic activity can return (as we have seen happening in China). Government efforts across the globe to control the virus with lockdowns of indeterminant durations are going to cause a severe economic shock, whatever local or coordinated fiscal and monetary measures are undertaken to alleviate the damage, pushing the global economy into recession.
In the light of what has happened, most companies earnings expectations set earlier this year are now wholly irrelevant, with many management teams withdrawing guidance until there’s more clarity on the length of the shutdown and how it will affect them. Unable to trade for weeks if not months, normally cash generative businesses with appropriate levels of debt (1.5x-2x EBITDA) are likely to see a rapid escalation in their liabilities as they draw down their banking facilities to meet fixed cost commitments. Whilst tax and rates liabilities can helpfully be deferred from a short-term cash flow perspective, these will nonetheless build up future liabilities on the balance sheet, reducing companies’ equity value relative to debt within their overall Enterprise Value. As with the 2008/9 financial crisis many stocks will need to re-equitise not so much this time to pay bank debt under pressure from their bankers (who will be restrained by government) but either to stay afloat in the short-term or to re-build working capital as life returns to normal.
From the Growth Fund’s perspective, the worst affected stocks have been consumer stocks relying on discretionary consumer spend and in-store customer footfall, like DFS Furniture and Rank Group (casinos and bingo), although we did manage to sell down a large part of the Rank holding before the crisis broke, and stocks exposed to global economic activity with higher levels of leverage such as Elementis and RPS. Both of these companies have strong business models and are highly cash generative in normal circumstances, but look exposed if they’re unable to trade for a number of months. However, in most cases, banks are likely to relax debt covenants, as we’ve already seen at Elementis, and be accommodative through this difficult period. On an Enterprise value to sales multiple, both companies look absurdly cheap in any environment with a semblance of economic normality.
On an Enterprise value to sales multiple, both companies look absurdly cheap in any environment with a semblance of economic normality.
As we have highlighted before, we were fortunate to go into this sell-off with relatively high cash balances, thanks to inflows following the Conservative election victory and several take-over bids for portfolio companies turning into cash. We have been drip feeding cash into the market as it has fallen, topping up holdings that have sold off heavily, as well as building up positions in less economically correlated stocks that could trade relatively well through this difficult period like Gamesys (online bingo and casino operator), EKF Diagnostics (a medical diagnostics company which has recently won a component order for a COVID19 test), Future (online publications and e-commerce) and GoCo (car insurance price comparison site). Somewhat presciently we invested in the IPO of FRP Advisory, an insolvency practitioner, just as the crisis was breaking, which unhappily will probably now trade even more strongly than we’d originally anticipated. Overall, our number of stock holdings has risen slightly as we have found attractively priced investment opportunities in a falling market, which will also help reduce stock specific risk in this challenging environment. Whilst investing into the falls, we have retained relatively high cash balances in the Fund, refraining from chasing the market last week as it rallied strongly, until we have a clearer idea of when governments can get on top of the medical crisis and start to end the lockdowns. It will be important to retain some liquidity to support portfolio companies as they come to the market to re-finance their balance sheets. Indeed, we participated in our first such fund-raising last week for Ten Entertainment, normally a highly cash generative bowling alley business, as it battens down the hatches until it can recommence trading.
Our investors will remember through the second half of 2019 we started to build up holdings in UK cyclicals for the first time since the BREXIT vote. Despite the dramatically changed back-drop we remain happy with this decision as most of the exposure we took on was in the construction sector in companies such as Travis Perkins (builders merchant), VP Group (plant hire), SigmaRoc (aggregates), and Severfield (structural steel), which, whilst being impacted by the lockdown like other businesses, should be early out of the blocks once the crisis is contained and the government pulls the fiscal lever to jump-start the economy.
Whilst we can't predict the bottom of this market, at least the initial free fall has been broken by a rally, meaning this bear market is no longer one directional. Whatever the short-term performance is from here, we believe in the long-term this, like other major sell-offs, will represent a great opportunity to accumulate quality assets for longer term asset appreciation.