In anticipation of a resumption of economic growth, the UK equity market has rapidly recovered over the past two months. Jonathan Brown and Robin West caution that it could be two-three years, however, before the economy returns to full health. Given their preference for quality businesses with strong balance sheets, they believe that it’s never been more important to maintain their focus on businesses with the ability to do well even in more difficult times.
The impact of Covid-19 and the economic cost of the measures put in place to try and contain it have injected unprecedented levels of volatility into the UK equity market. As countries around the world entered lockdown, economic activity in many sectors ground to a halt.
Investors reacted by selling shares and in the first quarter the FTSE All-Share index posted its biggest quarterly fall for more than three decades (to finish down 26%). Since then, volatility has reduced but it remains well above pre-pandemic levels for both large and small-cap equities.
Initial fears about the economic fallout from Covid-19 saw typical ‘safe-haven’ assets rally, such as government bonds, gold, and defensive stocks. This was accompanied by significantly higher valuations of technology and internet-related companies. As valuation-conscious investors, we remain highly aware of the impact that valuation can have on future returns. So, while some investors were happy to pay very full valuations for these stocks, we were more inclined to take profits.
More recently, however, the FTSE All-Share has recovered strongly from its lows and is now around 16% off its February pre-COVID-19 correction level on fresh stimulus measures and hopes that economies are on the mend as lockdowns ease. This in large part can be attributed to the expected impact of a dramatic easing of fiscal and monetary policies in all the major economies. Investors certainly seem to have pinned their hopes on a swift economic rebound in the UK. This has led to lower quality cyclical stocks, which often do not meet our quality criteria, rallying hard.
In our view, however, markets have seemingly shrugged off the economic cost of the pandemic, which is likely to be significant. The UK is expected to face a severe recession and estimates for Q2 GDP are around -16%, and -8% for the year (Bloomberg consensus as at 29 May 2020). Unemployment could more than double by next spring, according to the Bank of England, and we believe that it could be two-three years before the economy returns to previous levels of activity.
Our UK Smaller Companies strategies
Our focus is on finding quality businesses with strong balance sheets, and which have the potential to be significantly larger in the medium term. Crucially, we prefer to invest in those which have the opportunity to grow irrespective of the health of the wider economy.
In the UK Smaller Companies strategies, we prefer to invest in businesses exposed to higher growth niches, restructuring stories, businesses that have scope to roll-out a successful concept more widely, or companies that can consolidate a fragmented industry and derive a benefit from increased scale.
As active fund managers, our approach to stock selection is driven by our assessment of valuation and growth potential over the longer term. Companies have to be good businesses of course, and not just cheap. We remain confident in our portfolio and our existing process and caution that there are dangers with buying growth at any price rather than at a reasonable price.
In recent months we have been somewhat perplexed at the bifurcation of the small cap market. Those companies that have performed extremely well have quite often been highly, if not overvalued businesses, or have often been lacking in quality, in our view. This has meant that our strategy of buying fundamentally good business at sensible valuations has been out of favour.
One notable observation that further highlights the bizarre nature of the smaller companies’ market is that the Numis Smaller Companies Index (ex ITs) is currently 4th Quartile year to date in the IA Smaller Companies sector. This is something that we have not observed in our careers before.
During the market sell off, we added a mixture of stocks trading at deep discounts and some high-quality names which we had been following for some time. Amongst the heavily discounted names were new holdings such as Gym Group and Mitchells & Butlers. Gym Group is the second largest operator of low-cost gyms in the UK. We had always liked the model and had been waiting for the right entry point. The shares fell 75% in the recent sell-off, enabling us to buy the stock on a “pre-virus” P/E of between 5x and 10x (the stock has been very volatile).
Mitchells & Butlers is the largest pub operator in the UK. The recent sell-off left the stock trading at a 70% discount to tangible NAV, having fallen by 75%. We think there is significant value in this stock. On a P/E basis we have paid 3-4x for the shares (on pre-virus numbers).
For stock pickers such as us, the small-cap end of the market is an exciting place to be. Significantly lower analyst coverage of smaller companies compared to the large-cap index offers the opportunity to find genuine mispricing, whilst a high proportion of founder-ownership encourages management to focus on long-term shareholder value creation.
Our analysis is focussed on the sustainability of returns and profit margins, which are vital for the long-term success of a company. We continue to look for businesses with “pricing power” by assessing positioning within supply chains and having a clear understanding of how work is won and priced. It is also important to determine which businesses possess unique capabilities, in the form of intellectual property, specialist know-how or a scale advantage in their chosen market.
We continue to manage the portfolios with the same uncompromising focus. We believe that the current unusual movements of the market will provide us with opportunities, but it has never been more important to stick our principals and continue to invest for the long term.
The value of investments and any income will fluctuate (this may partly be as a result of exchange rate fluctuations) and investors may not get back the full amount invested.
The product may use derivatives for efficient portfolio management which could result in increased volatility in the NAV.
The product invests in smaller companies which may result in a higher level of risk than a product that invests in larger companies. Securities of smaller companies may be subject to abrupt price movements and may be less liquid, which may mean they are not easy to buy or sell.
The use of borrowings may increase the volatility of the NAV and may reduce returns when asset values fall.
As a result of COVID-19, markets have seen a noticeable increase in volatility as well as, in some cases, lower liquidity levels; this may continue and may increase these risks in the future. In addition, some companies are suspending, lowering or postponing their dividend payments, which may affect the income received by the product during this period and in the future.
This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
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