Update on UK Equity Income Strategies
The coronavirus-triggered falls since mid- February are plainly evident across all markets. Joanna Smith considers how the effect in the UK has been substantial.
As of the morning of 25 March, the FTSE All-share Index had fallen by 28% since the 23 January; this is the date the World Health Organisation first convened in Geneva regarding the outbreak of novel coronavirus (2019-nCoV).
We are witnessing extreme moves in financial market volatility, sometimes occurring hourly. In this market sell off we have seen investors firstly reach for the perceived “safe haven” asset classes of gold (which has risen by 3.8% in US$ terms), followed by US$ (that is strengthened by 9.1% relative to sterling at the time of writing), then US$ revenues.
Within the UK the FTSE 100 Index (down 26.4%) has outperformed the FTSE 250 Index (down 31.9%). The fall in the FTSE 250 Index, which comprises slightly smaller, and largely UK-orientated businesses with sterling earnings, has been more acute. Non-oil FTSE 100 constituents have generally held up better than some of the FTSE 250 constituents as a result of greater US$ revenues. The price of Brent is down 57% as a result of geopolitics and an ongoing dispute between Russia and Saudi Arabia.
It is simply not possible to know the depth or indeed duration of suppression of economic activity. But it is clear that the most recent consensus estimates for the UK are now beginning to factor in a significant recession in 2020, follow by a marked bounce back in 2021. By way of perspective, as of the end of February the consensus of 40 Economists tracked by Bloomberg, forecast GDP growth in 2020 at 1.0%, and in 2021 at 1.5%.
As recently as 18 March HM Treasury Independent Forecasts put GDP growth at 1.1% in 2020 and 1.4% in 2021. The latest BBG consensus forecasts are (respectively) 0.5% and 1.3% - however this consensus contains a number of forecasts that appear stale. The average of 13 economists who have submitted forecasts to BBG since 18 March is for a decline in UK GDP of - 2.41% in 2020, with a bounce back of +2.25% in 2021.
As part of its ongoing efforts to mitigate against the impact of the coronavirus outbreak, the UK government has announced substantial measures to support corporate and household cash flow in the coming months. We expect further action to be taken to support self-employed persons. Separately, the Bank of England lowered interest rates further, to 0.1%, and announced large scale asset purchases. The strength and depth of the UK’s economic policy response offers us some reassurance.
Liquidity in UK equity markets is generally holding up. Risk trading is somewhat quieter but programme volumes are up, as are electronic volumes. Bid-Offer spreads do not appear to be unusually distorted. The bigger challenge to trading is volatility; indices, as well as individual stocks, continue to gyrate on an hourly basis such that when looking to reposition a portfolio – by selling one stock and redeploying capital elsewhere - there is a greatly elevated risk of being “out of the market” even for a short while, at the wrong price.
Clearly, individual earnings-based valuation measures of UK equities will be challenged by lack of visibility with respect to the “E” in “P/E”. Any attempt at valuation is more appropriately grounded in fundamental, less volatile measures of price to sales and price to net tangible book.
In the near term however, the priority of companies, and indeed the focus of our work, is on cash and liquidity, rather than earnings. Access to liquidity to bridge the period to recovery, taking into account in particular working capital movements, is taking even greater precedence over the levels of debt themselves. But in considering liquidity it is necessary to look further into the structure of debt finance, the timing of maturities and key covenants.
Many companies have been forced to cease their customer-facing operations, shut their doors and take action to reduce discretionary cash flow. Businesses are not surprisingly wanting taking a cautious view regarding paying out cash in the form of dividends. We are fully supportive of prudent management, the preservation of cash within a business, and more generally doing what is right for businesses in the best long-term interest of employees, shareholders and other stakeholders alike.
Looking at the four main themes in the UK Equity Income funds; UK Domestic Value, International Growth Opportunities, Tobacco and Non-Correlated Financials, it follows that companies within the UK Domestic Value theme, which are more heavily exposed to sterling weakness, have tended to underperform.
The better performing stocks are those more exposed to International earnings (including Tobacco) which are relative beneficiaries of $US strength. The Non-Correlated Financials theme has exhibited a particularly wide range of outcomes – with one company example, PLUS500, actually up (due to increased trading on CFDs (contract for difference) by people isolating at home). On the flipside non-prime lenders have tended to be weaker.
The reach of COVID-19 is without borders, every country is being affected; but when we begin to see evidence of the tide beginning to turn against the virus, we believe that we will see the perceived “safe-haven” status of the $US wane. As such, sterling should recover from its 35-year lows and those companies that we consider UK Domestic value should return to the path that had started to become more evident since October last year.
Meanwhile, our approach is to hold a balanced portfolio of companies with strong cash flows, which can exhibit some defensiveness in periods of heightened market volatility such as we are experiencing at the moment.
We will also be looking for companies whose long-term fundamental valuation we believe to be significantly mispriced as specific stocks and sectors are being sold off amidst short-term pressures. Short-term shocks can be highly disruptive, and it is not yet clear how long the pandemic will last. But at some point, we expect the pandemic will pass, and the market will return to looking at the long-term term fair value of the businesses in which we invest.
At a time of great stress for financial markets, the investment philosophy consistently applied across all the income funds which is: valuation led, bottom up and stock specific, and above all cash flow driven, has never been more relevant than it is now.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
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