After the storm: how to find top stocks amid the ruins
Investors are caught in a topsy-turvy world, says Jonathan Compton. He surveys the scene, assesses the outlook and suggests where – and how – you should look for healthy returns.
The world has gone mad. Unless restrictions are lifted immediately the global airline industry is facing bankruptcy within months at most. So too are many major companies in other sectors. The global cruise industry is now notorious for imprisoning its passengers on “plague ships”. Cinema chains worldwide have been forced to close. Hotel chains are suffering in a similar fashion as leisure travel collapses.
These bankruptcies may be just the first dominoes in a long row. Keep an eye out for construction groups, carmakers and nail bars after that. It is not out of sympathy for the three million-plus employees already furloughed that the UK and other governments have rapidly shaken every old and new money tree they could find, but out of necessity. If these businesses were to close for good, their bad debts would sink other businesses and every financial institution.
Through the looking glass
Unprecedented state and central-bank interference means we now have false prices across all equity markets, where a mere month ago price manipulation could result in an unlimited fine. Even more topsy-turvy, we also have non-disclosure of key facts introduced by the regulators, forbidding companies from reporting preliminary results “to prevent investors acting on out-of-date information”. What more information the shareholders of struggling leisure industry operators require is hard to fathom. Concurrently the Bank of England advised – ie, ordered – banks not to pay dividends; the Treasury has leaned heavily on other companies to do the same.
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Events have moved so rapidly that one debate likely to terrify investors has hardly commenced: whether to close stockmarkets until the worst of the pandemic has passed. There are both good reasons for, and serious problems with, so doing. I would currently give it a one-in-five chance, higher if further large falls ensue. Even Sleeping Beauty would have noticed that the last quarter has been hideous. Using FTSE Global Equity Index Series data to the end of March, the falls have been stupendous. In local currency terms and on a total return basis (ie, capital plus dividends), a UK investor has lost 24%; the figure for France and Germany is about the same. It is little solace that leading emerging markets were worse, down 25%, or that America fell by just 20%.
Traumatised investors miss the bottom
Small wonder then that legions of investors have been selling in droves. More will follow on each bounce, many swearing never again to invest in stockmarkets. And as in the crashes of 2008, 2001 and earlier, they will spend many years waiting for the final fall to reinvest even as markets recover. The adage “panic now before the rush” has again proved correct, but I think the time for indiscriminate dumping has passed.
I can empathise with the fleeing masses. Parts of my portfolios have been shredded. Many positions have suffered through well-documented psychological mistakes investors make: loss-aversion, denial, unjustified optimism and rabbit-in-the-headlights syndrome. The positive decisions of last year – no energy, natural resources or retail plays; little emerging-market or consumer exposure – have softened the blow even as my brain remained in the freezer. Why did I keep holding Saga, with its new investment in cruise ships, or Costain with its wafer-thin margins and debt?
Where to start looking now
Lesson hopefully learned, again. So where next? There are some flickering signs of interesting opportunities, especially in UK and European mid-caps, companies with a value between $2bn and $10bn. Recent legal changes such as the EU’s regulation of investment services (Mifid II) have inadvertently weakened research coverage of these companies, making it easier for sharp-eyed investors willing to do some digging to find some promising prospects. And as it seems probable that governments and businesses will want more goods and services to be made locally, having suffered the risks inherent in long supply chains and “just-in-time” practices (low stocks, margins and cash buffers), medium-sized companies in or near the UK should benefit the most.
The simplest and best route for most investors is undoubtedly through funds, particularly because the investment landscape will change significantly after the pandemic. Such changes require constant attention, which in turn necessitates a decent professional fund manager. Many de-facto bankrupt companies will be bailed out by the government, but it remains a gamble to identify which ones with certainty. For instance, the mood music supporting the little Scottish regional carrier Loganair is politically stronger and even potentially more important in terms of local transport than that surrounding giants such as Virgin (see page 7), whose proprietors/key shareholders have irritated Westminster with their greed and tax plans. Like many industries, the airline business had serious overcapacity and is on the “most wanted” posters of the growing green/environmental, social and governance (ESG) lobbies. Many will fail.
Don’t “do a Woodford”
Open-ended funds (unit trusts and open-ended investment companies, or Oeics) have performed worse than the market and I think will continue to suffer. Forced sellers as investors made a dash-for-cash, they had to cut their most liquid and often best positions, leaving their portfolios badly skewed and less liquid; on any recovery, funds tend to flow in fast, which dilutes the gains for existing holders. Open-ended funds investing in venture capital, private equity or property remain even more dangerous than usual. Often holding illiquid investments that are impossible to value, they tend to close for redemptions in downturns while many of their underlying holdings will be making large cash calls to survive. These vehicles run the risk of “doing a Woodford”.
Many investors have switched into money market funds, in theory safe, enhanced deposits. Yet in the 2008 meltdown many such funds were unable to keep their promises. Standard Life was particularly brazen, either refusing redemptions or paying out below the “guaranteed” rate. US money market funds have been wobbling. Avoid absolute-return funds too. This should have been their year given promises to protect investors’ assets in a downturn, usually for a chunky fee. Yet performance has tended to be sub-index on the way up and down. The upshot? The best way to invest is via actively managed investment trusts.
What to avoid
For those like me who still enjoy stock picking, it is crucial to remain disciplined and avoid three types of company. Firstly, beware of apparent winners. The supermarkets have managed their supply lines and operations superbly to keep the country in food and other necessities. Their share-price performance has reflected this. Post-Covid-19 demand is likely to slump as hoarding is unwound and household budgets are inevitably squeezed as a result of the lockdown and layoffs. Other companies thriving amid the pandemic, such as Renishaw (possible maker of ventilators), Ocado (distribution), or Avon Rubber (respiratory products) also seem fully priced.
Then there are the zombies, companies that have been kept afloat by ultra-low interest rates and monetary expansion, making a return on capital lower than its cost. While fiscal expansion will remain in place for some time, banks and governments have too many businesses to support and will pull the plug on the worst, especially as now is the best time quietly to take the loss and blame genuinely unusual circumstances. Moreover, governments and banks lack the expertise or personnel to focus on every small company. There are 441 distilleries (up 22% last year alone) and 30,000 nail bars, for instance. So the authorities must focus on larger or key businesses, which with bridging finance should survive and recover. The exemplar in this context is the bailout of Rolls-Royce in 1971; it eventually became a global leader in its field. Even the expensive and ultimately futile British Leyland rescue (1975-1985) provided breathing space for better-managed foreign companies to reform and restore the UK vehicle industry and to keep myriad components suppliers afloat.
Some stocks won’t recover strongly
The third rule is never to assume that a stock will recover to previous levels. Remember, after a share price has halved the downside risk remains unchanged at 100%. Moreover, the recovery potential for many businesses has been curtailed. World GDP growth after a bounceback will be muted, household incomes weaker and soon, taxes higher. It is therefore difficult to see luxury goods or high-value brands such as LVMH, Burberry or Aston Martin enjoying a strong recovery, especially with weaker demand from China. Nor can I see people queuing up for cruise ships even after they have slashed prices, or frequenting holiday resorts as densely as before. The car and steel industries were suffering severe overcapacity before the pandemic; weaker demand will now hurt both.
Then there is the structure of the service sector. We are in the midst of the greatest homeworking exercise ever. There are clear benefits for the employee – no commuting and other costs – while for the employer, technology allows close staff monitoring with the enticing prospect of permanently slashing expensive office costs. Commercial property is in trouble.
Stocks on my list
What I’m looking for are firms with little debt or no near-term repayments, historic strong free cash flow and products or services that will remain in demand in a less wealthy world. A solid earnings record also inspires confidence. Apart from changing work patterns, other trends are already clear, such as the proven value of warehousing, automation, software and “necessities”. (Asterisks denote companies I already own.)
For warehouses Segro* (LSE: SGRO) is an easy choice with good sites and well-funded tenants. Employers have rediscovered the importance of payroll and online accounting systems. Enter Sage Group* (LSE: SGE), now seeking to become a wider software services firm. The government will need even more outsourcing and while the sector teems with nincompoops, Serco* (LSE: SRP) had already turned around and has a financial discipline competitors lack.
We don’t yet know how shopping habits may change, but the fillip to online businesses will endure. One-time market star and online fashion retailer ASOS (Aim: ASC) peaked at £7,400 in 2018 and at £1,090 now the price assumes no growth, ever. More nimble Boohoo Group (Aim: BOO) lost a third of its value in a month. Its model is sound. Germany’s Zalando SE* (Frankfurt: ZAL) is a candidate to outperform both.
An online spin-off is packaging manufacturers. Bunzl (LSE: BNZL) rides out every storm. Meanwhile, the price-comparison website Moneysupermarket.com (LSE: MONY) should attract more customers hunting for savings. In education Pearson (LSE: PSON) has consistently bungled the move online, but finally has a workable offering. Beverages are a low-growth business, but valuations seem too low for niche players such as A. G. Barr (LSE: BAG), which makes Irn-Bru, and Britvic* (LSE: BVIC). In Europe Finland’s Olvi Oyj (Helsinki: OLVAS), the country’s biggest drinks group, is a strong multi-product leader and in Italy Davide Campari Milano SpA* (Milan: CPR) with its eponymous brand (and other alcoholic products) has lost 40% of its value. It is a clear recovery play.
Waste will still need collecting and Biffa (LSE: BIFF) is the pick of the bunch. Will the utilities/internet/telecoms sectors need more cabling? Italy’s Prysmian SpA (Milan: PRY), a global player, looks a likely winner here. Free-to-view television companies are considered history by many analysts, but I believe the model has legs. ITV* (LSE: ITV) and Germany’s ProsiebenSat 1 Media SE (Frankfurt: PSM) have been hammered even as more viewers tune in.
An old saw is that after a nuclear winter only cockroaches and insurance salesman will survive. Neither RSA Insurance Group (LSE: RSA) nor Direct Line* (LSE: DLG) should suffer many pandemic claims. Good value has re-appeared in Tate & Lyle (LSE: TATE), which makes sugar and sweeteners, Babcock* (LSE: BAB), a defence group, and complex engineering specialist Johnson Matthey* (LSE: JMAT).
I’ll be drip-feeding spare pennies over the coming months into those above I don’t own and plan to top up the others. Grim and nasty though the pandemic may be, as Niccolò Machiavelli said: “Never waste the opportunity offered by a good crisis”.
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Jonathan Compton was MD at Bedlam Asset Management and has spent 30 years in fund management, stockbroking and corporate finance.