Typically, recessions are caused by rising interest rates and lending or liquidity drying up, resulting in a meaningful squeeze in monetary conditions.
Due to the pandemic and resulting restrictions, consumers are spending considerably less on transport and travel, leisure activities and eating out – normally a substantial share of their spending – leaving them with more disposable income to spend on housing, DIY, electronics and sports equipment and clothing. This trend has benefited our holdings in specialist retailers such as Halfords, Dixons Carphone, Studio Retail and Frasers Group, which have been reporting stronger-than-generally-anticipated trading.
Housing is another area where activity has rebounded strongly, and where we are finding attractively-valued stocks well positioned to benefit from changing accommodation needs, lower rate mortgages and help-to-buy/stamp duty support initiatives.
Narrow market focus
However, the current market focus has been extraordinarily narrow, leaving large swathes of the UK equity market overlooked and unloved. Investors seem to have lost sight of valuations and are focusing on those stocks they think might become long-term winners. Even steady companies with visible and relatively safe earnings are getting very little attention. This is resulting in very cheap valuations and the most opportunities I can remember since 2008.
We are not having to compromise on quality or invest in companies heavily impacted by the pandemic. We are even able to buy companies that are seeing earnings upgrades but remain very cheap compared to the broader market. The result is a portfolio of companies with more resilient earnings, better returns on capital and less debt but on considerably more attractive valuations than the broader market.
Differentiated sector views
We continue to favour life insurers with strong positions in pensions and retirement income. The life insurance sector offers an attractive combination of cheap valuations, strong demand/supply fundamentals and growing earnings. The cyclicality of these businesses is lower than it was and their solvency significantly better than during the financial crisis. The improved disclosure by these companies during the Covid-19 crisis further strengthened our conviction and recent results demonstrated their improved resilience.
We believe that the durability of the cash generation, ongoing potential for management actions and the likelihood of future deals are not currently reflected in valuations.
Conversely, two areas where we are significantly underweight are oil companies and banks. While both sectors are very cheap, their medium-term outlooks are uninspiring. Mainstream banks are likely to continue to suffer from low – or even negative – interest rates and potentially deteriorating credit demand would add to those woes. Meanwhile, UK oil majors Royal Dutch Shell and BP have decided to embark on long, complex and high-risk transitions towards a more diverse energy mix, which will likely put pressure on future cash flows and their ability to distribute cash to shareholders.
Looking ahead, as we await an effective vaccine for the virus and clarity on the Brexit negotiations, there is undoubtedly a lot of near-term uncertainty.
While a no-deal Brexit scenario would be negative, the robustness of UK supply chains through Covid-19 does give us some comfort that there is a lower risk for businesses than originally perceived and companies are better prepared.
Improved clarity on these matters may well be the catalyst for investors to broaden their investment horizons beyond the narrow range of secular growth stocks currently in favour.
The recent period has been painful for value investors, but we believe it sets up a very attractive opportunity set and very good upside potential from here. We believe the portfolio offers great value and are continuing to find a lot of new investment opportunities.