The Covid-19 outbreak has plunged the globe into chaos. We are in uncharted territory, from both a societal and a financial market perspective, and trying to predict outcomes is virtually impossible.
As stewards of investors’ capital, we acknowledge that we don’t know what will happen, and believe it is dangerous to make explicit top-down forecasts for the economy or try to predict the impact on financial markets. What we can do is focus on stocks, answering two key questions:
- Do our investee companies have the resilience to weather the Covid-19 storm?
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Has the general collapse in stock market prices surfaced attractive new opportunities for our clients?
We have also re-evaluated our existing holdings given the Covid-19 uncertainty, using appropriately conservative assumptions.
Where our work has highlighted companies that have suffered a permanent impairment of value, we have acknowledged this new reality and changed our portfolios even at the prevailing low prices. Given that our portfolio companies entered the COVID-19 crisis with resilient balance sheets, low earnings and cheap valuations, i.e. large margins of safety, the impact of these portfolio changes was largely insignificant.
Every extreme market disruption feels unique at the time. Consider the Global Financial Crisis (GFC) following on the unprecedented US housing and mortgage market collapse, and 9/11 when global terror was unleashed. With the benefit of hindsight, we can say that these periods of extreme uncertainty enabled us to build portfolios of exceptional businesses that set up our clients’ funds for the next cycle. We believe the COVID-19 disruption could provide a similar opportunity and have identified three areas of opportunity.
The sell-off of geared companies
One parallel to the GFC is that as credit spreads widened, companies carrying leverage have been aggressively sold off. This is a rational response. However, some companies are better suited to leverage than others. This includes those with resilient revenues, long-life assets, wide cash operating margins and management teams that conservatively structure debt and keep ample liquidity available. These companies should not be tarred with the same brush as other leveraged businesses.
The scramble to get out of emerging markets
Emerging markets, including South Africa, have suffered enormous outflows of capital as foreign investors sold investments and repatriated their funds. Emerging markets were already looking cheap, with low earnings and ratings near cyclical lows. This latest move down provides fantastic value across even very high-quality emerging market companies.
An aversion to financials
Finally, the financial sector has displayed a very high ‘beta’, falling much more than the broader market. We think much of this is due to ‘muscle memory’ from the GFC when financials were the epicentre of the crisis and their highly leveraged balance sheets and high valuations provided a catalyst for dramatic drops in prices. However, the situation preceding the Covid-19 sell-off was very different, with strong capital levels (lower leverage) and attractively low multiples of book or embedded value. In particular, life assurers focused on protection products have been severely devalued, despite a resilient business model that carries little systemic risk and stable contractual revenues through the economic shutdown. Mortality stress tests have little impact on embedded values, given the high average age of Covid-19 related deaths, offset from products such as annuities and the finite period over which the pandemic is likely to play out.
Seeing the opportunity in the crisis
We have been buyers of companies like AB Inbev, Shoprite, Liberty Global, Prudential, Discovery and Brookfield Asset Management. These are stocks we know well and like but in many cases had historically chosen to sell or reduce our positions as prices rose and the margin of safety diminished. Thus, while Covid-19 has produced much hardship and loss, it has also afforded us an opportunity to buy shares in these quality companies at remarkably wide margins of safety.
Our ongoing research is focused on adding more ‘quality on sale’ stocks to our portfolios. We are finding these both among our historic holdings that we know well and can convert quickly, and in new opportunities. While we don’t know how long the Covid-19 disruption will last, we do know that buying resilient businesses priced at financial crisis ratings offers a fantastic starting point for excellent long-term returns.
Kevin Cousins is the Head of Research at PSG Asset Management