UK Equities: With COVID-19 uncertainty comes opportunity

Chris St John, Portfolio Manager for the UK mid-cap and multi-cap strategies delves into the unprecedented times in which the world finds itself, the impact of the pandemic on the UK equities market, and how in times of uncertainty come pockets of opportunities.

What are your thoughts on the effects of COVID-19 on companies?

These are unprecedented times. What started as a supply shock on China has turned into a global demand shock. We have seen material reductions in turnover across several businesses, with certain companies in the eye of the storm; for example, consumer travel and restaurants, which have been hit harder than other areas. We have seen an enormous response from governments and central banks, which, through various supportive measures – including VAT deferments and the furloughing of staff – have been trying to stop a liquidity crisis from turning into a solvency crisis. The government and central banks have been trying hard to ensure the productive capacity of this country has been kept intact. This is so that when we come through what is hopefully a transitory period, the productive capacity is still in place, which will then give these companies the opportunity to return to an interesting period of profitability and cashflow. The focus is on companies reacting rationally to look after their cash balances, and to prevent solvency issues that result in closures.

Moreover, we are seeing ‘stakeholder collaboration’ between the businesses in which we are investing, the equity and debt market, suppliers and customers alike. We are finding this very reassuring. It is giving us the confidence to look through this crisis, and the effect it will have on the rest of the year, and will allow us to look further out. Ultimately, when you have the confidence that solvency is not an issue, you can begin looking at the productive and economic output that companies can have in normalised times; this, in turn, is creating some attractive opportunities.

What impact is government support having on the workforce?

We have seen a huge amount of government support, including for the self-employed, small, medium and large-sized companies. When we speak directly to companies, the mechanism of transaction has been relatively swift in the context of history. However, given the dramatic falls in demand that companies have seen, it has not protected every job out there. Companies have certainly made some difficult decisions in terms of redundancies, cutting agency staff (which is generally less difficult for businesses to do), and significant action around their permanent workforce. The government website for furloughed staff went live on Monday 20 April. My understanding is that it stood up well, and that the process is relatively straightforward.

What types of companies are raising money?

Generally speaking, companies have received a great deal of support. When it comes to the decision to fundraise, I think this is a question of keeping the balance of power in the hands of equity holders and taking the risk of insolvency off the table. This, in turn, is allowing investors to look ahead in terms of how they value businesses. You can see why these fundraisings have been well supported if it means that the future earnings of the business and economic output can, in some way, be underwritten.

The fundraisings themselves have come from a range of sectors and, interestingly, with different balance sheet strengths and business models. There are even companies raising money that you wouldn’t ordinarily think would need to do so. For example, Auto Trader raised £165 million. Given their business model, it’s debatable whether they needed the capital, but it ultimately takes the question of whether they will be around in the future off the table. Also, SSP, a company affected by commuter travel as much as recreational travel, has raised money.

One of the key features we are seeing at present is the impact of preserving cash on dividend payments. Do you expect this feature to continue?

We have seen widespread dividend cuts or deferrals as a direct response of the pandemic, as companies look to preserve capital on their balance sheets. Dividends have been cut for various reasons. We have seen some big dividend cuts in the FTSE 100 Index, particularly with banks, and has some of the highest dividend-paying companies. By contrast, some UK mid-cap companies (FTSE 250 Index) across a variety of sectors have also cut dividends, but it has not been as impactful as the larger names, where income forms a larger part of the total returns. The Financial Conduct Authority has made it clear that banks should cut dividends, and the government has taken the view that banks need to be part of the solution to this crisis. The government has put banks under pressure in order to preserve their capital position and capital base. This is so they can help support the economy by extending loans, and keeping their capital positions strong in order to deal with the inevitable write-downs. HSBC and Barclays have declared dividends and subsequently retracted them.

In addition, we have seen the insurance sector put under a certain level of pressure, although less so than the banks in terms of dividend payments. Dividend cuts have also taken place outside of these industries, including companies like Bunzl, Serco and Hollywood Bowl. It is quite an interesting moral dilemma, with companies putting themselves under pressure and questioning themselves about dividend payments, particularly if they have taken government subsidy. There is a feeling that we are all in this together, which is particularly evident by the salary cuts being taken by board members.

With the economic capacity kept intact, these companies will look to pay dividends again once they have further clarity on the outlook. Positively, a lot of these companies have not cancelled dividend payments; for example, Dunelm, which is able to pay its dividend today, has deferred pay-out until later in the year, as has Ultra Electronics.

Oil is a key sector that is under-focused at present. Do you have some broader thoughts?

This is the first time we have seen the West Texas Intermediate turn negative, with a lot of debate around why this. Reasons include the amount of storage space in Oklahoma running out, although producers having to pay to take oil away is quite extraordinary. Stock prices have historically been correlated to the oil price, which has fallen a lot more than the shares themselves. The futures curve is in contango – which means when you look further down the futures curve in oil, it’s higher than the spot price. If oil prices remain at low levels for a prolonged period, there will undoubtedly be some difficult capital decisions to be made by the big oil companies.

The long-term effect of COVID-19 is difficult to predict. Do you have any thoughts on how it may impact consumer behaviour and your investment strategy going forward?

It will certainly change people’s behaviour. We all have the capacity to forget and return to normal, but there are several trends coming out of this crisis. We can see an acceleration in the growth of online relative to the high street. I think there will be a lot of people who were previously very reluctant to shop online but would have been forced to do so by the lockdown; in reality, they may have found that it’s an effective way to shop. So, I can see some of the strains in the retail market accelerating. I suspect working from home will become more of a feature of people’s lives, for which there will be implications. Also, a cashless society as people are being increasingly encouraged not to use cash. We could see an expansion in plenty of technology applications, particularly in the financial sector. We will continue to speak to businesses in order to understand how their market dynamics are changing, and we will react accordingly.