Protecting the Vulnerable

On the afternoon of Sunday 23rd February – now almost two weeks ago – I tried the new Azuma trains running along the East Coast Mainline down to London ahead of meetings starting first thing on the Monday morning.  These new rolling stock are supposed to be a great leap forward in train travel.  I am no expert in the merits of the Japanese engineering behind the nuts and bolts of making the trains faster and more efficient, but as a user of the first class experience it is only a leap forward if you have a fetish for 1980’s East German functionalism.

Therefore, with little else to distract me, I spent the time writing one of our regular blogs, scheduled to be sent out the following morning.  The key message of the blog was that, up to that point in the results reporting season, the market as a whole was showing signs of complacency over the potential impact of Covid-19 on short term economic activity, and the fairly standard assumption across corporates themselves that economic recovery would take a V-shaped form over the last three quarters of this year.  We felt that assumption was heroic, and there was significant risk to profit forecasts for the remainder of the year.

However, over that weekend the market “got it” on Covid-19; markets fell precipitously on the Monday morning, and continued that way for the rest of the week.  Unsurprisingly, that blog post never saw the light of day.

In aggregate, the UK and global equity markets are substantially lower over the last two weeks.  Within markets, certain companies and sectors have been dealt with much more harshly than others.  The spread of Covid-19 across the globe has yet to be declared a pandemic, but the semantics matter little.  The virus is having a material impact on economic activity in certain parts of the world, and even if its effects do not deepen in regions already affected, they will surely broaden out further from the current hot spots.  We need to have some view on what our approach should be.

It goes without saying that we are no experts on epidemiology.  Not only do we have no greater insight into the what happens next than governments and their medical advisers, we almost certainly don’t have any greater insight than other fund management houses posed with the same question.  Our view is that Covid-19’s contagiousness means that its economic impact is likely to be widespread, but its relatively low virulence in healthy people means that the depth of that economic impact may be less than feared.  We are not insensitive to the risk Covid-19 poses to the elderly or those with underlying health problems.  All life is precious.  However, it appears that the key thrust of the UK government’s action plan (which appears to be pretty much universally acknowledged as sensible) is to slow the spread of the virus to the extent that the health authorities can cope with severe cases in a phased manner, and everyone who needs treatment gets it.  The government does not appear to be necessarily worried about the impact of this virus on the vast majority of the population.  In summary, the actions being taken to slow the spread of this disease are to protect the vulnerable, not necessarily to protect us all.

One needs to be careful in circumstances like this to try and avoid whimsical points or corollaries.  But a similar force is playing out in the UK corporate space.  If our central prognosis is correct, then the impact of Covid-19 will be felt by virtually every listed company in some way or another; and for most it will result in varying degrees of discomfort.  Where there is some corollary is that it will be most serious for those businesses that are already vulnerable.  Wednesday night’s collapse of Flybe is case in point.  The impact on air travel of Covid-19 may be the straw that broke the camel’s back, but no observer can be at all surprised that Flybe finds itself one of the first to go given the troubles that have dogged the company over the last two years.  The UK government and the Bank of England realise the impact that this potentially short term blip could have on otherwise viable businesses, and action is being taken to ensure where possible that access to funding and credit is available, particularly for small privately owned businesses.

In public markets, the magnitude of the sums involved and the increased moral hazard reduces the chance of meaningful support coming through.  Therefore, investors are currently making their own assessment of quoted companies, identifying businesses for which the resulting economic slowdown will exacerbate existing problems.  The most obvious of these problems is balance sheet gearing, and the ability to meet debt covenants and liabilities as they fall due.  In recent days, the heaviest selling pressure has come on those businesses with underlying problems on both of these metrics.

The result has been that a number of investments now approximate the characteristics of binary options.  As an example, insurance provider and cruise operator Saga’s equity is likely to be either worth nothing or multiples of its current share price.  The range of scenarios where the company is actually worth its current equity plus outstanding debt is very narrow indeed.  For the record, we have no position in Saga, and at this point have no intention of taking a position.  We merely highlight the situation as an example that will increase in prevalence as this process unfolds.

All of this serves to remind us of a stock market tautology.  Share prices are a reflection of investor sentiment at a finite point in time.  Money that has been lost today can be regained tomorrow.  And vice versa.  This only fails to hold when the investment is sold, or if the company invested in goes bust.  At that point your loss is permanent.  This is the reason we value strong balance sheets and robust cash flows over virtually all other analytical metrics.

We still don’t have a clear picture over what the next few months are going to hold for the global economy and global stock markets.  However, we have done what we can to make sure that the consequences of any slowdown don’t do any permanent damage to the portfolio.

Glen Nimmo