Will companies adapt and thrive, or stand still and dive?
There’s an old saying that a rising tide lifts all boats. In the investment world, that means positive sentiment is broadly supportive of most companies, regardless of whether the underlying individual businesses are strong or weak. By the same token, news that causes extreme anxiety – such as the COVID-19 pandemic – puts many companies under pressure, even the robust, well-run ones.
The onset of the pandemic has left no corner of the corporate sector untouched. And the challenges facing companies today bear no resemblance to the outlook at the start of the year. Back then, the future looked rosy for UK companies. The certainty provided by the decisive general election result on 12 December was welcomed by investors of all stripes, sending sterling, share prices and consumer confidence higher. We had just seen a stellar year for equity returns in 2019. Companies exposed to the UK economy were especially well positioned to benefit from a level of certainty not seen for many years. Then everything changed.
How are companies responding?
With the lockdown completely changing working habits – not to mention putting a big crimp in corporate supply chains – it’s no surprise that many companies are facing difficulties. The pandemic is affecting corporations with strong, differentiated business models, not just those that are uncompetitive and weak.
The prudent and logical approach is to focus on short-term liquidity and survival. That means delaying capital spending and cutting operational costs. With working capital being squeezed, staff are being furloughed or made redundant. Some businesses, such as food manufacturers, are ceasing production of less profitable product lines and focusing on core items. Smaller suppliers are doing the same. Accrol, a company making own-label toilet paper and kitchen roll, has shrunk its product lines from 120 to 301. UK retailer WH Smith2 is one of many companies trying to strengthen its position – it raised £166 million in an emergency shares placement.
Listed companies are also deferring or cancelling their dividend payments. It’s rapidly becoming socially unacceptable to pay dividends to shareholders if any level of government assistance has been received.
Banks are under particular scrutiny, due to their role in the global financial crisis. In the years since, regulators forced banks to rebuild their capital. This time round, rather than being part of the problem, banks will need to be part of the solution. Already, the UK’s Financial Conduct Authority has stepped in to request that no dividends are paid in 2020. There are some promising signs, though, with Lloyds waiving interest on current account overdrafts up to £300. Barclays, meanwhile, has stopped collecting interest on all overdrafts during April, and is making it easier for customers to request a mortgage holiday.
What does it mean for shareholders?
The economic consequences of the crisis have developed rapidly, and it’s still unclear how severe and long lasting the impact will be. We are encouraged when we see company management teams considering if additional capital is required. As the lowest-ranking creditor, it’s vital for shareholders that the balance of power is in the hands of the equity holders and away from the debt holders, particularly in times of distress. It is logical, therefore, for listed entities to at least enquire into the possibility of raising equity. When in dire straits, it is better to suffer some share dilution if it helps to prevent insolvency.
To date, the stock market has attempted to ‘price in’ the inevitable earnings downgrades caused by the expected drop in global GDP. Selling has looked rational on a short-term basis and has been exacerbated in terms of speed by the pools of passive and algorithmically controlled capital. Ultimately, we believe the effects of this virus will be transitory, although the duration and severity are unclear.
As active investors, we believe effective stock selection is key to successful investment management. Our investment philosophy and process are unchanged. We believe that a rewarding strategy is to actively invest in UK-listed companies that are increasing their economic output by compounding their earnings and dividends. We continue to focus on domestic and internationally exposed UK-listed businesses, where the fundamental profit drivers are entrenched, and equity holders benefit from management’s capital allocation and risk-taking.