Over the past few weeks it has seemed to us we have been living in parallel universes. Since the market floor in mid-March, the Covid-19 data has got progressively worse, while markets have bounced, almost virally, seemingly just chasing the next dollar. As managers responsible for the preservation of client assets we had already taken some evasive action in February but as markets started to plunge we undertook a thorough reassessment of the portfolio. This resulted in the sale of several companies we thought would be challenged in the new environment, their replacement with others considered more resilient, plus additions to some holdings that had been excessively sold off. The portfolio turnover was elevated, though the majority of the names in the portfolio remained intact. We may be in unprecedented times, but the focus on maintaining a portfolio whose companies are capable of delivering 15% p.a. earnings per share growth with high cashflow returns on assets and low debt remain as important as ever.
We have been trying to assess how the ‘new normal’ will look coming out of this crisis. Views vary, from ‘business as usual’ to Armageddon. Often they tend simply to reinforce pre-existing biases. But the question is worth a hard think, as the outcome will be reflected in portfolio results. We have been canvassing different age cohorts within and without our company and also speaking to all the companies we invest in and some that we do not.
There is general agreement that the workday patterns, habits, and IT systems for remote working established during this lockdown period are unlikely to disappear. While we may miss some of the personal interface, many of us white collar workers have proved we can be just as efficient working from our home ‘offices’, less time is wasted, and the inessential tends to be brushed aside. The reduction in our carbon footprint from the daily commute and the improvement in the work/life balance are added bonuses.
As a consequence, the tech giants will continue to hold sway. Online platforms such as Microsoft Teams, that we use here, have become the new corporate forums rather than conference calls on the telephone used previously. There are several smaller companies in this space, mostly US quoted, which have already performed well and trade on lofty multiples. The IT services companies that implement this sort of capability will also have a tailwind for some time to come. As management of one of our portfolio holdings, NetCompany, recently told us, “Long term we will see a big splash on new projects as people will see the importance of having devolved infrastructure. The UK government agencies will see it is not such a good idea to outsource everything to India, where working remotely does not actually mean working from home”. This could spell more on-shoring in future.
What of global trade? If the interminable US China trade conflict was not adequate indication of the unsustainable arrangements of global commerce, the pandemic has exposed the fragility of having very extended global supply chains. Assuming Trump gets elected for a second term, and that is not a given, we can expect to see far greater vertical industrial integration within the US, if not a second Cold War. Companies that have domestic manufacturing will be better placed long term, Varta the German producer of microbatteries is interesting in this respect. The group’s manufacturing is all domestic and not at all labour intensive. Globalisation as we know it has peaked. Its shortcomings have been exposed in the most cruel and indiscriminate way, largely affecting the most vulnerable, the old, the sick and people in relatively low paid jobs, healthcare workers, frontline services, supermarket workers, workers in retail and hospitality, without whose labours society cannot function. Businesses and governments need a fundamental shift in perspective as to priorities, and how we best organise ourselves in future. We are more mutually dependent than we care to admit and we need to get sorted at a national level first before placing our trust in other countries whose motives and interests may be widely different to our own.
The issue of trust is an important one, and has been in sad decline, for good reasons. But one thing this pandemic has demonstrated is what tremendous goodwill there is at a national level to pull together to alleviate suffering when the chips are really down. People formerly divided by politics can collaborate when there is a clear need. Hopefully this will carry through to get countries that have been riven by politics back on track.
We are continuously told it could take up to 18 months for companies to come up with a vaccine and given the less than wholly successful track record of existing flu vaccines, we suspect this could take longer. Of the multiple companies trying to develop one, trying to work out who will be successful is difficult, and finding a pure play in this area impossible. The one company we had our sights on, the German company Qiagen, which makes testing kits, was snapped up by US Thermo Fisher quite early on in the crisis. A more obvious investment case for us was that of Essity, Europe’s largest manufacturer of hygiene products. This was corroborated by their recent announcement of a 67% increase in Q1 profit, largely on the back of the stockpiling of toilet roll and other tissue based items. While that particular phenomenon may pass, the focus on hygiene is unlikely to for the foreseeable future.
Will people start to take more personal responsibility for their health? Almost certainly, yes. While the media will no doubt focus on the debate over funding for the NHS, the crisis has demonstrated the inability of the authorities to keep us safe, and can only increase people’s desire to stay out of hospital and care homes if humanly possible. Just as the financial crisis eroded trust in the ability of so called ‘experts’ to avoid catastrophe, so this health crisis has diminished confidence that the ‘experts’ in the field of public health really know what they are doing. We suspect it will be the corporate sector that steps into the breach. In the short term those that come up with a vaccine will get a boost, but longer term it will be those companies that continue to invest in the R&D that improves our life prospects that will come out on top.
It was interesting to see in a recent press release from Varta that it is increasing R&D into ‘printed electronics’ for both medical and leisure use, intelligent skin plasters and wrist appliances, such as smart watches and bracelets. This included a mobile monitoring system for arteriosclerotic vascular diseases with 3D real-time depiction of oxygen saturation in areas of the body under analysis. It can be used in outpatient care, during or after an operation, in rehabilitation, and in sport, e.g. offering marathon runners the opportunity to monitor their oxygen saturation during a race to avoid overstrain.
We are also looking for companies that will play a part in the country’s economic recovery. The traditional way to stimulate the real economy after a major contraction is through government financed infrastructure projects. In this respect we were glad to see that work on the UK’s HS2 rail network has been authorised to proceed, even though there are good arguments against it, simply because this will support the business of at least two of our portfolio companies, Hill & Smith and Marshalls. We would be more supportive of a concerted effort to rejuvenate the North of England, the so-called Northern Powerhouse project. It seems to us that if the government can support the population through a period of mass unemployment and a potential short term drop in GDP of 30% or more, then it could support plans such as this, but we shall have to wait and see.
We note that EU Commission President, Ursula van de Leyen, has made an apology to Italy over the EU’s handling of the crisis. The apparatchiks in the EU have not exactly covered themselves in glory over this crisis but then it was inevitable from day one that the southern countries of the EU would draw the short straw in this great political experiment to create a united states of Europe. This looks more disunited by the day. Reports in the press of the alleged theft of PPE (personal protective equipment) by France of consignments destined for other countries (and paid for!) speaks volumes. Each country acts in its own national self-interest. Extraneous shocks like this expose the pretence of any political grouping working for the greater good. Inasmuch as the portfolio is concerned we may well have to contend with volatility such as that seen during the Eurozone crisis of late 2009 to 2012. We have no investments in Italy, Spain or Greece but are under no illusions about the challenges of running European money if there is a return to the Risk-On / Risk-Off trading patterns of those years.
The portfolio has no investments in airlines, oil & gas, or tourism, and we think these areas will be challenged for some considerable time. Although the younger generations seem as keen as ever to travel, the risk of getting caught up in some future catastrophe on a cruise ship, in a foreign and distant country, let alone the risks of close confinement in an airplane will deter many. We have had some exposure to hotels through the fund’s real estate investments and recently took advantage of falls in their share prices, to levels well below net asset value, to add to holdings. But having enjoyed the bounce, we may now reassess, though at the very least, bricks and mortar can be reconfigured to alternative uses, residential, for instance. The reduction in flights will have a very beneficial impact on carbon emissions and pollution, stay at home tourism, and video conferencing. The latter should play well to companies like Barco with their Clickshare product for wireless video conferencing. There will be strong demand in the corporate sector and from universities, who can link over 80 students remotely by video for teaching purposes using Barco’s product, a real benefit when so many universities have had to close their doors.
Work by research houses Gartner and Bain shows that the 100 most innovative companies spend even more during a recession, and in the long run this pays off. In this context, we continue to favour ASML, the monopoly producer of the most leading-edge lithography equipment that creates the patterning on silicon wafers that is allowing for the digitalisation of virtually everything. The company’s strong balance sheet and cashflow have allowed it to invest heavily in downturns, and this time will be no different. This crisis will see the rise of chips for virtually everything needed to enable a fully digitalised, and contactless society. The company’s revenue is driven by the long-term strategic investments of customers, and the demands of Moore’s law, for semiconductor manufacturers to deliver ever faster and more efficient chips. The company’s High NA (net aperture) model will offer a resolution and overlay capability that is 70% better than the current EUV (extreme ultraviolet) model D. The company experienced a few supply chain issues at the start of the crisis but has now resolved these so that they are unlikely to see much impact on full year results. We expect the ASML to comfortably meet our 15% p.a. EPS growth target over the next few years.
It was no surprise to see Formula 1 go virtual. I visited McLaren HQ over a decade ago and saw one of their drivers racing the Monaco Grand Prix in a simulator – a lot more environmentally friendly than the real thing, but terrifying to experience the speed and see what the driver sees from inside the car. E.sports and the whole computer gaming area will be getting a considerable boost from the current lockdown. We have re-invested in Ubisoft, which is due to launch 5 Triple-A games in the current year after deferrals in 2019. We believe the market is underestimating the growth potential of this company.
E.commerce, already booming pre-crisis, will only get stronger. There are multiple investment opportunities in this area. The ones most obviously benefitting from the current pandemic are in the area of food and we have toyed with an investment in Ocado which implements the warehousing and systems required for online delivery by supermarkets. Given the unprecedented demand the company has faced, registration for new customers was closed quite early on, prioritising the most loyal customers and the most vulnerable, so the crisis was not a licence to print money. However, to quote a company representative “I think the crisis has unquestionably raised people’s consciousness of online as an option.
Our most loyal customers are of course very glad to have access to the service at still relatively high rates of performance (on-time delivery, substitutions and so on). Will new customers come to Ocado in greater numbers when the crisis has passed? Our instinct is to say yes. And once customers experience the very high levels of service they get from Ocado Retail, history tells us that they remain very sticky”. The main driver for the company’s growth and profitability, however, is less Ocado Retail than Ocado Solutions which actually designs and builds the customer fulfilment centres (CFCs) for supermarkets. They are limited in terms of project management capability on the numbers of these they can deliver in any one year. When we spoke to the company they had just launched one for supermarket chain, Casino, on the outskirts of Paris, very timely in the circumstances. The initial outlay for these CFCs is substantial at c.£30m and although the group has a tidy cash pile from a recent convertible bond, as well as from selling its interest in a joint venture with M&S, another round of financing is highly likely if the 50+ CFC target is going to be achieved.
We prefer companies that can self-finance their growth from a high cash return on assets (CROA), rather than those which rely on debt or equity to fund their growth.
This we are able to achieve in a focussed portfolio of 37 European growth stocks, with an average CROA of 27%, net debt to equity of 41% and expected average 3-year EPS growth of 17%, trading on a PEG ratio of 1.1x. The portfolio valuation was not expensive going into this crisis and it now looks even more attractive, in our view.
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