Where are we now? The HL Select fund managers’ view of the world

Steve Clayton - Fund Manager

7 May 2020

The Covid-19 virus has proven more influential than any other health crisis in our lifetimes. Vast swathes of industry have been shut down in the efforts to contain the virus and economies are only now starting to reopen.

Covid-19 has not gone away. But at least the period of lockdown looks set to ease. Social distancing can hopefully contain the situation, whilst the researchers in the lab work late into the night in search of vaccines and treatments. Our thoughts are with those families affected and our gratitude is heartfelt for all those who have so bravely put themselves at risk in the struggle to manage this crisis.

The impact on stock markets has been dramatic. Businesses have been shuttered and some are struggling to see how they can operate in the post-coronavirus world. Others have suffered severe costs. Millions of workers have been furloughed or made redundant and will be worrying over what the future holds for them and their families.

The prospects for many industries have been transformed, and losers seem to outnumber winners.

Oil fields are not easily switched off. The threat of storage tanks being overwhelmed in the USA briefly sent prices into negative territory. Efforts to lower production have been dramatic, but not as dramatic as the fall in demand. Futures markets suggest that oil prices will be higher than today’s levels in a year’s time, but well below where they were before the virus emerged.

For producers, that means squeezing hard on costs to try and salvage profits. Vast swathes of industry exists to serve the energy sector and they will feel the pinch too. Exploring for oil has become a mug’s game; unless the oil found has very low costs of production, it could be uneconomic from the off. So expect layoffs from energy companies and their suppliers too. Royal Dutch Shell has cut its dividend for the first time in almost a century, so significant are the challenges ahead.

Normally a low oil price is a boon for transport companies, but not this time. Grounded fleets of aircraft cannot benefit from cheaper jet fuel. Airlines like Lufthansa are seeking bailouts, British Airways is slashing jobs and Ryanair are warning that bailing out the weak is unfair, whilst social distancing on aircraft could kill budget air travel, even if quarantining on arrival doesn’t. As with the oil sector, suppliers are restructuring to meet lower demand, with aero engines manufacturer Rolls Royce already talking of slashing its civil aero engines headcount by a third.

Planes will of course fly again, but it seems likely there will be fewer flights and quite possibly emptier flights too. The leisure sector faces huge issues here. Will holiday makers want to face a flight, starting with a socially distanced airport (imagine the queues), and ending with accommodation that might have had a Covid-19 carrier in it the night before? Throw in the need to refund people with outstanding bookings and you can imagine how uncomfortable it is at all stages of the leisure travel market currently.

As for pubs, clubs, restaurants and bars, the challenges are obvious. If we have to social distance, the establishment will feel half empty at best and the only way for operators to make a profit is to charge the earth. Which will hardly pull them in.

These industries will face huge hurdles getting back to sustainable profitability and bargain-hunting investors risk picking up pennies in front of a steamroller.

But is it all doom and gloom? Of course not. We have all learned that despite a massive shock, the world has coped, by and large. Populations were pretty accepting of the extraordinary measures imposed upon them. The food kept arriving on the shelves, even if the loo roll flew off them. Above all we have seen amazing community spirit and determination to pull through.

Businesses the world over showed that they could continue operating, even though their staff were now dispersed. Some, like Netflix even saw their activity soar, because they met new needs.

Looking ahead, the HL Select team see a number of distinct themes playing out as the world moves closer to a post-Covid-19 future.

Strength Matters

This is no time to back weaklings. Robust finances and positive cash flows prove their worth in times like this. Start-ups are so last year. We are going through a slow-down of extraordinary scale. The first and foremost question investors need to ask is will a business get through the next year or two, even if it has to keep much of its operations shuttered?

Some businesses have borrowed their way through this crisis. On the other side of it, their ability to invest to grow will be constrained by the need to pay down these debts. Those who went into the crisis from a position of strength will be able to take advantage further down the line.

Digital Keeps Winning

Services delivered remotely are more sustainable in a socially distanced world. This can only tilt the scales even further in favour of Digital Winners. Digital businesses tend to be capital-light and cash generative and there are no barriers to serving their customers.

Little Has Changed, Apart From Everything

People will still grow up, still want to eat and drink. People will still care about how they look, seek entertainment and want to progress in life.

But how they do all the things they have always done cannot be the same, until we have the measure of this disease and a way to contain it. Some workarounds are easier than others.

Controlling the spread of Covid-19 can raise the cost base of a business, whether by incurring extra IT spend, modifying working practices or redesigning workplaces. So investors need to look for businesses with pricing power, to defend those all-important profit margins.

Wages Could Go Higher

The impact of Covid-19 has exposed that too many people are working for wages that do not seem to reflect the risks they have to face in their day to day work. Companies with large, customer-facing workforces could see pressures here.

What Happens Next?

Unemployment has rocketed across much of the world. As furlough schemes end, firms will need to decide whether they take the full cost of employees back onto their books, or let people go. Investors will need to see businesses returning to hiring before too long, to provide the comfort that governments can move away from the huge deficits they are running.

There are plenty of risks, but this is still a time of great innovation. The modern ability to crunch data in vast quantities should hasten control of and ultimately a cure for this virus. Track and trace apps have a role to play in the former, whilst the accelerated vaccine developments underway globally hold promise further out. We see automation accelerating as firms seek to solve social distancing challenges.

Healthcare spending seems set to rise, which will create opportunities. Supply chains will be rebuilt to cut the risks of disruption. Whenever the world reinvents how things work, new potential is created. As fund managers our task is to steer money away from those firms on the wrong side of change toward those able to take advantage.

The HL Select philosophy has always been to focus on businesses with pricing power and robust cash generation. We look for financial strength because we want to own the companies that can take advantage of the opportunities that downturns can create. This is such a time. Above all we seek to invest in companies that can deliver dependable long term growth. Businesses that can compound their earnings for long periods of time are jewels, and when we find them, we look to own them for years to come.