THE LOSERS

The companies hardest hit by COVID-19 fall, roughly, into four categories. Firstly, there are companies for which social distancing presents an all-but-unsolvable problem because they need their customers to be seated or standing near each other to make money.

The airline industry and the hospitality sectors are the obvious examples here.  So far this year, the number of travellers passing through security checkpoints at US airports was lower by almost 80% from the year before, according to the US Transportation Security Administration.

Similarly, the hospitality sector has been one of the hardest hit, and in the UK we saw a first quarter decline in sales of 21.3%, according to the industry’s principal trade body, UK Hospitality. Alcohol is usually considered a defensive sector due to its status as an ‘essential’ product. However, as it turns out we drink a lot of beer in crowded pubs and restaurants – who would have thought??  In April, Anheuser-Busch InBev globally sold almost a third less beer than the year before due to pub and restaurant shutdowns.

Next are the heavy industrials, which have suffered not only lower demand but have seen their supply chains hit too. Production lines have needed to be adapted to keep workers safe, but factories have either been shut or working with limited staff.  Some of the changes to working practices may have to be permanent or at least in place until a vaccine is developed. Manufacturing is all about efficiency so playing around with highly specialised processes is not only time consuming but costly. In this basket we find companies from carmakers to chemical groups.

Then there are the energy companies, where too much supply has been the main problem. The Saudi government raised its national oil production in an attempt to corner the global market just as the pandemic was gaining momentum.  Saudi Arabia was anxious to defend its market dominance against a rising tide of oil production in the US and Russia after talks with other OPEC members failed to result in an agreement on new limits for global production.  However, as the pandemic spread globally, oil demand collapsed, and the International Energy Agency expects oil demand to fall by almost a fifth this quarter. This excess supply and lack of demand caused the price of oil to tumble and at one point the oil price fell into negative territory.  The price of Brent crude is now some 40% lower than it was in January, even after bouncing off its May lows. This has had a materially negative effect on the oil majors such as Shell and Saudi Aramco and the pain has been even more severe in the US shale sector. The shale players have always been only marginally profitable and require heavy investment.  Many have gone bankrupt and more will likely follow.

Then, there are the banks, life insurers, and asset managers. Profits for these companies are sensitive to interest rates, which COVID-19 has sent to even lower levels. Central-bank policy and diminished growth expectations have driven the yield on the 10-year Treasury from 1.9% to 0.7% since the beginning of the year and have left most other developed government debt instruments yielding less than zero – negative rates.  For the banks, the risk that the recession will lead to waves of loan defaults provides further worry. Even well-capitalised banks such as JPMorgan and Bank of America have lost a quarter of their value this year.

Then finally we have property companies, which have been impacted by concerns over the solvency of many tenants due to Coronavirus, along with fears of a post-lockdown structural change in work practices and use of office space.

THE WINNERS

In a challenging year for most companies, there are certain sectors and companies that have shone. Pharmaceutical groups boosted by their hunt for a COVID-19 vaccine; technology giants buoyed by the trend for working from home; and the internet retailers offering lockdown necessities online.

Pharmaceutical companies have been some of the biggest winners from the coronavirus crisis as c.$10 billion has been pledged globally to try to find a vaccine.  In the UK, one of the beneficiaries has been AstraZeneca which was, for a time, Britain’s most valuable company.  Its shares, already boosted by strong first-quarter results in April, moved significantly higher in May after the news that it was helping to develop a coronavirus vaccine as early as September.  The U.S. Department of Health and Human Services indicated that it would provide up to $1.2bn to them to develop a potential vaccine from a laboratory at Oxford University.

Other healthcare companies that are either racing to produce a vaccine or that provide existing drugs that aid recovery from the virus have helped boost the entire sector into positive territory.

Other sectors to triumph have been technology related.  Tech has been the growth story for more than a decade, epitomised by companies such as Microsoft and Facebook (which is seen as a ‘communication services’ business).  Such has been the increase in profits made in the sector that many investors had already started to trim their positions when the crisis hit, fearing that the sky-high prices of most tech companies would not last forever.  However, if anything, the lockdown has made these businesses even more central to the lives of billions of people around the world as working and living remotely has become the new normal.  Facebook, which owns WhatsApp and Instagram, has said that messaging activity increased by 50% in countries enduring the strictest lockdowns, whereas Microsoft announced that 75m people used the Teams communication app in a single day in April, up from 20m in late 2019.

For online retailers (which are viewed as consumer discretionary companies), the pandemic has pushed purchasers who had been reluctant to buy goods online towards internet shopping, which has further enhanced a trend that we have seen in recent years. Amazon has unsurprisingly been the largest beneficiary, announcing in April that it would hire a further 100,000 staff in less than a month to keep up with increased orders. As world leaders ordered their citizens indoors, Amazon became the emergency port of call for those desperate to stock up on vital household goods — a rush that led the company to temporarily suspend sales/delay distribution of “non-essential” items.

The next few months should see these tech-focused businesses consolidate their power. All have billions of dollars in cash on their balance sheets and are expected to buy smaller rivals, while also hoovering up talented developers at start-ups who could otherwise find themselves out of work.

The five largest tech-related stocks in the S&P 500 outperformed the rest of the index by 31% in the first five and a half months of 2020 — indicating just how much investors are backing the concept of a ‘new normal’ caused by COVID-19.  The combined market capitalisation of this ‘FAAAMily’ of five companies – Facebook, Apple, Amazon, Alphabet and Microsoft – now accounts for 21.4% of the S&P 500 Index, making them as large as the bottom 350 companies in the index combined!  This dominance of technology companies within the S&P 500 has turbo charged the performance of US equities during 2020, particularly when compared to other global equities.

This has also reignited the debate about ‘Growth’ vs ‘Value’ stocks. A growth stock is any share in a company that is anticipated to grow at a rate significantly above the average growth for the market. These stocks generally do not pay dividends because they typically reinvest any profits in order to accelerate growth in the long term.  They tend to be expensive to buy when considering their current earnings because investors buy them on the expectation that their earnings will grow exponentially, justifying their current high prices.  Technology companies are a prime example.

Value stocks tend to trade at a lower price relative to their fundamentals, such as dividends, earnings, and sales, making them appealing to investors who want more certainty and are happy to accept lower growth.  Energy companies are a typical example.

Traditionally value stocks have outperformed in a falling market due to their more defensive characteristics.   Therefore, during what has been the most protracted bull market for equities of all time, it should be no surprise that ‘value’ stocks have not performed as well as ‘growth’ companies.

Before COVID-19, investors were slowly starting to rotate out of growth and into value, as concerns about a trade war, US election, Brexit and the possible peak of the stock market convinced some to adopt a more cautious stance.

However, when the COVID-19 crisis hit, growth stocks outperformed in both the sharp falls experienced in February and March and the subsequent rebound as investors sought the perceived safety of the lockdown winners.  In some ways, this crisis has brought the future into the present, and exaggerated the structural investment trends that we had already started to see over the last 10 years.

In the market rebound since the end of March, there have been brief periods when value stocks outperformed, as investors changed their buying habits and looked to ‘bargain hunt’, buying the cheap companies at distressed levels in those sectors that were devastated by the virus. At these times, share prices of travel groups, airline stocks, aircraft engineers, hospitality and leisure groups have all rallied sharply, but these ‘value’ rallies have yet to be sustained because concerns persist about the impact of the coronavirus on the fundamental structure of their businesses.

HAS ANYTHING CHANGED IN OUR INVESTMENT THESIS FOR THIS YEAR?

While value stocks are cheap and some growth stocks are looking expensive, we think that having some selective exposure to both within our equity allocation is prudent. In the short term, the lockdown winners such as big tech will continue to benefit from the uncertainty caused by the coronavirus and the new way of living and working remotely.  Indeed, we may be at the start of a completely new normal, where these companies dominate for years to come.  However, we also recognise that there are some very attractive opportunities in sectors and companies that have been adversely affected by this crisis and, provided that government support works properly if required, some of these sectors offer excellent value.

We have owned healthcare companies as a theme for many years and have added exposure to technology as a sector more recently.  However, the outperformance of tech, healthcare and other non-cyclicals during this rebound tells us that investors are still cautious about how and when the global economy and corporate sector will emerge from this economic crisis, so overall we believe it is prudent to remain diversified and defensively positioned.