Pockets of value arise amid corona crisis

The coronavirus crisis has created pockets of value among investment trusts and UK equities, says Gary Moglione.

Value investing is difficult enough in benign environments, but in the current circumstances, it is proving particularly challenging. Suddenly, consumers are confined to their homes and global demand for many products has moved close to zero, with the exception of medical supplies and groceries.

Investors hate uncertainty. When faced with such extreme risk and uncertainty, their first instinct is to flee. The stock market has been a conduit of fear in recent weeks, which is perfectly understandable given the chaos that surrounds us.

It is currently very difficult to value companies. We have no firm idea of when the world will be moving freely again, and this has massive consequences for trying to understand both the economic environment and individual company cash flows. Predicting how companies will perform over the short term is essentially akin to buying a lottery ticket, as any of a wide range of potential scenarios may emerge.

There are two elements to this crisis that need to be overcome before stocks can recover. First, the health risks need to be brought under control through testing, treatments, vaccines or herd immunity. The second element will involve tackling the economic damage, the extent of which will depend on the time it takes to get people back to work and companies operating normally again. These two issues will be resolved, but it may take years rather than months to put things right. The vast range of economic scenarios that might unfold stretches from a V-shaped recovery to a global depression.

Sell-off demands a switch of strategy

There are two main strategies we as investors need to embrace when investing in these markets. First, we need to have a long-term investment horizon. When economies are eventually thriving again, stocks will trade on significantly higher valuations than they do currently. We have to accept that this could be years away, though, and that there will be significant volatility before we get there. We would be very lucky to time the bottom of the market, so we have to be mentally prepared for investments to trade significantly lower before things begin to improve.

Second, we need to be comfortable that our investments can survive. Excessive debt combined with a global lockdown is a toxic mix. Despite government support packages, numerous business will not survive, and debt will be a key component of their demise. Avoiding permanent loss of capital is the most important risk to manage.

The crisis has resulted in significant losses across most asset classes and regions. However, some areas of the market have been hit excessively hard, and these will provide fruitful hunting grounds for value investors.

Investment trusts are a good place to find value in a crisis. There are two pricing mechanisms in play: the net asset value or NAV (the value of the underlying assets) and the share price. When the market panics, the value of underlying assets will reflect market fear, but the share price can magnify that fear as investors rush to sell their holdings, meaning trusts may trade at a significant discount to their already depressed valuations. We have added to selected REITs and private equity trusts trading at wide discounts.

Bargains to be found in Brexit-bound Britain

UK equities are another area where value is abundant. Prior to the crisis, UK domestic stocks were trading at a discount to their global peers as the uncertainty about the UK’s Brexit negotiations with the EU weighed on investors’ minds.

The recent sell-off has widened the gap between UK and global stocks: the FTSE 250 fell by 30% in the first quarter of 2020, while the MSCI World index fell by 15%. One reason for this relates to Brexit and its impact on the pound. At one point in recent weeks the pound fell to a 35-year low versus the dollar, as investors flew to safe haven currencies such as the dollar and the yen. Meanwhile, the Brexit-bound UK is so unloved that patient investors can pick up bargains there.

The focus of the sell-off has been in the more cyclical sectors such as consumer discretionary, industrials and financials. These sectors will face severe challenges, but they contain many solid businesses that are well-equipped to navigate the crisis.

Gary Moglione is a fund manager at Seneca Investment Management.