In depth 

Surviving the sell-off

Surviving the sell-off

The worsening of the coronavirus situation and a plunging oil price has seen major economies take on a new level of fear in the last few weeks – that’s a painful additional blow to investors in the face of a mounting health crisis. Amid the uncertainty, we try to put some perspective into what is going on.

 

How did we get here?

Since the global financial crisis back in 2008, the world’s central banks have tried to revive economies and underpin the value of financial markets with very low interest rates. 

Economic growth has been relatively lacklustre, but there can be no doubt that low interest rates have been very successful at inflating values in stock, bond and property markets.

The stock market has benefited from near-ideal bull market conditions. Low or negative interest rates on savings accounts and government bonds have led many investors to think that there was little alternative to buying shares to get a decent return – meaning above inflation – on their money.

Companies have done their bit to keep share prices going up. Profits for many businesses have kept ticking up while cheap borrowing costs have encouraged companies to buy back their own shares and pay special dividends to turbo-charge returns to investors. From the March 2009 lows to their recent peaks, the FTSE All-Share Index delivered total returns to shareholders of around 250 per cent, with the S&P 500 index in the US more than double that.

During this time, there has been an ingrained and well-justified belief that the US Federal Reserve will essentially do whatever it needed to prop up the value of the US stock market, and with it most major western stock markets. This was proved most starkly at the start of 2019 when it cut interest rates after trying to raise them to more normal levels – close to or even above the rate of inflation – and caused the US stock market to sell off sharply.

The belief in the power of central bankers and the view that there was little alternative to shares arguably led investors to be dangerously complacent with the values that they put on them. Valuations that would have been seen to be extremely overvalued in the past were justified as perfectly reasonable given the quality of the businesses concerned, their ability to grow and a low-interest-rate world.

The coronavirus and the reaction of governments to it has changed this mindset rapidly. This is not a temporary blip that can be put right with even cheaper money. This is a real and powerful economic shock. When people are told to stay at home in places such as China and Italy, shops do not open and factories do not produce goods. People do not go to restaurants or take flights. It should be no surprise that economies and company profits will find it difficult to grow in this kind of environment.

For the first time in over a decade investors have now woken up to the likelihood that company profits can actually fall rather than go perpetually up. Cheap money or not, the expectations of future profits remain the main driver of share prices. If these are expected to be lower – perhaps a lot lower – then share prices can and do fall a long way.

The real worry for markets is that the US has been too slow in testing people for the virus. If it starts to follow the same path as Italy in quarantining people then the damage to the economy could be severe.

If the impact and uncertainty caused by the coronavirus wasn’t bad enough, the decision over the weekend of the Saudi Arabian government to pump more oil after Russia refused to join Opec members in pumping less has caused the oil price to crash from just under $60 a barrel a few weeks’ ago to around $34 at the time of writing. (Click here for our latest analysis of the oil shock and its effect on companies.)

 

 

There’s always a possibility that the current goings-on with the oil price are a tactic being used by the Saudis to force the Russians back to the negotiating table. If this is the case and the Russians buckle to the price pressure this issue may be solved relatively quickly. The fear is that it won’t be – Russia has been bullish over its ability to withstand lower oil prices – and this could seriously damage the US shale oil industry.

If oil prices stay at current levels there are worries that many US shale companies that are carrying lots of debt on their balance sheets could get into financial difficulties. This then leads people to worry about banks with exposure to the industry. Stock markets do not take kindly to these kinds of thoughts.

 

Surveying the damage

The stock markets have been hammered, with Monday 9 March’s rout pushing the FTSE 100 and FTSE 250 into bear market territory – respectively down 22.3 per cent and 20.6 per cent in price from their 2020 peaks. The S&P 500 closed on Monday down 18.9 per cent from its record high close on 19 February.

Airlines, tour operators and oil companies have seen their share prices hammered. Travel-related businesses such as hotel operators and travel retail have also fared very badly. Companies that are vulnerable to a collapse in demand and are also highly indebted, such as Cineworld (CINE), have seen big share price falls.

Very few companies have escaped unscathed. However, defensive businesses such as supermarkets, water companies and electricity grid networks have held up well. 

Investor fear has spiked and volatility has increased as measured by the VIX index. Investors should expect this to continue for the next few weeks. They should expect relief rallies from time to time but these may not be a sign that a downwards trend in the market has passed. If history is any guide and the problems facing the world right now are as serious as they seem, it will take some time for things to get better.

 

Central banks can’t fix this

As usual, the big firms in the City and on Wall Street have been calling for interest rate cuts to help prop up the markets, just as they have for the past decade or so. This has not worked, despite a Fed rate cut last week. Further cuts in interest rates are expected, with an increasing view that they will be at zero fairly soon and possibly even negative by the summer.

Some commentators are even beginning to talk about “helicopter money”, where the government effectively gives money to households. This would be a truly desperate measure in my view and would not necessarily revive an economy facing a big deflationary shock. There is no guarantee that people would spend the money nor does it take into account the effect it would have on the value of that money and what goods and services it would buy through its exchange rate. 

This is a real-world economic problem to do with the production of goods and services. Low or even negative interest rates do not cure viruses and get people out of their homes, and get factories working again.

Instead of propping up stock markets, the biggest help the government and central banks can give in a worse-case scenario is to provide liquidity to businesses. Company cash flows are likely to dry up if the decline in economic activity means that suppliers are not paid. Banks withdrew overdrafts in the last financial crisis just when companies needed vital working capital. It would be a good idea if this was not allowed to happen again (click here for our detailed view on what Covid-19 means for the banking sector).

 

 

Why this is not a temporary blip

During the past few years the right investing strategy has been to buy the dips in the stock market. I think this is unlikely to work out this time.

There are hopes that the virus will start to die down by the summer and that things will get back to normal quickly. This could be wishful thinking. If China is any guide, it will take some time for economic activity to pick up again. 

Some lost economic activity will have been lost forever. A restaurant meal or a flight that has been missed won’t necessarily be rebooked. There also has to be a risk that the changes in behaviour taken by businesses and individuals in response to the virus outbreak may become permanent. 

For example, companies may realise that more of their workers can work at home more often and become more productive. This may mean that they need less office space and workers use public transport less. Conference calls may replace some flights in the future.

It seems that there is a large amount of complacency amongst professional analysts, particularly on Wall Street. They seem to think that company profitability will take a hit in the first half of the year, but that anything that is lost will be largely recovered in the second half of the year.

Looking at earnings per share (EPS) forecasts for the S&P 500, they have not changed much since I wrote about the outlook for US shares in December 2019.

 

S&P 500 EPS Forecasts and PE

S&P 500

2020F

2021F

Dec 2019 EPS

179.6

195.1

S&P 500 Dec 2019

3191

3191

Dec 2019 PE

17.8

16.4

March 2020 EPS

171.8

192.6

Forecast Change

-4.3%

-1.3%

S&P 500 March 2020

2746

2746

March 2020 PE

16.0

14.3

Source: S&P Capital IQ

 

If the coronavirus and lower oil prices lead to a global recession then these EPS forecasts will prove to be wildly optimistic and should not be used to say that the US stock market is cheap. These EPS forecasts also exclude all the bad stuff that reduces profits and is supposed to be a one off. Looking at actual reported profits and EPS suggests that the market is more expensive.

Based on 2019 trailing EPS figures, the FTSE 100 trades on a PE ratio of 16.4 (EPS of 363.9) times at Monday’s close of 5956, with the S&P 500 trading on 19.8 times (EPS of 138.7) at 2746. If EPS shrinks as it tends to do in a recession then the market will look more expensive than it does now. 

There is a distinct possibility that the big shock to the economy and company profits that is likely from current events could lead to a big rethink by investors as to the valuation that they are prepared to pay for shares. With smooth upwards profit growth not taken for granted and a heightened sense of risk that comes with this, it is not unreasonable to think that valuation multiples could fall back. For some shares the retrenchment could be considerable.

 

Riding out the storm

The bond market has so far been the best hiding place from the stock market rout but there can be no doubt that the price of safety here is very high. Investors are getting little return on their money in many government debt issues and in some cases are paying for the privilege to own them through negative yields.

 

Source: S&P Capital IQ

 

Bond yields have collapsed in recent weeks and have delivered good price returns for investors. If 10-year redemption yields in the UK and the US are to go negative, as they have been in Germany for some time, then further gains can be made.

 

Returns and duration of bond ETFs as of 9 March 2020

ETF

YTD Return %

1 year Return %

Duration (years)

Vanguard US Government Bond

9.8

13.1

6.6

Vanguard UK Government Bond

13.4

20

14.3

iShares Index Linked Gilts

11

14.7

22.5

Vanguard S&P 500 ETF

-11.8

2.5

 

FTSE All Share index

-18.9

-9.7

 

Source: Vanguard, iShares, SharePad

 

If we look at the returns that have been received by UK investors in the year to date and over the past year we can see that owning UK and US government bonds has handsomely beaten owning US shares and the UK stock market.

When investing in bond funds investors need to consider the sensitivity of the price of bonds to changes in interest rates. The relationship between prices and interest rates is nicely explained by comparing them to a seesaw. This means that when one of them is up the other one is down. One measure of bond interest rate sensitivity is known as duration

Bonds with longer maturities have longer durations and are more sensitive to interest rate changes as the bond holder has longer to wait for their returns. The UK government bond ETFs shown here have much longer durations than the US bond ETF and partly explain why they have performed better as expectations of interest rate cuts have increased. If interest rate expectations continue to fall then they may continue to outperform. If interest rates increase – a very unlikely scenario in the current market – then expect them to underperform and potentially experience big falls in price.

The other safe haven that has been sought out is gold. In US dollar terms, gold is up 9.5 per cent in the year to date and by 27.9 per cent over the past year. In pound sterling terms, the Wisdom Tree Physical Gold ETF (PHGP) is up by 10.2 per cent in the year to date and by 27.2 per cent over the past year (other physical gold ETFs are available).

 

 

Gold is where investors tend to flock to in times of panic. Its status as a safe haven needs to be understood and crucially depends on the state of the world going forward.

The bull case for gold is relatively straightforward. With low or negative interest rates on bonds perhaps even going lower, the opportunity cost of owning gold is also lower. With talk of more quantitative easing and even helicopter money, it seems that central bankers have few misgivings about destroying the value of paper money in a desperate attempt to create inflation and avoid a deflationary bust in a world that has too much debt.

However, there is no guarantee that these actions will create the rampant inflation – or the fear of it – that provides the conditions for the gold price to surge upwards.

Instead, the jolt to the world economy caused by the coronavirus and to a lesser extent a low oil price could create a big deflationary shock and a recession where prices fall. Gold would be unlikely to do well under such circumstances. 

The problem is that no-one knows what’s going to happen. Central bankers are really afraid of deflation and are trying to stop this happening. If they are successful and create inflation then gold could provide some decent protection to the purchasing power of your investment portfolio. If they fail, then cash and bonds may actually increase their buying power and perform better.

Gold is also a notoriously volatile asset with the ups and downs in its price on a par with and maybe slightly more than equities. If you are the kind of investor that gets freaked out by wild price moves – particularly downwards ones – then think carefully before you buy some gold for your portfolio.

 

Looking for opportunities in the UK stock market

While a lot of discussion centres on the mayhem and the losses that investors are suffering, the current market conditions may be creating some potential bargains in certain shares.

You are unlikely to call the bottom of the market, but the UK stock market undoubtedly offers some interesting situations right now depending on your appetite for risk.

At bear market bottoms, excellent businesses can often be picked up for great prices. It’s hard to say that we have reached this point when shares in companies such as Halma (HLMA), Spirax-Sarco (SPX) and London Stock Exchange (LSE) still trade on more than 30 times forecast earnings.

Defensive investors who don’t want to own cash or bonds will often seek out the sanctuary offered by secure dividends in a market like this. Very high dividend yields are often a sign of high risk and that the dividend will be cut and end up being a value trap.

For example, at the time of writing BP (BP.) and Royal Dutch Shell (RDSB) offer forecast dividend yields of more than 10 per cent. Can these companies earn enough profit and generate enough cash flow to maintain their dividend payouts if oil stays at $35 a barrel? It must be doubtful, which makes these shares quite high-risk yield plays right now. On the other hand, if the oil price quickly recovers then they could turn out to be opportunistic buys.

 

Safe-ish sources of dividend yield

Company

Price(p)

fc DPS(p)

2y fc DPS(p)

3y fc DPS(p)

fc Yield %

2y fc Yield %

3y fc Yield %

fc Div cvr

2y fc Div cvr

3y fc Div cvr

BT Group

120

15.4

11

10.8

12.8

9.2

9

1.5

2.1

2.2

British American Tobacco

2979

217.4

234.9

252.9

7.3

7.9

8.5

1.5

1.5

1.5

SSE

1475

80

82.2

84.4

5.4

5.6

5.7

1.1

1.2

1.1

National Grid

977

48.7

50.1

51.3

5

5.1

5.2

1.2

1.2

1.2

United Utilities

919

41.7

42.5

43.3

4.5

4.6

4.7

1.4

1.2

1.2

Telecom plus

1250

56.7

61.3

66.3

4.5

4.9

5.3

1.1

1.1

1.1

Pennon Group

1066

44

45.8

47.8

4.1

4.3

4.5

1.3

1.2

1.3

Severn Trent

2439

100.1

102

104

4.1

4.2

4.3

1.3

1.2

1.2

Unilever

4168

150.7

161.8

167.9

3.6

3.9

4

1.5

1.5

1.6

Tesco

241

8.3

9.2

9.9

3.5

3.8

4.1

2

1.9

1.9

Source: SharePad

 

The great thing about dividends is that once they have been paid they cannot be taken away. They represent a real, tangible return on your investment in a business. In stark contrast, in rough markets, previous share price gains can disappear very quickly.

Investors might wish to turn their attention to traditional safe-haven shares such as network utilities where their regulated income streams can be very stable and predictable (subject to a regular review by regulators). These companies pay out most of their profits as dividends, so dividend cover is normally very low. Water companies such as United Utilities (UU.), Severn Trent (SVT) and Pennon (PNN) have also just had a regulatory review of their prices and now offer at least five years’ of dividend stability.

BT (BT.) is a share for the brave and has regularly disappointed investors given its business issues and very large pension fund deficit, which will be creaking as interest rates on bonds go lower. But a big dividend cut is already being forecast. With customers unlikely to stop using their phones or the internet, the shares could offer a chunky yield even after the cut is considered.

Where things get really interesting at the moment is with certain shares in travel-related sectors that have taken a real beating in recent weeks. There are some good businesses here that are going through a period of (hopefully) short-term pain. The risk that profit forecasts are downgraded further is high, but picking the shares up in a wave of pessimism is worthy of consideration in my view.

 

Travel-related shares to consider

Company

Price

1 y low

%chg 1m

%chg YTD

fc Net debt to EBITDA

fc Int cover

PE roll 1

fc Yield

Dart Group

1084

680.5

-42

-36

-0.3

8.6

9.4

1

easyJet

1060

840

-29

-26

0.7

18.5

9

5.3

InterContinental Hotels

4042

3682

-15

-22

2.6

6.6

16.2

2.6

National Express

363

349

-18

-23

1.1

5.7

9.5

5

SSP

457

383.5

-30

-30

1.6

11.8

13.4

2.9

WH Smith

1723

1582

-28

-34

1.2

13.2

13.6

3.7

Source: SharePad 

 

One of the most important things to understand when looking at any business is how operationally geared it is – how big the changes in its profits are compared with changes in revenues. Operational gearing is great in an upswing, but potentially lethal in a downturn.

Airlines and travel operators are some of the most operationally geared businesses out there. They have lots of fixed costs and this makes them high risk. A fall in the oil price will have seen sentiment towards airlines improve, but if fuel costs have been hedged they are unlikely to feel any benefit. What’s far more important is how full their planes are. They need to be fairly full (ideally 90 per cent full or more) to make good profits and the risk is that flying is going to be quite low on people’s to-do list right now.

However, I don’t see companies such as Dart Group (DTG) or easyJet (EZY) going bust given their financial positions. When flyers return, profit forecasts and sentiment towards their shares should improve rapidly.

Hotels also tend to have high operational gearing if they are owned outright. InterContinental Hotels (IHG) is primarily a franchiser and does not own hotels and therefore has a vastly reduced business risk compared with an owner. The operational gearing risk is with its franchisees. As long as hotel occupancy picks up and they can pay the franchise fees, IHG is likely to remain an outstanding business with profit margins in excess of 40 per cent.

I wrote about National Express (NEX) in last week’s magazine. This is a well-managed business that is capable of delivering steady growth in profits and cash flows. If the coronavirus sees US schools being closed then its school bus business will see temporarily lower profits while workplace shuttle services would also be at risk – again temporarily. The shares look attractively valued and offer a good dividend yield, which looks safe.

SSP (SSPG) and WH Smith (SMWH) make good returns from their stores at airports and railway stations.  Unsurprisingly, both shares have taken a beating, with WH Smith’s profit forecasts being significantly downgraded in recent weeks. Their forecast PEs have come down a lot and could still be flattered by forecasts that are too high, but both businesses have decent long-term growth prospects that are priced a lot more attractively than they were a few weeks’ ago.

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