In today’s stock market, value investments tend to be clustered in certain sectors. These sectors are often viewed as cyclical, leveraged, over-regulated, and populated by individual companies that are financially weak or poorly managed.
Looking at these sectors in more detail, it’s clear there are many companies to be best avoided. However, there are also genuinely misunderstood value assets, which not only offer good long-term prospects, but have performed robustly in the current crisis.
Best-in-class miners are overlooked
Mining is the classic cyclical sector. People build during booms, then stop building during recessions. Mining companies deplete resources in the good times, overpay for replacement resources at the top of the cycle, borrowing huge sums in the process, and then, during the ensuing slump, are forced by their banks to reduce debts by off-loading assets at fire-sale prices.
A mining boom that lasted from 2001 to the end of 2010 gave rise to the idea of a ‘commodity super-cycle’ expected to last into the mid-2020s. Instead, it was followed by a savage recession, and miners’ share prices declined by around 75 per cent.
During this period, the world’s largest mining companies became more shareholder-friendly, more discriminating over what assets they bought and, in the process, reduced debt levels, and materially increased dividends. These well-financed, prudently managed, world-class businesses will benefit from an infrastructure boom, as the fiscal spending takes over from monetary policy to fuel economic growth. They also remain cheap.
For example, Rio Tinto trades on less than nine times last year’s earnings, and offers a dividend yield of 7.9 per cent. In 2019, it paid its final dividend in full. Rio’s main business is selling around 330 million tons of high-grade iron ore a year to the Chinese from its mines in Australia. During the crisis, the price of iron ore has crept up from $80 dollars a ton to $100. Rio is one of the world’s lowest-cost producers, with an extracted cost for iron ore of $15 dollars a ton. Environmentally, the company is moving in the right direction too, investing in wind farms and divesting its coal assets.
Fiscal stimulus will boost construction and housing
The construction sector is another direct beneficiary from fiscal stimulation through infrastructure spending. The last decade has been dire for the sector. However, a UK government, which dropped the Covid-19 ball, needs to realise election promises to develop the country as a place to do business and ‘level up’ the regions. Construction companies can help deliver these goals.
Construction companies in our investable universe have experienced management teams who understand the cyclicality of their business and usually have net-cash balance sheets. They have all either adopted, or are adopting, realistic carbon-reduction targets.
The housing sector is a crucial part of the UK economy, and is likely to receive government support as part of any recovery package. However, such considerations didn’t prevent the price of Taylor Wimpey falling 57 per cent between 17 February and 17 April. Its peers received a similar treatment.
It appears this reaction is overdone. Several housebuilders have expressed surprise at the continuing level of demand underpinned by a steady level of new reservations, few cancellations, and little pricing pressure.
Selective opportunities in financials
The financial sector is the largest of the ‘value’ sectors covering a wide range of companies, from banks to financial advisers. Within this group, there are an array of high-quality financial companies, where we selectively find value opportunities. Many appear cheap to us, for no other apparent reason than investors see the sector as cyclical and have been avoiding it in anticipation of a downturn.
The sector fared badly during the GFC because companies allowed finances to become overstretched. Today’s financial companies run more conservative balance sheets, many with piles of cash and no debt.
For illustration, we have selective positions in high-quality insurers overlooked by the market. L&G, for example, has two world-class businesses. ‘Bulk Annuities’ relieves large companies of the administrative burden and unlimited financial responsibility of final-salary pension schemes. LGIM, the UK’s largest asset manager, looks after over £1trn of assets, mostly for investing institutions through low-cost index-trackers. LG Capital invests in long-term income-producing assets mainly in the UK, including build-to-rent housing and urban regeneration.
L&G is a genuine growth company. In 2016, the company set itself the target of increasing its earnings per share by 50 per cent over five years. In March this year, the company announced it had delivered 58 per cent EPS (earnings per share) growth in just four years. This growth is not reflected in the share price, which is lower today than it was five years ago.
Even after a recent rally, the company trades on a price/earnings ratio of 7.9x, roughly half the long-term average multiple for the UK market, and offers a dividend yield of 7.8 per cent. The company also paid its dividend in full, unlike the majority of its peers. Legal & General could also be a beneficiary of Covid-19, as the extension of zero interest rates will place renewed pressure on the finances of final-salary pension schemes.
Can retail return?
At the end of last year, the online share of total UK retail spend was a little over 20 per cent. It will be significantly higher now. Equilibrium will be reached at some stage. We do not know where that stage might be, though we doubt the final proportion will be online 100 per cent/physical 0 per cent. Again, we believe there are selective opportunities following the sell-off.
The fund’s exposure to this sector is around 5 per cent, including 0.9 per cent in easyJet, which we see as a very well-run company. It is also the most environmentally aware of the UK-listed airline stocks, and ultimately a potential beneficiary of the shake-up in the industry.
The fund’s other consumer-facing holdings include: Bakkavor, which manufactures and sells food to supermarkets; Alliance Pharma, which acquires and markets non-prescription medicines; and Shoe Zone – an importer and retailer of budget shoes.
Indiscriminate property carnage signals value
Commercial property, unlike the housebuilders, has barely started to recover since the sell-off. We fully understand investors’ concerns about physical property. Retail is dying, and offices may be going the same way.
Apart from a few specialist niches, it seems the only properties investors want to own at present are the retail warehouses serving online shopping trade. These, in consequence, appear fully valued. It is worth bearing in mind that most of the retail properties we own are in retail parks, which have fared better than shopping centres, which in turn have fared better than high street shops.
Over half the floor space in the retail parks owned by Ediston Property, the fund’s largest property holding (2.6 per cent) is let to ‘essential’ retailers, who have remained open and busy throughout lockdown. Ediston report collecting around 70 per cent of rent due since the shutdown. It expects to collect nearly all the remainder in due course through arrangements under which, post-lockdown, arrears will be repaid over an extended period.
Property funds went into the global financial crisis with high levels of debt. Today, debt is far cheaper than it was then, and in aggregate, the companies we own have less than half the level of indebtedness considered normal in 2007. The above considerations may go some way to explain why Brookfield Investments, a large investor based in Ontario, Canada, has built up a 7.3 per cent stake in British Land over the last few weeks. It is often easier to see things more clearly from a distance.
Tony Yarrow is a fund manager at Wise Funds. The views expressed above are his own and should not be taken as investment advice.