Events of the past 12 months have major implications for consumers and companies
Thursday 18 Feb 2021 Author: Ian Conway

Despite all the upheaval of the past year, anyone glancing at the financial markets today might find it hard to believe investors were in the throes of despair 12 months ago.

Following the global markets crash in February 2020, the recovery has been spectacular. The US Nasdaq 100 and S&P 500 indices are at all-time highs, Japan’s Nikkei index is at a multi-decade high, China’s Shanghai index is at a multi-year high and the MSCI All Countries World Index is at a record high.

In the UK the FTSE 100 and FTSE 250 are still in negative territory since February 2020 although the losses aren’t nearly as extreme as they were when the pandemic first took hold.

Markets have been fuelled by support from central bank and government stimulus measures, low interest rates and optimism over the pace of economic recovery thanks to the creation of Covid vaccines.

Risk appetite is alive and well as shown by the surge in crypto currencies, the volume of investment grade bonds now trading with negative yields (bond yields fall when prices rise), herd behaviour on social networks regarding stocks, the deluge of cash shells to acquire businesses, the warm reception for new stock market listings and the race by private equity firms to deploy their mountains of cash through acquisitions.

Later in this article we look for cheap stocks that have still to play catch-up.

First, we explore what’s changed in terms of how companies do business and how we manage our money.

STRUCTURAL CHANGES

It almost seems as though nothing has changed; in fact, everything has changed. Much of what might be called ‘new’ isn’t new at all – many of the biggest trends to emerge in 2020 had been waiting in the wings for several years, the pandemic just brought them centre stage much earlier than expected.

The greatest change has been the shift to remote working (see When will we return to the office - if at all?), which had always existed on the fringe but had never been considered viable on a large scale. The surprise for many business owners was how off-the-shelf technology enabled them to quickly move to remote working without a hitch.

Moreover, remote working has brought benefits to many firms including cost savings, and it has improved the work/life balance for their employees. The flip side is that it is bad news for owners of city centre offices, transport companies and anyone who relies on either – or worse, both.

Companies with large central offices are mostly looking to downsize while those which were planning to expand have realised they can increase their staff numbers while staying in the same office and rotating their teams.

Those with several smaller regional offices may look to do away with them altogether and concentrate on making the working from home experience more fulfilling for their staff.

Bus and rail firms, which will have budgeted for a given level of revenue before the pandemic, now have to go back to the drawing board and rethink their plans, not least for capital spending, given they are likely to see far fewer passengers using their services in the future.

PERSONAL FINANCIAL HABITS HAVE CHANGED

The pandemic has brought behavioural changes, too. Ian Mattioli, co-founder and chief executive of wealth manager Mattioli Woods (MTW:AIM), says his firm has found that many people who, prior to last year, thought nothing of spending their disposable income on two or three holidays a year, are now saving the bulk of their surplus wages to give themselves a buffer in case they lose their jobs.

Recent announcements by holiday companies such as TUI (TUI) confirm that holidaymakers are being more selective. The ‘return to normal’ has failed to happen so far, with TUI reporting a 44% reduction in summer bookings compared with pre-pandemic (2019) levels, well short of its earlier expectation for a 20% drop.

WHEN WILL WE RETURN TO THE OFFICE (IF AT ALL)?

The latest AlphaWise survey from investment bank Morgan Stanley makes sobering reading for those hoping for a reopening of the economy by Easter.

According to the bank’s monthly telephone survey of 12,500 European office workers, despite the rollout of vaccines since its previous survey, employees’ expectations of when they can return to work have slipped from April to June.

As the survey says, ‘Clearly, this will not only impact office utilisation in 2021, but also leisure and retail property that depends upon the return to normal commuting patterns.’

Across Europe, 73% of office workers have been working remotely compared with half that proportion pre-Covid. Of these, 80% would like to work from home more in the future, with 51% happy to work out of the office one or two days a week, 29% three to four days a week and 14% every day of the week.

Chris Herd, founder and chief executive of remote infrastructure firm Firstbase, says remote work is ‘the biggest workplace revolution in history, and nothing will deliver a higher quality of life increase in the next decade than this’.

Herd believes new companies will be ‘remote first’, without the need for a corporate headquarters. Aside from the obvious cost savings, this allows them to hire the best people wherever they are in the world, not just within a certain radius. At the same time, companies which want to retain their staff will have to offer remote working as an option or risk losing them.

We are also becoming more discerning when it comes to shopping online for fashion. Gone it seems is the habit of picking six dresses for an event and sending five back, with retailers such as ASOS (ASC:AIM) noting a steady decline in the volume of returns throughout the past year.

If we aren’t getting dressed up and going out, or planning several trips to foreign climes, what are we spending our money on?

The latest Barclaycard study shows overall UK consumer spending fell 16% between 25 December and 22 January. Spending on essentials was up roughly 4%, with supermarket spending up 17% and online grocery spending up 127%, which is positive news for companies such as Ocado (OCDO).

Spending on non-essentials fell almost 25%, with health and beauty sales down 27% and clothing sales down 25%. With restaurants closed, takeaway and delivery sales jumped 33%, the highest growth on record for the category.

Total online spending was up 73% on the same period a year earlier and now accounts for a remarkable 55% of all retail sales, a genuine paradigm shift for the retail sector which has struggled to keep up with changing demand.

Moreover, most consumers believe they will stick with online shopping once vaccinations are commonplace as they now prefer the experience of ordering via their phone or computer and having their items delivered rather than schlepping to the shops in all weathers.

A SHRINKING HIGH STREET

Sadly, the flip side of this shift to online shopping is the high street as we knew it becoming a thing of the past. Footfall in January 2021 was down a staggering 77%, according to the British Retail Consortium, and the outlook for February is not particularly encouraging.

Few chains look to have the right financial strength and proposition to sustain a town centre presence long-term, with the list of likely survivors (among companies whose shares trade on the
UK market) more or less measurable in single figures, principally Greggs (GRG), JD Sports (JD.), JD Wetherspoon (JDW), Marks & Spencer (MKS), Next (NXT), Primark-owner Associated British Foods (ABF), Sports Direct-owner Fraser (FRAS) and WH Smith (SMWH).

And, where previously an empty shop might have been turned into a café, bar or restaurant, the decimation of the hospitality industry means there are few players with the financial wherewithal to step in and take up the space, especially if footfall is permanently reduced.

According to the Coffer Peach Business Tracker survey, turnover for the hospitality industry was down 54% last year from £133.5 billion to just £61.7 billion. If anything, the fourth quarter trend was worse than the annual average, down 57% from £33 billion to just £14.3 billion.

All of this bodes poorly for commercial property companies for the next few years. Strong retailers will have their pick of the best sites and will likely demand low rents with much of the responsibility for upkeep passed onto the property owners.


STOCK MARKET WINNERS AND LOSERS

When sifting through what worked and what didn’t work over the past year in stock market terms, we have looked at both the broader FTSE 350 sector indices and individual stocks.

Unusually, industrial metals, mining, industrial transportation and industrial engineering have been the leaders in terms of performance, even though the global economy took an enormous hit during the pandemic and by most estimates it will take three to five years for world output to return to ‘trend’.

On the other hand, considering the devastation wrought on the hospitality industry, it’s somewhat surprising travel and leisure or pubs, restaurants and hotels weren’t among the worst FTSE 350 sector performers.

Instead, the worst sectors have been aerospace and defence, banks, fixed-line telecommunications, oil and gas producers, and oil and gas equipment and services, the last two despite a sharp rally in crude oil prices since the start of 2021.

STOCK-LEVEL ANALYSIS

It won’t be a surprise to investors that companies which were either already largely online or shifted their business model to online were among the biggest winners. The top performing FTSE 350 stock since the start of the Covid sell-off is AO World (AO.), up 307%. The online retailer of unglamorous items such as freezers, microwaves and washing machines became a stock market darling as domestic appliances became hot property during lockdown.

Spread betting firms like CMC Markets (CMCX) and Plus500 (PLUS) as well as gambling firms like 888 (888) and Flutter (FLTR) posted exceptional gains thanks to a surge in new account openings as those cooped up at home found new ways to entertain themselves by betting.

Savvy investors played the strong performance of overseas markets through collective investments, especially those with a US/technology bias, with Baillie Gifford US Growth Trust (USA) and Scottish Mortgage (SMT) clocking up gains of more than 100%.

Asia-focused trusts also found favour with Fidelity China Special Situations (FCSS) almost doubling and JPMorgan Japanese (JFJ) rising by two thirds.

Interestingly, less than half the constituents of the FTSE 350 index trade above their February highs today, and a third are still lagging the benchmark with losses of more than 10%.

The list of big losers is littered with travel and leisure, aerospace, financial and industrial stocks, along with real estate investment trusts (REITs). Curiously, many of the housebuilders are still heavily in negative territory with losses of 30% or more despite the continued strength of demand in the housing market – as shown by their recent results – and a clutch of technology stocks are also nursing heavy losses which seems counter-intuitive.

It is worth noting that since 9 November when Covid-19 vaccines started to be confirmed, recovery plays have been in fashion, with travel and leisure stocks such as Cineworld (CINE) picking up, and more defensives such as Unilever (ULVR) lagging the wider UK indices.


3 STOCKS TO BUY NOW

We have chosen three stocks which we think have been overlooked, with varying degrees of risk attached.

THE 'SAFE' ONE

Beazley (BEZ) 350p. Market cap: £2.2 billion. 12-month forward PE: 11.7

Shares in Lloyd’s market insurer Beazley (BEZ) are trading 38% below their pre-pandemic levels, which seems to us as though the market is driving with the rear-view mirror.

The firm may have posted a $50m loss for last year due to claims for cancelled events and other Covid effects, but this was half the amount analysts were expecting.

What excites us is the 15% increase in renewal rates as the insurance market tightened conditions in response to the pandemic. Chief executive Andrew Horton described himself as ‘very positive about the year ahead’, as having raised capital in May the firm is well placed to capture the strong rate tailwind.

With its strong underwriting discipline and focus on capital returns, Beazley can cover the same risks this year with a much greater profit margin which should lead to earnings upgrades and a sharp rerating of the shares.


THE 'CHEAP' ONE

Bellway (BWY) £28.84. Market cap: £3.6 billion. 12-month forward PE: 9.2

Trailing 12-month price to book value: 1.2

Mid-market housebuilder Bellway (BWY) posted a record build volume for the six months to the end of January, and what it called a robust forward sales book with orders for almost 5,900 new homes or 28% more than the same period a year earlier.

It also pointed to full year completions of 9,800 homes, an increase of 30%, and an improvement in its underlying operating profit margin of ‘at least 200 basis points’ (2%) over last year’s 14.5% margin.

Given how much brighter the outlook appears, it seems odd that the shares are still some 30% below their February 2020 level. Moreover, the valuation gap between Bellway and the rest of the sector seems abnormally wide.

We can only assume that investors are worried the end of Help to Buy and/or the stamp duty holiday will lead to disappointment, yet the valuation offers a healthy margin of safety in our view.


THE 'RACY' ONE

Micro Focus (MCRO) 466p. Market cap: £1.6 billion. 12-month forward PE: 4.5

Infrastructure software supplier Micro Focus (MCRO) divides opinion like few other stocks. ‘Cheap for a reason’ is a typical response, which given its debt level and a surprise $2.8 billion writedown of goodwill in the 2020 results doesn’t seem unjustified.

The firm began its three-year turnaround plan in January last year, which was unfortunate timing, but if anything, the pandemic has forced it to grasp the nettle and cut down on unnecessary spending while focusing on key areas of opportunity.

The firm’s new guidance is for revenues to stabilise in the 2023 financial year, while its in-house IT infrastructure plan starting this year will generate further operational improvements and efficiencies.

For us, with the shares down 40% since last February, it’s a binary bet. Either the firm does what it promised which means the shares
rerate, or it keeps disappointing and gets taken over by a private equity firm. This is a high-risk investment and investors should only get involved if they have money they can afford to lose.

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