Bailouts fuel the debt bonfire, so investors will need to renew their focus on quality, says Andrew Pitts.
Extraordinary times call for extraordinary measures – and then some. In little more than a month, the fiscal and monetary measures to prop up economies and financial markets in the great coronavirus crisis (GCC) have already exceeded what was done during the global financial crisis (GFC) of 2008/09.
Now, as then, we see clear examples of ‘moral hazard’. Excessive risk-takers are effectively being bailed out – from hedge funds engaged in socially and economically useless trading activities, to highly leveraged private equity and companies that have binged on cheap debt to fund share buybacks/dividends and short-term executive stock options. One could arguably call it socialism for the rich.
A clear example of excessive risk being rewarded is the US Federal Reserve wading into the junk bond market, as it did before Easter, as part of a $700 billion ‘support’ package. And it did so not through buying the distressed debt of individual corporate issuers, where collateral (however dodgy) could presumably be exchanged for the Fed’s support, but by buying shares in exchange traded funds that track the market in high-yield debt. These ETFs include junk bonds issued by companies owned by private equity groups. Perhaps the Great Collateral Crisis, or lack of it, is just as fitting a moniker for these strange times.
Extraordinary and morally questionable measures such as these helped Wall Street to record a 12% gain in the four days before Easter, its highest weekly gain since 1974. Global markets, as always, took their cue from the US, helping to restore a thin veneer of gloss to battered portfolios.
The counterpoint to the moral hazard argument is that the GCC is a ‘black swan’ event that has more profound financial and economic consequences than the GFC. Therefore, the money being pumped indiscriminately into stressed markets has saved our collective financial bacon: from private investors (and their agents) investing for their future and funding retirement, to companies seeking to avoid bankruptcy and preserve jobs.
However, it is difficult to get away from the argument that in this crisis, like the last, any attempt to preserve prudent saving and investments has played second fiddle to bailing out speculators: rescuing bad companies that should be allowed to fail, propping up debt-fuelled private equity, and failing to clamp down on hedge funds that engage in morally questionable methods of squeezing profit from trading rather than investing.
Such ‘rentier capitalist’ activities (loosely defined as gaining significant profit without a contribution to society) almost halted trading in the world’s most liquid pool of tradeable assets – US Treasury bonds – in March, before the Fed was forced to step in with a promise to buy unlimited quantities of these ‘risk-free’ assets.
Worse to come?
Ordinary savers and investors lost out during and after the GFC. Having already suffered significant losses in the early stages of the GCC, there is worse to come, not least a forecast 30% reduction in UK dividends for this year. Meanwhile, cash-rich private equity firms are eyeing up distressed businesses trading on depressed valuations. The top tables of high finance will reap the rewards when these businesses recover, leaving the scraps for us.
Even after a decade of robust global economic expansion, the GCC has exposed the underlying weakness of corporate balance sheets and the instability of financial markets. The explosion in corporate debt is a big part of the problem. Worldwide, non-financial companies have issued $13 trillion (£10 trillion) in bonds, states the OECD, double what they owed (excluding bank loans and other lines of credit) in 2008. The Institute of International Finance reckons the total global burden of corporate debt has more than doubled since 2005 to $75 trillion.
That is a great deal of debt that needs to be serviced and refinanced. Unfortunately, it comes at a time which the IMF forecasts will be the worst global economic contraction since the Great Depression. Gita Gopinath, the IMF’s chief economist, warns that the loss in output this year will dwarf the GFC, with only a partial recovery in 2021, “with considerable uncertainty about the strength of the rebound”. As she further notes: “This is a deep recession. It is a recession that involves solvency issues and unemployment going up substantially, and these leave scars.” On top of the corporate debt burden, one shudders to think about the depth of those scars in global consumer credit and the resulting damage to consumption.
It is a stark reminder, if one were needed, that the 20% rebound in global stock markets from the March nadir will likely be a flash in the pan. As Money Observer has reported online, veteran investor John Chatfeild-Roberts at Jupiter Asset Management warns that “what bear markets do is suck people in and then destroy their money. So those sorts of retracements, we think, are an opportunity to make sure that anything you didn’t want to hold you can get out of at a reasonable price.”
As I write, the earnings reporting season for the first quarter is under way, and it seems that investors are indeed taking fright again, with increased volatility evident. Future earnings guidance will be largely negative in the face of unprecedented global economic contraction in a debt-ridden and plague-ridden world.
There’s one thing that can be counted on: investors will turn their immediate focus to survival of the fittest. Cash, and more importantly levels of free cash flow, will take centre stage as investors look in forensic detail at the ability of companies to service debt and to fund growth and dividend payments.
I confess to a new-found interest in the arguably dull and repetitive qualities that many fund managers of our Rated Funds say they look for in companies they invest in – such as high return on capital, robust balance sheets, strong barriers to competition, acceptable levels of debt, relatively low capital intensity and sustainable growth.
Qualities to look for
For the foreseeable future, they are exactly the qualities that private investors should be looking for, particularly in funds focused on equities. The accompanying table is quite revealing in this respect: it shows actively managed Rated Funds that focus on global equity and equity income that have beaten the return from the MSCI World index over the year to 14 April, a period that also includes the big market wobble back in the third quarter of 2019.
Note the preponderance of funds that feature ‘sustainable’ and ‘quality’ in their names, or are known for following sustainable growth and/or income themes (virtually all of them). Note also that these Rated Funds generally fell less than the market over the past three months and bounced back better than the index from mid-March. The longer-term performance numbers also compare well.
Such funds, and those that aim to generate a real return (and to preserve accumulated wealth), are those most likely to shine in the short to medium term.
The author was editor of Money Observer from 1998 to 2015.
Actively managed global equity Rated Funds that beat the index*
|Percentage total return
(Income reinvested) after:
|Name||1 mth||3 mths||1 yr||3 yrs||5 yrs||10 yrs|
|Scottish Mortgage IT||16.7||4.5||19.4||73.3||133.4||479.3|
|Investec Global Franchise||9.6||-6.5||7.6||29.4||77.7||-|
|Edinburgh Worldwide IT||20.0||-2.7||5.3||80.1||113.4||278.4|
|Trojan Global Equity||5.1||-9.4||5.2||26.9||67.3||182.2|
|T. Rowe Price Global Focused Growth Equity||11.5||-8.8||5.1||39.2||91.2||210.2|
|Mid Wynd IT||8.2||-9.4||4.3||30.5||69.2||248.5|
|Securities Trust Of Scotland IT||8.6||-15.7||4.2||16.0||43.6||147.7|
|Rathbone Global Opportunities||9.0||-8.4||2.8||36.2||74.0||225.4|
|Ardevora Global Equity||2.2||-10.9||2.7||29.2||70.2||-|
|Fidelity Global Dividend||5.7||-10.3||2.2||14.3||45.6||-|
|Fundsmith Sustainable Equity||5.8||-7.5||2.0||-||-||-|
|Scottish American IT||11.6||-10.6||1.7||22.3||76.1||170.4|
|BMO Responsible Global Equity||8.3||-12.0||1.6||27.0||57.0||161.5|
|Fidelity Global Focus||5.1||-12.0||1.2||21.4||54.9||164.4|
|Fidelity Global Enhanced Income||5.7||-10.1||0.1||10.3||41.4||-|
|Brown Advisory Global Leaders||0.7||-14.8||-0.5||-||-||-|
|Sanlam Global High Quality||5.6||-10.4||-0.5||15.9||66.9||174.0|
|Guinness Global Equity Income||3.9||-12.1||-0.9||16.1||43.2||-|
|Lindsell Train Global Equity||10.9||-8.4||-1.6||43.3||89.2||-|
|JP Morgan Global Growth & Income IT||8.3||-15.1||-2.7||13.0||52.8||128.8|
|MSCI World index||3.4||-14.3||-3.3||13.2||43.3||139.0|
Notes: *Ranked over one year to 14 April. 10 globally focused Rated Funds failed to beat the MSCI World index, although it should be noted that some investment trusts also suffered substantial falls in discounts to net asset value. Data source: FE Analytics
The opportunity cost for value investors
Unless Covid-19 is swiftly defeated and economies stage a remarkable ‘V’-shaped recovery, it is likely to be some time before funds focused on cyclical or absolute value return to favour. But that does not mean they hold no appeal, particularly for those prepared to wait.
It’s always darkest before the dawn, as the saying goes, and that is what the asset allocation team at US-based firm GMO have entitled their most recent ‘white paper’ on the topic of value investing.
The team point out that bear markets play out in three phases: history shows that ‘cheap assets’ can get relatively cheaper still in the first phase, before outperforming in phase two and generating both absolute and relative positive returns in phase three. They concede, though, that “holding a basket of potentially risky companies during a period of heightened uncertainty… can feel terrifying”.
Nevertheless, examples of the ‘cheap-loses-then-wins’ dynamic in bear markets abound, including the 1973 bear market, the bursting of the Japanese stock market bubble in 1990 and the TMT crash of 2000.
What fits this dynamic today? GMO reckons Europe, UK and Japan value stocks are cheap in absolute terms, while emerging market value stocks are extremely cheap. More importantly, GMO says the time to act is now, in phase one of the bear market, because once peak volatility fades, the opportunity to make the most of the value trade fades.
The unanswered questions are whether this bear market will follow the characteristics of past bears and just how long ‘phase one’ is set to last. Whatever the answer, history shows that value investors had to wait a few years before real ‘value’ became apparent in superior absolute returns.