Must we wait for the recovery?

We too are worried about this outcome, as a second lockdown would add to the already immense pressure on companies.

Illustrating how out of favour cyclical stocks are, NatWest Group’s share price, has just dipped below the previous lows made in April. At 92p, with a tangible book value of 263p, the bank trades on 0.35 times book value. Adjusting for excess capital (which it would like to return from 2021), it trades on 3 times conservatively estimated normalised earnings. Of course, banks are controversial given their history, record low interest rates (potentially negative interest rates) and mounting credit losses. Nevertheless, they are outstandingly cheap in valuation terms, with NatWest Group being the most conservative among peers in terms of capital position and loan loss reserving.

Take another stock, ITV, where traditional linear TV is under pressure and with it the associated advertising revenue. However, the company generates half its revenues from its Studios business, and content is king in entertainment. The ITV share price is basically only valuing the Studios business, you are getting the rest of the business for free.

An interesting comparison is that the bond market seems much more relaxed about the business, than the equity market. ITV’s 2026 bond trades at par, yielding 1.4%. The company’s CDS having spiked in March, is down to levels comparable to those of the years before the pandemic. Its current net debt is lower than it was at the end of December 2019.

The market does not appear willing to see through the crisis for these companies. We don’t dispute that earnings are somewhat impaired, that it may take several years to get back to 2019 profitability levels, but one doesn’t need to get back to those levels to make a very good return from these companies.

Meanwhile, the market is willing to value The Hut Group at 6x revenues and believes it can grow future sales by 20% to 25% per year, while giving it a pass on its terrible corporate governance. Further afield Snowflake is valued at 165x last 12 months’ revenues.

While The Hut Group and Snowflake demonstrate the mood of the market, we don’t need to go to the extremes to find contradictions. For some companies the market seems perfectly willing to look through the trough. Safran, the French supplier to the aerospace industry, looks fully valued on 2019 revenues, even though those revenues are expected to fall 35% this year and will take until 2025 to get back to peak. Why is the market willing to overlook Safran’s challenges?

The question for investors is whether to buy the unloved value stocks now, with such obvious risks, or must one wait for the economic recovery to develop?

In our view, the first thing is to be sure a company can make it through, the balance sheet and liquidity position must be strong to make it to the other side of this crisis. We have been highly impressed with how our portfolio companies have moved in this respect and as with ITV many are in better shape than pre crisis. Once we have comfort on the balance sheet, to achieve the most attractive returns, we have to act before the market changes its mind, once it does these share prices may move very fast. Royal Mail Group’s share price has risen 40% in less than two weeks on the back of strong growth within its parcels business (GLS). And here is a central point, there is an issue of structural decline in some of these companies, like ITV and its Broadcast business, Royal Mail is suffering letter volume declines, but like Studios for ITV, Royal Mail is just about reflecting the value of GLS, the rest of the business is for free.

Even before the market may change its mind, companies themselves may act. We have seen such activity in the past couple of months; Dixons announced the potential IPO of what we believe is its very strong Nordic business, Aviva is selling its Singapore business, Capita is selling its software business, NatWest Group announced a potential closure of Ulster Bank (freeing up £4 billion of capital). The list goes on as companies look at ways to unlock value.

Therefore, if the balance sheet is strong and given the exceptionally cheap valuations, there is huge potential asymmetry in the outcome, in favour of investors willing to get involved at this time. We are not denying the risks such as COVID-19 and a second lockdown, but the potential reward, in our view, is great and greater again versus those stocks that the market is currently comfortable with, which may become the source of funding if and when a rotation materialises.

Maybe we are wrong to be sanguine about the long-term prospects of these value stocks, alternatively I wonder if I will look back at this period and think these were some of the best bargains of my career.