During ten years of extremely benign monetary conditions, the low cost of borrowing has created a good backdrop for many companies to thrive within.
During ten years of extremely benign monetary conditions, the low cost of borrowing has created a good backdrop for many companies to thrive within. However, when economies go into deep recession, it often means conditions are ripe for “Corporate Darwinism” and only the strong may survive. Recognising which companies have the qualities to make them part of this cohort of survivors could be key to successful portfolio management. R&M’s William Lough and Hugh Sergeant explain this concept and how they are applying it to their portfolios.
While we live through these exceptional times, with the large human and economic costs associated with the COVID-19 pandemic, we believe it is essential as custodians of client capital that we keep our eyes not just on the present, but also towards what the investment landscape will look like as we emerge through to the ‘other side’. One of the areas we have been focusing our analysis on is the concept of ‘Corporate Darwinism’ – that is, the strong getting stronger – trying to find those companies, often in cyclical sectors, which may face a very difficult next 6-12 months, but can end up with stronger market positions, and therefore the prospect of greater earning power and a higher equity valuation, as weaker competitors struggle to survive.
The concept of Corporate Darwinism (often also referred to as ‘creative destruction’) is a key pillar of a capitalist system, but is one that, with low interest rates keeping the cost of borrowing extremely low, has been more absent during the cycle from 2009 to today. In short, these loose monetary conditions have likely allowed weaker businesses to stay in business that may otherwise have fallen by the wayside during some of the ‘mini-cycles’ (such as 2011-12 and 2015-16). The incredibly severe nature of the current recession suggests it’s likely that many businesses will unfortunately fail to survive, with or without government support.
Such conditions provide opportunity for market leaders with management teams who possess long-term vision and, critically, the balance sheet capacity to deploy capital aggressively at the bottom of the cycle. To some extent, it can be more of an advantage being a high-quality company in a cyclical industry, than one with a more stable end market, as downturns typically allow you to ‘widen
the moat’ of competitive advantage while weaker competitors are forced to retrench. This contra-cyclical investment allows them to compound earning power often more effectively than even the best players in the most defensive industries (where, by definition, fewer businesses face the same level of stress).
Within our portfolios, we wanted to highlight some names from some of the most hard-hit sectors where the considerations above play an important part in our investment thesis. Retail, particularly those companies with a physical store base, is under immense pressure as lockdowns in many parts of the world have led most companies to shutter large parts of their estate. The near halving of its share price has created an opportunity to buy back into global ‘athleisure’ retail champion JD Sports, whose large cash position places them in a strong position to take share, as there remains a tail of weaker capitalised smaller competitors in all their markets. Greek discount retailer Jumbo has already proven its resilience through the deep downturn in Greece – taking share and maintaining gross margins – and has what we perceive to be a structural advantage in its family-ownership, giving them a longer-term strategic outlook than the average listed company. Within the travel industry, clearly 2020 is going to be an incredibly difficult period but Booking Holdings, with their net cash balance sheet and robust business model, are likely to emerge as a relative winner because hotels will lean on them to fill empty rooms during the recovery. We see their superior execution relative to peers during 2019 as a good ‘dress-rehearsal’ for the challenges they currently face. Finally, times like this are in many ways tailor-made for the more conservative manner our Japanese industrial cyclical holdings have typically managed their balance sheets. Nitto Denko, which supplies into a range of highly technical customers but predominantly smartphone displays, has a long history of innovation and a net cash position (with minimal gross debt) equal to nearly 40 per cent of the current market cap. Both factors position them well to participate in any end market recovery.
“Such conditions provide opportunity for market leaders with management teams who possess long-term vision and, critically, the balance sheet capacity to deploy capital aggressively at the bottom of the cycle.”
Within the portfolios there are many more companies like these that we believe are well-placed to emerge from recession with improved prospects. We believe that it is appropriate for investors to be spending time thinking about these opportunities as well as the desire to protect capital. Such opportunities are particularly exciting if they are less obvious and therefore do not come with the high price-tag that many ‘quality compounders’ continue to enjoy. We will elaborate on these points further in a future ‘white paper’.