Small caps underperformed their larger counterparts in the sell-off. In a sector context, few areas were unscathed but shares in cyclicals and particularly companies involved in the likes of travel and leisure as well as businesses operating with high debt levels, were sold off aggressively. We always major on maintaining a diversified portfolio across geographies, sectors and individual holdings – a stance that tends to help us weather challenging periods, but a lot of our holdings were marked down sharply. Thankfully, since then, much of the lost ground has been recouped as the impact of the significant policy response from governments and central banks has again supported financial markets.
We removed the gearing on the trust by early March, recognising the impact of COVID-19 on the global outlook. In addition to this though, our immediate response to the escalation was to re-examine our portfolio holdings company-by-company. We tried to assess the likely impact of the crisis on sectors and companies within them. At the stock level, leverage is one of the key things we are always mindful of when analysing a business, and we favour lower geared businesses which are better placed to deal with turbulent times. Our preference for balance sheet strength alongside other ‘quality’ characteristics meant that after we had done our review, we only had to exit a small number of names. These were where we felt uncertainty was simply too great given that COVID-19 had fundamentally undermined their outlook or where the financial risks had become too elevated given a collapse in anticipated profitability.
Economic data is suggesting that activity is now rising again, perhaps not surprisingly given that lockdowns are being eased in the key developed economies, and there has been some stabilisation in earnings forecasts, although many companies remain reluctant to give any guidance as to their expected profits. We wait to see how effective the fiscal and monetary stimulus will be both in a local and global context, which will inform our views around geographic asset allocation. Market sentiment will be vulnerable to any second wave infection spikes though of course progress on a vaccine would have a big positive effect. Undoubtedly though, we’re facing a challenging period for many businesses. 2020 will be a very poor year for corporate earnings and many weaker companies will do well to survive. Job losses are starting to become more evident as companies re-size their operations to take account of lower demand.
Unsurprisingly, much of our activity and near-term focus reflects the economic environment as we emphasise businesses capable of weathering challenging conditions. At the same time though, we are mindful that opportunities often present themselves in times like these so are also considering structural impacts of the pandemic in the context of where longer-term themes may be found.
One close to home – quite literally – as I write this from my home office is the impact on the working environment. At BMO, we have been working from home for over three months now and our return to the office seems to remain some way off. We’re not alone in this and it’s reasonable to expect some of the practices people have adopted during the pandemic to persist long-term. There will be repercussions for companies geared into business travel. When will air traffic return to pre-pandemic levels? And what are the prospects for hotel operators and those servicing travellers with food and drink for example? More fundamentally, in terms of where we normally work, what will be the impact on demand for office space going forward? Some companies could choose to take advantage of a proven ‘working from home’ model to trim their desk space requirements and rental costs, impacting the value of real estate portfolios exposed to offices. What seems clear is that companies in all sectors will need to ensure they have effective and robust IT systems to ensure service levels can be maintained with large proportions of their staff working from home.
We are beginning to see some return to normality on the high street but COVID-19 has provided further impetus to the shift towards online retail. This move has been taking place for some time, but shop closures in the lockdown have forced many consumers previously less familiar with buying products online to use this channel. Many will continue to buy more products in this way going forward, further undermining the economics of bricks and mortar retailers.
As we look forward our global smaller companies team is continuing to busily reassess the outlook for the portfolio and whether we should adjust our sector skew. With markets set to remain volatile depending on the success of the re-start of economies, there are almost certain to be valuation anomalies that we will seek to exploit. Indeed, we have already been able to take holdings in a number of stocks in the pull-back which we had felt were previously overvalued. Longer-term, the global smaller companies market remains an attractive and dynamic universe in which to search for such opportunities.
Investments in smaller companies carry a higher degree of risk as their shares may be less liquid and investment values can be volatile.