Beyond Bulls & Bears

Equity

Adaptability Goes a Long Way for UK Small and Mid-Cap Stocks

As the United Kingdom falls under further social distancing measures to combat the coronavirus pandemic, what lies ahead for the UK economy? Franklin UK Equity Team’s Richard Bullas and Dan Green share their perspective, and what a slowdown in economic activity could mean for UK small- and mid-capitalisation stocks.

Given the improving UK economic outlook many of us previously anticipated for 2020 and beyond, the expected negative economic impact of the coronavirus pandemic on the UK economy has caught many investors by surprise. We had entered the year with optimism, given the recent UK election result and the government’s commitment to spending.

Now, we think a recession is unavoidable in the United Kingdom, as upcoming economic data is likely to show a massive reduction in economic activity due to the pandemic. The question everyone’s asking is how long this recession could last—whether it’s a temporary three- to six-month event, or a deeper and more prolonged one.

What’s been encouraging to us during this pandemic is the coordinated response between the Bank of England (BoE) and the UK government. The BoE’s decision to reduce interest rates to near zero—at the same time newly-appointed UK Chancellor of the Exchequer Rishi Sunak essentially promised a blank cheque to support the economy—is a concerted effort to move early and avoid anything similar to the panic we saw during the 2008-2009 global financial crisis.

The UK government is really living up to the mantra of doing “whatever it takes” to cushion those most vulnerable during this period by supporting the overall economy through National Health Service (NHS) funding, business support grants and job retention schemes.

While we don’t expect the UK government to solve all the nation’s problems, what it is doing is pumping cash into the real economy to cushion it though this period by supporting incomes and those business affected. We’re hopeful this economic slowdown could be temporary, but whether we see a sharp V-shaped rebound—marked by a rapid downturn and then rapid rebound from the trough—or a more gradual U-shaped recovery, remains to be seen.

Ramifications of a Truly Global Event

The coronavirus is unique because it has affected so many people, businesses, governments and markets across the globe in a scale and scope we have never seen before.

What started as a supply shock in China that disrupted global business supply chains has now created a demand shockwave in the West. Economic activity in many cities or countries has all but shut, and a severe recession is now unavoidable.

But this hugely disruptive period will end. As long-term investors, we need to think about how the world will look and behave coming out of the other side. We believe this experience will have far-reaching implications for businesses, governments, society, consumer habits, demand patterns and working practices. We’ll be alert to any opportunities that emerge after this period.

We could see an acceleration of underlying structural trends in many industries, such as online retail, working practices and capabilities, and the network and data infrastructure that supports them. We may see a faster upgrade to a fifth-generation (5G) world through better communications infrastructure.

Implications for UK Stocks

Unsurprisingly, many UK businesses are now in survival mode given that they are temporarily closed. This creates a cash flow crisis and the reality is some won’t likely survive the economic fallout from the coronavirus. Companies are being forced to remove financial guidance to shareholders, suspend dividends and buybacks, and cut costs to conserve cash.

Small- and mid-cap stocks have generally underperformed during the recent market crash relative to the wider market, primarily due to differing sector makeup—there’s a greater domestic bias for these types of stocks, which are more cyclical in nature.  Many of these stocks have seen declines in the region of 30%-40% of market value, as a result of this “risk-off” period and a clamour for cash and poor liquidity.

Without a doubt, the sectors with the largest declines have been oil and gas, consumer discretionary and retail. Within these sectors, companies in travel and leisure—such as cinema chains, gyms and restaurants—have been hit particularly hard. The cancellation of major UK sporting events and the closure of some cross-country routes has also affected bus and railway companies. We’ve seen a selloff in the more cyclical names at the smaller end of the market, including housebuilding companies and those that are involved in the construction supply chain. Businesses within the financial sector have borne the brunt of the selloff, too.

Adaptability Goes a Long Way

As we would generally expect, companies with stronger balance sheets before the pandemic have been more resilient, such as health care and utility companies in the more defensive sectors of the market. Food retail and food producers, for example a leading UK pork producer, have seen extra demand due to customers stockpiling ahead of the shutdown but also consuming more food at home.

Other companies that are beneficiaries of this environment include video game producers. Unsurprisingly, online gaming platforms have reported an increase in video game consumption as people are forced to stay at home.

Our investment process means we are selective. We favour companies that meet our criteria of strong balance sheets and experienced management teams. Many businesses have shown they are adaptable in times of crisis and uncertainty—and those are the ones we think have the best chance to weather the crisis. Many of these businesses managed to survive the Brexit uncertainty not so long ago—we’d expect management teams to put the lessons learned from past experiences to good use for the foreseeable future, and emerge from the coronavirus pandemic to take advantage of the opportunities this will create.

 

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