Listen to our latest “Talking Markets” podcast to hear from Evan, Grant and Jonathan. A transcript follows.
Host/Lee Rosenthal: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.
Ahead on this episode: an in-depth look at US equities following the latest market movements, and outlooks for the tech and biotech sectors in particular.
Franklin Equity Group’s Evan McCulloch, Grant Bowers and Jonathan Curtis join Renee Anderson for this conversation.
Renee Anderson: As localities and countries enact sweeping restrictions to slow the progress of the COVID-19 virus, the impacts to the global economy are just starting to be felt. Economic growth projections are declining quickly as policymakers seek to stem the spread of the virus. Grant, what has been your view of this volatility in US equities and what risks to long-term growth are you watching for?
Grant Bowers: The spread of the COVID-19 virus combined with a freefall in oil prices really lit the fuse for the selloff in equities and for that matter most asset classes around the globe. It has been unprecedented in not only its speed but also its severity. Volatility spiked to levels we haven’t seen since the financial crisis and correlations between assets have been at very high levels. Investors around the globe were clearly searching for liquidity, selling everything they could to reduce risk exposure in their portfolios quickly. The selloff at its core has really been driven by uncertainty. The purposeful stopping of the global economy in such a rapid fashion has never been done in history and investors are uncertain not just about the risks that COVID-19 virus brings to humanity, but also how we will restart the economy once the pandemic eases. And then, at what pace will that recovery take place and ultimately will post this recovery, change consumer or corporate behaviour in the future?
From an economic standpoint, it’s pretty clear that we will be in a recession in the United States for several quarters. The negative impact to GDP [gross domestic product] and employment will be significant and probably last into the third or fourth quarter of 2020, before we start seeing any sense of economic growth rebounding. We don’t believe that this will lead to a global depression or a multi-year economic downturn, but the timing and pace of the recovery will be the focus of the markets as we go forward. In thinking about the recovery, we see several areas that could provide support in coming weeks and months.
First, when we looked at China, the epicentre of the crisis, new cases of the virus have slowed materially, and people are returning to work and consumers are starting to resume traditional spending patterns. This is a good leading indicator that the measures being taken can be effective. We have been in discussions with our Franklin Templeton Global Research teams in Asia to get on the ground perspectives and insights on this topic. And recently as a side note, we have seen cases in Italy plateau as well.
Secondly, the Federal Reserve has acted quickly to inject unprecedented levels of liquidity into the market. I would expect additional fiscal stimulus in the coming days and weeks in the US and globally. Governments around the world are stepping up to support and stabilise the global economy. These measures take time but can be very effective.
And lastly, the turmoil in global oil markets has caused great uncertainty and has really impacted the energy sector in the US, but there is a bright side to that. The tailwind of lower raw material costs for many companies and lower energy prices for consumers should be supportive of an economic recovery.
So I guess really in summary, Renee, as long-term investors, we believe that this pandemic, while scary and disruptive, will ultimately pass and that the economic damage, while severe in the short term, will subside as consumers emerge looking for new opportunities with pent up demand for goods and services. The world feels to many like it has changed, but the fundamental underpinnings of the US economy are just bent, not broken. For investors, looking at the market, history has shown us that broad-based selloffs of this magnitude are often good entry points for active investors who can identify the high-quality companies and look through the near-term uncertainty with a long-term view.
Renee Anderson: Concerns about the supply chain risk really abound right now and there are certainly implications for the technology sector. Jonathan, what are your thoughts on supply chain dynamics across the tech space?
Jonathan Curtis: Certainly, we have seen a significant disruption to supply chains mostly in China, as the Chinese government and companies there have imposed restrictions on gatherings and economic activity. But encouragingly, we are starting to see many Chinese employees and workers go back to work now. These supply chains are coming back online, and we are even seeing economic activity picking up in China as people resume their daily lives.
On the demand side, we think there is really important signal that we can be looking at for many of the publicly traded Chinese companies that saw benefits, quite frankly, through the recent crisis they faced. Their e-commerce vendors all did well. Many of their video conferencing vendors did quite well. Some of their online gaming and education companies did well. And we think we are going to see similar trends here in the US. In fact, we are already seeing that as we are seeing a significant increase in work from home and video conferencing occurring, educate from home, exercise from home, health from home, all of these services are really seeing very strong demand trends. And of course, e-commerce is really being adopted much more broadly. There is a vast number of consumers and workers that are being retrained on these technologies and services and we think that these areas of the economy actually are going to do quite well going forward as a result of this.
Renee Anderson: Evan, tell us what you are seeing in the biotech arena. What is your view on the impact to drug discovery or development?
Evan McCulloch: Most hospitals and physician practices are focused on COVID-19 right now plus shelter-in-place orders are restricting people’s movement and patients are thinking twice about visiting health care settings out of fear of being exposed to the virus. So, this is most definitely having an impact on launching new clinical trials and enrolling existing ones. So, there does seem to be a bit of a pause in clinical development of new drugs at the moment. That said, many biotechnology and pharmaceutical companies have diverted their own resources to addressing COVID-19. From redeploying already approved drugs to starting new vaccine programmes, the industry has rapidly mobilised to try and find a solution.
Renee Anderson: Coming into this crisis, corporate America was generally pretty healthy. Grant, how would you characterise the health of corporate America today?
Grant Bowers: At a high level, corporate America and the US consumer was very strong going into this crisis. At the corporate level, cash flows and balance sheets were healthy. The long economic expansion was clearly in the later part of the cycle and we were not seeing excessive leverage, bloated order backlogs or grand expansion plans from the majority of the market. Aside from some select sectors that are more dependent on credit or equity markets in this downturn, this downturn has really been focused on the consumer. The impact of economic shutdowns on employment and consumer spending will be significant, especially in sectors like travel, hospitality and traditional retail. I think we will have a good sense of the level of demand impact we will see over the next few quarters. But the important question is once the crisis passes, how quickly do people go back to work? How quickly do they resume their traditional spending patterns and how quickly do we get a sense of normalcy in the economy?
Renee Anderson: Jonathan, we have seen healthy margins and cash flows from the technology sector over the past decade. Do you feel this sector is more resilient than others?
Jonathan Curtis: Coming into the crisis, tech and comm services were the third and fourth most profitable subsectors of the S&P 500. From a balance sheet perspective, tech and comm services were the second and third best positioned, with information technology being net cash positive to a very large degree. But certainly, as we see B2B spending really slow and technology projects slow temporarily, we are going to see pressure on some of these companies. Now thankfully, they can flex their cost structure a bit and take out some sales and marketing expense. So that will help to protect cash flows and their cash positions. The B2C companies, companies that rely heavily on advertising for revenue, they have high fixed costs. They’re seeing their usage increasing, but they will definitely see advertising revenue decline going through this. However, coming out of this, we think that both the B2B and the B2C technology companies are going to see really a resumption of the trends that we have been talking about for a long time around digital transformation. And so, these models will look every bit as healthy as they did going into the crisis, coming out of it, but definitely we are going to see some pressure in the middle of it.
Renee Anderson: Evan, how is the health of the biotech sector? Are there risks we should be aware of?
Evan McCulloch: These companies discover, develop and commercialise branded pharmaceutical drugs. The commercialisation end is fairly resilient. Most people continue to take their drugs and we expect revenue lines to be fairly stable. However, a majority of biotechnology companies have yet to launch a product and are reliant on the capital markets to finance the research and development expenses. With valuations down and the general availability of capital reduced, the financing environment is going to be a lot more difficult, compared with what was a very healthy environment just a few weeks ago. On the brighter side though, if the industry can produce new treatments and vaccines for COVID-19, the need for a healthy biopharmaceutical industry will be recognised and it lessens the risk of onerous legislation on drug pricing, alleviating a risk that has hung over the sector for the past four years.
Renee Anderson: The market’s move has been swift and severe in many cases. Some companies are faring well, but others have been dramatically repriced downward. Grant, how do you view current US equity valuations overall and are some areas starting to look relatively attractive?
Grant Bowers: Valuations have come down significantly for US equities, but I think it’s still too early to say the market is broadly cheap. Given the unprecedented speed of this global event and the uncertain timeline for recovery and earnings, it’s very difficult to have a clear picture of the overall market valuation in the near term. That said, I’m very confident that the US economy and corporate America will recover. And as a long-term investor, when I look out 12 to 24 months, I see many leading US companies with resilient end markets, great competitive positions, strong cash flows, and firm balance sheets at valuations not seen in over a decade. Many of these high-quality companies will not only weather the crisis but, will actually be positioned to thrive when we move past it.
Portfolio-wise, we have asked our analysts to focus on those two to three high-quality ideas that they think will be best positioned for the recovery and will create the most economic value over the mid to long term. We are already seeing opportunities to initiate or add to positions in what we consider to be the best-in-class growth companies levered to many of the multiyear growth trends we have talked about over the last few years.
Renee Anderson: Jonathan, let’s talk about technology valuations relative to history. Can you share some thoughts on how the sector looks today relative to 10 or 20 years ago?
Jonathan Curtis: Certainly, valuations have come in from where the market peaked in early February, and tech has been a relative outperformer during this downdraft. But, you know, certainly the tech sector isn’t cheap relative to 10 years ago, EV-to-trailing revenue is still well above where we were 10 years ago, but the composition of the information technology sector has changed dramatically over the past 10 years.1 It’s become much less cyclical, much less dependent on hardware and non-recurring revenue sources like semiconductors and much more oriented towards recurring revenues and software. So, the composition of the technology space has changed dramatically. And so, the valuations appropriately have changed relative to 20 years ago, which we were right in the middle of the internet bubble selloff and the telecom equipment selloff and we are nowhere near those valuation levels on a trailing 12-month basis. So certainly, we have seen valuations improve. When we look out over the next one to two years and we think about the big themes we have been focused on, we find many of the highest quality growth companies really nicely discounted to what we think is their long-term fair value. And so, we are seeing good opportunities across technology right now.
Renee Anderson: Evan, are valuations in the biotechnology sector reflecting your views for long-term growth?
Evan McCulloch: Again, the major driver for these companies is revenue growth and these trends are fairly stable and if anything, we are getting more comfortable with the long-term revenues estimates if the threat of drug pricing reform is coming off the table. And yet, biotechnology stocks have come down along with everything else. So, with these stock prices down, but the outlook for many of the later commercial-stage companies fairly unchanged, we do think valuations are attractive.
Renee Anderson: Let’s talk about the future, once we get to the other side of COVID-19, growth likely resumes. Evan, what is your longer-term outlook for the biotech industry?
Evan McCulloch: Once we get through this near-term challenge, we still have a very positive outlook for the biotechnology industry. We are excited about the tremendous amount of innovation taking place. We are excited about gene therapy and gene editing, precision oncology and still the massive room for improvement in the treatment of cancer. Hopefully, progress in other areas of unmet medical need like Alzheimer’s disease, other neurodegenerative disorders and NASH and then also opportunities at the other end of the prevalent spectrum in addressing rare diseases. There are also many discovery tools that are being used behind the scenes that enable faster drug discovery and development.
And as I mentioned before, now that the world is looking towards the biotech and pharma industries for solutions to COVID-19, I think the political attacks against the industry will lessen.
Renee Anderson: Jonathan, within the tech sector, I know you are focused on a number of themes. Do you anticipate a change in your views or has this current crisis firmed your belief?
Jonathan Curtis: Well, I think we have seen the technology is really the antidote to many of the challenges that this crisis has created. In terms of social distancing, some of the social platforms have really helped people reconnect with one another. Work-from-home technology has allowed people to continue working and remain engaged with their colleagues. Certainly, underlying all of this is a really robust and pervasive cloud computing platform. And so, we think many of the themes we have been talking around on the big idea of digital transformation, supporting themes of cloud computing, security as a service, digital payments, e-commerce, many of these themes will actually end up being accelerated as a result of this as many companies, many employees and many consumers now are being trained in how to use these technologies and really accelerating their adoption. So, if anything, our views are being bolstered by this unfortunate crisis we are going through.
Renee Anderson: Grant, what’s your overall outlook for US equities and where are you seeing opportunities?
Grant Bowers: I absolutely agree with many of the themes that Evan and Jonathan just mentioned. These are not passing trends, but really decade long transformations that will continue to be investible themes, even as we move past this crisis. The technology and health care sectors will remain a large focus. Beyond tech and health care, two sectors that we think have opportunities are industrials and consumer. In the consumer sector, where probably the greatest damage has been incurred, we are focused on two areas. First, large global brands that while impacted from slowing economic growth will be the first areas that consumers return to for purchases. These businesses are high quality with very strong competitive positions and valuations are very attractive.
The second area is an area where consumers were introduced to new ways of buying goods or living. As Jonathan mentioned, the shift from offline to online retail will be accelerated. This will benefit e-commerce companies, but also digital payment companies who provide the backbone for many of these transactions and many emerging home consumer companies that have seen really unprecedented demand for their products as we adjust to our new sort of temporary living situations. We think many consumers are going to see the quality and value proposition that these products offer and will dramatically change their behaviour going forward. In the industrial sector, the crisis has really exposed some weaknesses in our manufacturing and supply chains in the US. It’s highlighted areas that we believe will need significant investment in future years. As we emerge from this crisis and the economy settles, investments in domestic manufacturing and logistics will be a priority for many companies. This will ultimately drive a large CapEx [capital expenditure] investment cycle in the industrial sector. These investments will be more focused on digitising factories or automating production lines across the industrial complex, but could last for many years post the end of this crisis.
Renee Anderson: Thank you all for sharing your insights and perspectives with us today.
Host: And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, or just about any other major podcast provider and we hope you’ll join us next time when we’d uncover more insights from our on the ground investment professionals.
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1. Source: Enterprise value (EV) is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalisation.