Manager update on Henderson Smaller Companies

The impact of COVID-19 on markets has resulted in an economic shock unlike any in modern times. Demand is drying up and this is not a recession of normal proportions – effectively economic activity is ceasing. The fiscal and monetary response from Governments to help try and tackle this is unprecedented and it’s apparent they are prepared to do ‘whatever it takes’ to support the economy.

At the time of writing (21^st March 2020), it has been an extreme two weeks in markets with dramatic declines in equity markets and volatility has spiked. After initially holding up well compared to large caps, small and mid-caps materially underperformed last week and there is now a liquidity premium.

Regarding stock performance, everything has been caught in the maelstrom. However, the worse hit has been companies with leverage. In particular, those most exposed to the consumer and small and mid-caps. Additionally, liquidity has reduced – a ‘buyers strike’, which is particularly relevant in small and mid-cap space.

Turning to how we’re thinking about our portfolio, the whole conversation we are having with management teams has changed. Questions now focus around leverage, debt facilities, liquidity, monthly cash burn etc. Corporate earnings will be sharply down in 2020, so there’s an argument that conventional valuation methods are currently irrelevant. Dividend yields are also illusory. We have already seen a number of corporates passing on dividends and cancelling those already declared. This is something we expect to continue. As a result, we are focusing on our current portfolio and not looking for new ideas at this moment in time.

Where we’re adding is to portfolio positions where we believe the share price has fallen too far. For example, we’ve been counter intuitively increasing our positions in leisure stocks such as Cineworld, Hollywood Bowl, Gym Group and Mitchells and Butler. Share prices of these stocks have been hit very hard but we believe they are all very strong franchises and have good management teams.

We’ve also been adding to Bellway, which is now trading well below net asset value and has a very strong balance sheet to weather the storm, and also Clinigen. The share price collapsed due to having high leverage but it is very cash generative and operates in non-cyclical markets.

Where we’ve been cutting positions are those companies where we lack conviction or feel the company is poorly placed to deal with the current situation.

Despite the sharp and sudden downturn or markets, I don’t think we’ll see much significant corporate failure for a few reasons. The banks will be under significant pressure not to ‘break’ companies but provide covenant waivers and extension of facilities. This may well result in higher interest rate margins and some fees further down the line but that is preferable to insolvency. Secondly, Governments have given extraordinary amounts of money to the banking sector. This isn’t the financial crisis on 2008-9 and the banking sector is well capitalised and in good health. Thirdly, the UK Government is also doing its bit and paying wages for staff who would otherwise have been laid off due to COVID-19 and allowing deferral of VAT, PAYE and NI payments.

There will inevitably be some requirement for equity re-capitalisation once we can see the other side. That is the function of equity markets and will provide some fantastic opportunities when markets recover. It’s just a question of when.

Glossary

Dividend – A payment made by a company to its shareholders. The amount is variable, and is paid as a portion of the company’s profits.

Dividend yield – The annual dividends expressed as a percentage of the current share price

Cash burn/burn rate – The rate at which a company is losing money that is typically expressed in monthly terms. 

Leverage – The use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset, or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets. 

Liquidity – The ability to buy or sell a particular security or asset in the market. Assets that can be easily traded in the market (without causing a major price move) are referred to as ‘liquid’.