The first half of 2020 has been eventful for investors as unprecedented health, economic and financial crises were triggered by shocks in China in January and February, before combining to create a brutal selloff in March, which was the sharpest plunge in history and resulted in a liquidity crunch in almost every asset class. European small and mid-cap companies were impacted and dropped an additional 7% in March compared to European large caps indices as investors searched for liquidity.
The responses from Central Banks and governments in Asia, Europe or the Americas were also unprecedented and followed a similar thought process, if not coordinated. Nevertheless, it is hard to hope for a short-term return to “normal”. The recovery will be partial, in stages and the after-effects will be numerous. The longer the shock lasts, the greater the potential impact.
Since March’s lows, European equities have rallied by as much as 35% by the end of the first half of the year in a gravity-defying move. The bounce, labelled as “the most hated rally in history” as some investors have remained stuck on the side-lines, saw the stock markets climbing in the midst of a devastating health and economic crisis. It was far from a straight-line recovery though, with draw downs and rallies, however investors have shown themselves to be eager to buy into the dips. The market has continually proved to be surprisingly resilient, even as earnings estimates and macro indicators tumbled, tensions between China and the U.S. resurfaced and the virus resurged in China and Europe.
One may argue that the stock market is not the economy. It is a tool for pricing in the future and, as such, has already discounted what is happening right now. Stock markets are also heavily influenced by the central banks’ massive stimulus around the world. The jury will remain out for some time regarding the effects of the significant money printing and uncertainty surrounding the viability of a large range of businesses, and will likely spur volatility for the months to come.
As we enter the second half of 2020 there is little room in the market if both future virus and macro data do not match investors’ expectations, but investors want to see the glass as half full, and there are reasons to support this view, notably the unprecedented stimulus response. In this uncertain environment, our responsibility is to deploy capital in a portfolio able to cope with all potential outcomes. As a fundamental investor we do consider the larger picture and take that into account, but company fundamentals have allowed the EI Sturdza Strategic European Smaller Companies Fund to successfully navigate this crisis, find profitable investment opportunities and significantly outperform the markets in H1 2020.
As the emergence of the virus was discussed in the press in January, we undertook a position level fundamental review of all the companies in the portfolio to further understand the direct and indirect impact of inactivity in China. As more clarity became available and Wuhan went into lockdown, we were quickly able to reposition the portfolio away from impacted areas, which predominantly included China and Auto related companies.
As the virus spread and sustained transmission became endemic in Europe, we made use of the experience of trading through the financial crisis of 2008. The key questions in March centred on the ability of the portfolio’s investments to cope with a prolonged lockdown and face a potentially important cash burn resulting from a long period of inactivity. Cash available on the balance sheet, undrawn credit lines and the potential upcoming debt repayment schedules were scrutinised for each individual investment and the companies that the team perceived as potentially at risk were fully divested during the month.
At the same time work was undertaken to build up a buy list of companies that would be either able to benefit from the environment or had been misunderstood by the markets and covid-19 would have limited impact. As a fundamental investor we are always looking for these fantastic opportunities to deploy capital in companies with resilient business models at heavily discounted prices.
There is a lot of debate about the shape of the recovery. Fundamentally a market drop at around 30% appears to be pricing in a 25% hit to earnings 5 years out, which seems extreme in our view and in the context of the huge fiscal and monetary stimulus we’ve seen, the market rebound since March being a demonstration of this. It can however be even more extreme on a stock by stock basis.
Spie is a great example of a company that has been completely misunderstood by the markets through this crisis. Spie developed from a civil, electrical, and industrial engineering company into a European leader in multi-technical services that provides energy, safety and environmentally focused solutions from initial design, through installation to long term maintenance and facilities management. As a company it provides great visibility given that 85% of the year is already secured on 1st January thanks to the installation backlog and the maintenance share of revenues. Spie’s activities are not tourism. What is gone will come back. The reopening of offices after weeks of shutdown will require maintenance. The company had €1.4Bn of liquidity at the end of 2019, so even in an extreme scenario, the group is very unlikely to need a cash injection, or to draw on any credit lines. In 2009, revenues dropped by 3% organically and EBIT margin increased, demonstrating how resilient the group can be in turbulent times. Despite the resilient and transparent business summarised above Spie was heavily penalised in March. It traded at €19.72 on 21st February and went as low as €7.81 on 23rd March. The 60% drop from peak to trough appears in our opinion totally disconnected from the potential earnings risk this year and as a result the Fund increased the position in March by 52% with an average acquisition price of €8.66. As of 30th June, Spie was trading at €13.3, an increase of 67% from the low in March, whilst still only trading at 13x 2020 earnings. Q1 EBITA, posted on 29th April, was 5% ahead of market consensus driven by organic growth and margins that have been more resilient than expected. While Q2 is likely to be more impacted by lockdowns, resilience in Germany and the Netherlands should continue, and we see no changes to consensus.
Ipsos is another great example where the market misunderstood the company’s business model and the economic impact of covid-19. Ipsos is a French listed company that conducts market research. It offers advertising, marketing, media, public relations, and social research and operates globally. 33% of group revenues come from studies that require face to face contact, but the company demonstrated very quickly in China in January that they were able to adapt, as we have all had to, to video meetings. The company had ample liquidity through the crisis and demonstrated resilience in 2009 with a mere 3.8% organic decline, whilst at the same time increasing operating margins. Ipsos fell from a high of €32.10 to a low of €15.82, a fall of 51%. The Fund increased its holding by 26% in the second half of March. Ipsos published a trading update on 26th May, indicating a clear improvement in the trading environment during the month compared to April. For the first five months of the year, both sales and the order book were only down 10%. Following the improvement in May, the easing of lockdown measures in most of the Company’s major markets should pave the way for a gradual upturn in ‘face-to-face’ studies. In addition, a far-reaching reset of consumption habits post covid-19 should support the market research sector over the coming quarters and confirm the resilience of the Company, a point well received by the market. As of 30th June, Ipsos is trading at €22.3, an increase of 41% from March’s lows and still only trades at 9.3X 2020 earnings.
As we all know, predictions are risky, especially when they are about the future. We are in turbulent times, however the team believe that one should not lose sight of fundamentals. We expect this environment of panic and swings to continue for the foreseeable future as the economic impacts of the coronavirus remain uncertain. We believe that this environment should allow the Fund to produce strong returns on both an absolute and relative basis as large market moves overlook company fundamentals.
Source data available upon request.
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The views and statements contained herein are those of Bertrand Faure of Pascal Investment Advisers in its capacity as Investment Adviser to the E.I. Sturdza Strategic European Smaller Companies Fund as of 01/07/2020 and are based on internal research and modelling. This does not constitute independent research and under no circumstances should the information contained therein be used as a recommendation to buy or sell any security or financial instrument or service or to pursue any investment product or strategy or otherwise engage in any investment activity or as an expression of an opinion as to the present or future value of any security or financial instrument. Nothing contained in the views and statements by Pascal Investment Advisers are intended to constitute legal, tax, securities or investment advice. The views and statements contain “forward-looking statements”. All projections, forecasts or related statements or expressions of opinion are forward-looking statements. Although Pascal Investment Advisers believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct, and such forward-looking statements should not be regarded as a guarantee, prediction or definitive statement of fact or probability.
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