19 March 2020
Merian UK Smaller Companies Fund – comments by Dan Nickols
For the Merian UK Smaller Companies Fund, there has been relatively little activity since the coronavirus-driven sell-off in markets. We entered the sell-off with a balanced position from a thematic and sector perspective, and have outperformed the Numis Smaller Companies Index (ex ITs) usefully in a falling market, both year-to-date and month-to-date, as at close of business on 17th March 2020.
I have thus far been reticent to commit any new money to this market, the logic for which has been that there is as yet too little visibility as to when the restrictions on economic activity required to flatten the curve of virus cases will be curtailed. Given the magnitude of share price falls and a fast moving and disorderly market, these are unattractive conditions into which to sell.
What’s held up? What hasn’t?
Thematically, travel and leisure and indebtedness have performed worst; structural growers (in spite of relatively high starting valuations), higher quality and defensive businesses have performed best. At a stock level, better performing positions have included Smart Metering Systems (sold a portfolio of meters at an attractive valuation) and Huntsworth (on a takeover bid). Relative value has been added by avoiding bus and rail (First Group, Go Ahead) and Finablr (which looks like the business may fail). Underperformers have included One Savings Bank, Dart and Workspace.
Travel and travel-related positions pose the greatest questions, given these are typically somewhat levered and the business-interruption dynamic associated with the COVID outbreak is likely to be most acute. For the fund, holdings in Johnson Service (hotel linen), Restaurant Group (a small starting unit) and Dart Group (operator of the Jet2 airline and package holiday business) are the holdings requiring the greatest focus – more clarity from Government on the details of business interruption loan schemes, commercial paper funding schemes and airline bail-outs will be key to establishing the likely funding needs of such businesses in the short term. I believe we need more understanding of the wider environment before we can accurately assess the valuations for businesses in this space.
The situation is fluid and fast moving. As recently as last week, some companies were reporting little meaningful change to trading conditions. One investee company told us that one of their manufacturing facilities had been open in Wuhan throughout the lock-down there. For footfall-related businesses, conditions in the UK have deteriorated materially very rapidly.
Looking at the big picture, markets already look attractively rated relative to history. The Numis Smaller Companies Index (ex-ITs) trades on a calendar 2019 price/earnings ratio of 7.1x and a yield of 6.3% (source: Peel Hunt). That said, until it’s clearer what the combination of the public health outlook and combined (global) central bank and government support measures are, it feels too early to commit money currently on the sidelines to this market. Our focus is on identifying those themes and sectors which we feel will ultimately lead the market when a bottom has been found. Having entered the sell-off relatively balanced from a sector and thematic perspective, we are minded to hold that stance until there is greater clarity.
The Merian UK Smaller Companies Fund is currently carrying deliberately above average liquidity, with cash around 8%. The market currently feels thin and disorderly, and intuitively feels somewhat driven by algorithmic players.
It’s clearly impossible to say with certainty. The debate/discussion with/about every company we hold essentially runs something like this:
(1) How bad will the hit be from a total 3/6/12 month lock-down, what are the stripped back costs that can’t be avoided in an environment if they will be faced with few/no revenues?
(2) What damage does a year or so of this do to the enterprise value of the business, if we assume things bounce back to maybe 80-90% of where they were by 2021?
(3) How does the capital structure fare? Is the equity worthless if you “haircut” the enterprise value?
(4) If not, but there are covenants that are likely to be broken, do we think it’s plausible that government support/bank forbearance will be given – especially if the breach is in truly extreme circumstances – or could a tactical equity raising solve a problem and be positive for the share price?
(5) Will this business be better on the recovery, say if competitors go bust?
(6) Are there second-order effects – eg, for the industrials sectors where a consumer-led recession will still hit them on second-order effects?
Whether or not we go into a depression from here depends a lot on the government responses. Central banks seem to get it, albeit are somewhat impotent against a virus. Governments can fix a significant proportion of the impact for businesses, but the scale required is truly vast and time is of the essence. The last few days suggests to me that they almost grasp the seriousness of the situation, albeit are still not quite there yet.
It may be that we need to see fiscal transfers in the order of 20-25% of GDP, possibly more, possibly for a few years. World War II is the playbook, not the 2008 financial crisis. I suspect the end game is some combination of government waiving taxes for 6 months, probably paying salaries up to a certain level, and forcing banks/lenders to waive interest payments for a period.
While it’s tempting to take the portfolio very defensive, most of the stocks in that bucket are on stretched valuations. There are scenarios where things bounce back faster (shock and awe government fiscal transfers, early vaccine launches (given China is pushing of an idea it could be six months versus prevailing view of 18), improving treatment protocols (this seems to be an iterative process), a weather-related respite in the summer, or more clarity on the overall infection/mortality rates being more benign – anecdotally, it sounds like three separate households on my road have it, albeit untested, so incidence could be much higher.
Against this backdrop, it is not inconceivable that we could see a sharp market rotation out of those defensive names into highly leveraged/cyclical businesses. A bit further down the line, it’s not necessarily nailed on that government debt markets will absorb the trillions of issuance that are coming without yields moving up. As and when the cyclical impact can be quantified, this also might lead to a significant rotation in market leadership.
Risks to the portfolio
Given the deliberate thematic and sector balance with which the fund entered the sell-off, the risk to relative performance should be around stock selection, rather than sector or thematic tilts. We are mindful of heightened risk aversion and are deliberately carrying elevated cash levels pro tem.
Merian UK Smaller Companies Focus Fund – comments by Nick Williamson
The portfolio was relatively thematically balanced going into the coronavirus-related sell-off, including a neutral exposure to UK domestic cyclicals as a result of our shift from an underweight stance at the end of 2018. In the early part of drawdown, by choice I was selling some of the better performing UK names in this bucket, as my view was that the impact was likely to be mostly felt here, rather than the growth names. As concerns have continued, share price weakness has become more widespread.
Clearly the situation is fluid, but the central case is significant short-term disruption, especially to consumer and cyclical businesses. Most of these names have now priced in a significant recession. Focus has moved over the last week or so to balance-sheet strength and the ability of businesses to weather weaker trading. Growth has generally held up reasonably well, as have cyclicals exposed to areas of Budget focus (eg construction/construction materials).
Most companies outside of the consumer sectors have yet to see a significant impact, but are expecting to. Those in consumer-facing areas are seeing a meaningful impact (albeit valuations have already adjusted significantly).
We have seen measured and modest outflows. I see value emerging in a number of areas. By choice, growth is probably favoured as it is potentially easier to assess the impact of the virus on business trading. Valuations in a number of cases here have come down to attractive levels on an absolute basis, even while shares have outperformed relative to the market. My gut feeling is that a number of consumer businesses are probably good value, too, but the range of possibilities for trading is still wide. We are mindful at times like this to maintain good levels of liquidity; with the market down some 40%, significant redemptions at this juncture would seem unlikely, but we will naturally remain prudent. This means I am being very selective in any purchases at present.
The key consideration now will be determining market leadership as we move beyond the pandemic. This is an active debate. My own view, especially with liquidity provisions, is that growth may do well.
Merian UK Mid Cap Fund – comments by Richard Watts
The portfolio has been thematically relatively balanced. Through the second half of 2019 we had been reducing the fund’s underweight exposure to UK domestic cyclicals and beneficiaries of sterling strength, mainly doing this through housebuilders, real estate and airlines. Heading in to the General Election, the fund was broadly neutrally exposed to the UK economy.
The fund started 2020 strongly (a ~5% outperformance in the year to 21st February) and was broadly holding its relative gains until the start of this week. Market action this week has been extreme and the fund has come under pressure. We fully appreciate the implications of what the coronavirus and its containment mean for the UK economy, but I’ve never seen price action like this in my career; it is more severe than what we witnessed in the global financial crisis.
We are hearing from investment bank trading desks that some high-profile hedge funds are struggling and, consequently, are deleveraging, leading to panicked liquidations – selling popular long positions, and buying back popular shorts. Margin costs are also rising, aggressively in some cases, adding to the deleveraging. So the moves in overall markets have understated what’s going on internally.
In terms of the fund’s performance, holdings in travel related stocks such as SSP, Trainline.com, WH Smith’s and Wizz Air have been sold off aggressively since the 21st February market peak, in the region of 60-70%, likewise for Ascential, which runs a number of trade events, and retail stocks such as boohoo, on economic fears.
However, the moves are extreme. Stocks such as OneSavings Bank are trading on 2.5x trailing earnings. Whilst we accept forward earnings may fall, buy to let proved to be very resilient in the global financial crisis. Elsewhere, SSP is trading on circa 5x trailing earnings and around 10x if they raised money in a stressed scenario to pay down debt. The same can be said for WH Smith’s, Ascential, housebuilders, real estate stocks, amongst others, that the fund owns.
In terms of action, we raised cash by reducing exposure to lower conviction ideas, such as Synthomer, and stocks that had held up extremely well, such as Rentokil, and are tentatively buying those names mentioned above that have sold off aggressively. However, we are conscious that these difficult markets might play out for some time and, as such, we believe it is appropriate to proceed cautiously.
Merian UK Dynamic Equity Fund – comments by Luke Kerr
There is no doubt that a significant recession is presently unfolding, with Q2 2020 GDP is likely to see a drop in the region of 15%. Central banks have been quick to take dramatic action, and whilst these measures will help avoid another credit crunch, it is up to governments to mitigate the economic hit.
Speed and size are of the essence. World War II is the playbook, not the 2008 financial crisis. Direct fiscal transfers, probably of at least 25% of GDP, are needed. While governments clearly recognise the need to do more in this direction, actions so far have fallen well short. The strength and duration of this recession is very dependent on how much government support is forthcoming. It is also highly dependent on the success or otherwise of the increasingly severe containment measures taken around the world and efforts to develop immunity tests, vaccines and treatments. At present this is a long list of unknowns and markets are reacting accordingly.
Through the second half of 2019 and into early 2020 we had moved the fund from underweight to overweight UK domestic cyclicals and beneficiaries of sterling strength, mainly doing this through housebuilders, retail, real estate and airlines as the UK economy looked set to accelerate post the significant Tory majority at the General Election. This stance helped the fund start 2020 strongly with relative outperformance for the year up to 13th March of approximately 5%. The sell-off had been relatively orderly up until the US markets opened on Monday this week. Since then stock and market moves have been extremely erratic and the fund has faced meaningful headwinds.
We are hearing from investment bank trading desks that some large, high-profile hedge funds are struggling and, consequently, are deleveraging, leading to forced liquidations – selling popular long positions, and buying back popular shorts. Gating of some property funds, coupled with short selling bans in many European markets have added further distortions. This has resulted in a market that is currently primarily led by underlying liquidity needs as opposed to fundamental valuations, leading to a rather random walk in share prices in the near term.
The decline in equities has been so rapid (the fastest in history in fact) that we have missed the boat in terms of materially reducing net exposure in the fund. With daily moves in indices of +/-10% and even wilder swings in stocks, it is a complete lottery to try and get the market timing right to significantly change the portfolio. So far, we have raised cash through the sale/reduction of exposed consumer cyclical stocks such as Dunelm, Dart Group, Wizz Air and Travis Perkins. The fund is now approximately 89% net long.
While it’s tempting to take the portfolio very defensive, domestic cyclical stocks have taken the brunt of the pain, and many look extremely good value on any semblance of recovered earnings. There are scenarios where things bounce back faster (shock and awe government fiscal transfers, early vaccine launches (China is pushing the idea it could be six months, versus the prevailing view of 18), improving treatment protocols (seems an iterative process), a weather-related respite in the summer, or more clarity on the overall infection/mortality rates being more benign. We are therefore maintaining exposure to this area concentrating on stocks that have robust finances and strong market positions.
In terms of the big picture, markets already look very attractively rated relative to history. That said, until it’s clearer what the combination of the public health outlook and combined Government support measures are, it feels too early to look for any meaningful recovery.