Post pandemic positioning for equity markets
The coronavirus outbreak has been a wake-up call for companies and investors alike. It is changing how businesses operate and reshaping industry prospects at alarming speed. How might investors position their portfolios for a post-pandemic world?
- The COVID-19 crisis has exposed some company weaknesses that were previously underappreciated
- Pandemics are likely to feature on many investors’ biggest risks list
- Lower leverage may be more desired, which may lower dividend payments and share buybacks
- Companies with quality, earnings visibility and balance sheet strength are likely to be sought-after.
After much lower earnings expectations for this year, following the outbreak of COVID-19, consensus suggests a strong rebound in earnings next year. This implies a return to some kind of pre-pandemic normality — likely needing a vaccine — or a way to recuperate lost ground despite social distancing and other virus-related hurdles. Seeing any of these scenarios happen in the very short term seems unlikely.
More changes are likely over the medium term. The financial crisis left many wondering when the next bubble would pop. This time, pandemics are likely to feature in many investors’ biggest risks list.
The risk of another global health crisis on the scale of COVID-19 in the near future is low, statistically speaking. Economies are also probably better prepared to tackle the next one than was the case this time. However, short-term memory bias — assuming that what has just happened will occur again — will likely translate into a higher risk premium for equities. While hard to gauge, this could cap company valuations for the time being, at least in some sectors.
Underappreciated weaknesses emerge
Low interest rates have allowed most companies to thrive. However, the coronavirus crisis has exposed some weaknesses that were underappreciated. For one, leverage is likely to be more of a focus for investors.
Companies have often been penalised in the last few years for not raising debt-to-equity levels enough to take advantage of widely available, and cheap, funding. Balance sheet strength looks set to become more of a priority for investors. This could reverse the recent trend of using debt to compensate equity holders and support share prices.
Shareholders may also be encouraged to support bondholders with more equity-to-debt swaps likely. This might affect company returns, both in the form of lower dividends and share buybacks. Depressed return on equity could then weigh on valuations.
Challenged business models
The pandemic is speeding up many trends. Store operators, for example, have faced mounting pressure from online rivals for years. In February, for the first time US online retail sales outsold general merchandise. As most shops have been closed during lockdown, the dominance of online retail has been reinforced, changing a long-term process to an existential threat almost overnight.
Additionally, office space demand might be permanently reduced, global supply chains could be more at risk and healthcare expenditure may climb substantially. As a result, some business models look challenged, while others appear well placed to profit.
It is likely that the premium commanded by companies with “future-proof” business models will climb further. As such, growth, or companies with strong prospects, is likely to outperform value, companies with valuations below their book value, over the long term. Also, active management can help position portfolios well for what might lie ahead.
Diversification to fore
Total equity valuations look set to be capped in a post-pandemic world. However, the gap between the “haves” and “have nots” will probably keep growing. Quality, earnings visibility and balance sheet strength will likely be more sought-after. Finally, it’s a place where additional risks, such as growing debt burdens, potential return of inflation or government involvement in some businesses, may need to be taken and diversified away.
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