05 May 2020
This is a market environment in which remarkable events are still commonplace, and the sudden collapse of the oil price below zero, meaning producers had to pay in order to get oil taken off their hands, is that latest example of that.
Our view on oil is that the current situation with the oil price is clearly unsustainable. The issue is that demand has collapsed (hopefully on a temporary basis) but the producers are still pumping oil, meaning that storage capacity is almost full. With nowhere to put the oil, physical delivery oil futures have been trading at a negative value because nobody wants to accept delivery of an asset they cannot store. Such a situation has never happened before, as far as we can tell.
It must be remembered, however, that the current price is so far below the marginal cash cost of production that it can’t last for long – there will be mass bankruptcies and the supply will inevitably fall as various producers go bust. This is especially true for the shale oil producers in the U.S. who are quite levered and have high costs. Eventually demand will return, and even if it comes back at a much reduced level, supply will adjust. As the saying goes: “the cure for low prices is low prices”.
So on a long-term view we see valuations as attractive, but in the short term dividends are likely to be cut in order to protect the balance sheet in what will be a brutal few months/quarters. Given that BP (held in the strategy) is now yielding 11% this is probably not a surprise to the market and so we are happy to continue to hold it.
This week the Investment Association (IA) announced they will suspend the yield requirement for its UK Equity Income sector for 12 months, as the coronavirus crisis has caused a significant number of companies to cancel their dividends. The IA also reported they it would revisit the 12-month suspension if it needs to. This seems to us like a highly sensible decision in the circumstances.
We have seen a significant pick up in the number of cancellations and suspensions of dividends globally. It has been reported that c.50% of UK companies have now cancelled or suspended their dividend. We believe that more companies will suspend or reduce their dividends this year and believe that this is prudent management and we fully support our companies cancelling or suspending dividends in this environment. Now more than ever a resilient balance sheet is vital, and as shareholders we will ultimately benefit from our companies strengthening their balance sheets by this means rather than new equity. We cannot predict how long income will be impaired for, but we assume income will be materially lower.
The majority of companies that have pulled their scheduled final dividend payment have also said they will re-assess when they announce their interim results. What this means in practice is that if the economic situation has improved significantly by July/August/September companies may decide to pay a larger interim dividend than usual to make up for the lost final dividend. The situation makes forecasting future levels of income very difficult because the plausible range is so wide. We could potentially have a situation where the majority of missed payments are recouped in the summer or we could have a year where 90% of companies cancel their dividends. It all depends on the length of the virus induced economic shutdown which is very difficult to estimate.
It is very disappointing that our strategy has underperformed its benchmark index when Value as a style of investing has previously held up in other downturns in the last 20 years (e.g. 2001, 2002, 2008, 2012 and 2018).
During this market turmoil low valuations have provided no protection so far. Investors continue to only want the dominant, recent winners, regardless of valuation. The relative underperformance of Value versus Growth has meant that our strategy is now on a Shiller PE of c.7x. These valuations are extremely low in relation to history (the Shiller PE on the US market since 1870 has ranged from 6x to 44x). Going into the market sell off the Shiller PE of the US market was 31x and, although it soon fell significantly to 21x, this is still above the long term average (16x) and higher than other periods of extreme market sell offs.
If markets start to look beyond the short term, valuation levels are incredibly low, and this is important because historically low valuations have indicated strong future returns. Even assuming zero earnings this year for all stocks held in our strategy, and mechanically moving the Shiller PE forward a year, the strategy’s Shiller PE is likely to be just around 7-7.5x in our estimation.
As long as the balance sheets can withstand this period and we avoid businesses that offer false value (perhaps shopping centres, coal production etc) it should be okay even though it feels very difficult right now. In this context we believe the strategy currently offers exceptionally good value for the long-term investor.
Notes
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the Fund Managers at the time of writing, are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
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