Lessons from past recessions for unloved domestic names; incumbents retake ground from insurgents; and what to make of reset European Growth valuations.
Lessons from past recessions for unloved domestic names; incumbents retake ground from insurgents; and what to make of reset European Growth valuations.
February 7 2023
Are Banks and Housebuilders Really Uninvestable in a Recession?
Recession fears seem to be easing – everywhere except the UK. According to the IMF, Britain is the only major economy projected to shrink in 2023. Recency bias dictates that a quick analysis of the implications of such a contraction will typically focus on the experiences of the Global Financial Crisis or early months of the pandemic. Both episodes, and basic intuition, would suggest avoiding domestically oriented names like banks or housebuilders.
But what if any downturn is different from those two instances? We believe a more instructive history could lie in the early 1990s. Inflation in the late 1980s led to higher interest rates, and – in turn – a recession as house prices fell by 12% in three years and unemployment rose from 7% to 10.6%.1
When we looked at representative housebuilders and banks through this period, we found both remained profitable and their share prices actually increased over this time – approximately tripling and doubling, respectively (Figure 1). We also note that today their valuations are in fact cheaper than they were 30 years ago, while their balance sheets are stronger. Opportunities are often forged in fear.
Figure 1. Performance of a UK Housebuilder and Bank During the 1990s Recession
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Source: Man GLG; as of 1 February 2023.
Insurgents, Incumbents and a Higher Cost of Capital
One effect of the loose financial conditions during most of the past decade was the rise of challenger companies. These businesses used cheap debt to acquire market share by undercutting established players, tolerating high early losses with the expectation of making money once they had won more customers.
Utilities were prime targets for such disruption, with unloved brands and legacy systems that were rarely user friendly. To illustrate this phenomenon, Figure 2 shows a major UK gas and electricity provider’s share price and earnings since a competitor named Bulb Energy launched in 2013. The incumbent lost around 90% of both its value and earnings under the pressure from Bulb and other similar start-ups that operated without a profit motive. Bulb entered administration in November 2021, followed by a number of its peers.
Now that we are in a higher cost of capital environment, this pattern could play out across other sectors that featured equivalent insurgents; these include banking, non-life insurance, and oil and gas. Suddenly, scale and strong balance sheets are advantages again.
Figure 2. UK Utility’s Share Price and Earnings
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Source: Bloomberg; as of 1 February 2023.
Multiples Pass the Baton to Earnings
Growth-oriented and longer-duration equities across the world benefitted from rising valuations between 2019 and 2021. In January 2022, we had expected this valuation expansion to unwind over a period of about 36 months, not the six months it actually took last year (Figure 3).
Savage as it felt, this was largely a mechanical compression – a function of the fact that risk-free rates of return went up so, in order for the risk premium to be maintained, earnings multiples had to go down. With inflation now seeming to have peaked and bond yields having stabilised, can we hope that these reset valuations are primed to spring back?
Perhaps, perhaps not. We prefer to look to earnings growth as the key driver of returns from here, as we believe we should not rely on any macroeconomic favours to reflate multiples. This means selecting the right companies, and we emphasise five criteria in our search. First, they should serve end markets with structural demand drivers; diabetes care and lithography are, in our view, such areas. Second, they should ideally have revenue visibility in the form of order backlogs or the selling of repeat-business consumables; affordable but high-quality cosmetics are an example. Third, these revenues should be geographically diversified so they aren’t reliant on any specific region amid the prevailing economic uncertainty. Next, we want to see growing market share and true pricing power so that their profitability does not rely upon macroeconomic tailwinds. And finally, we seek strong balance sheets and cash flow so that they have the financial firepower to reinvest in their businesses.
Figure 3. MSCI European Growth Index
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Source: Bloomberg; as of 1 February 2023.
With contributions from: Erin Ennis (Man GLG – Analyst), Henry Dixon (Man GLG – Portfolio Manager) and Rory Powe (Man GLG – Portfolio Manager)
1. Source: Man GLG; as of 1 February 2023.
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