Differences that can make all the difference
An active approach to the coronavirus crisis
The most important at a glance
The crisis is widening the gap between the winners and losers in the capital markets
Increasing dispersion in share performance and corporate earnings offers investment opportunities
- Active portfolio management can make the most of these opportunities
With differences come opportunities
You need go no further in the alphabet than the letter A to find winners and losers in the coronavirus crisis. There are plenty of both. Business at online retailer Amazon has gone through the roof since lockdown began, while American Airlines has had to keep virtually its entire fleet firmly on the ground. These two examples show that the gap between successful and unsuccessful companies is widening significantly even in these times of crisis. In this report we will show how actively managed funds can profit from this trend.
Numbers can sometimes say more than a thousand words – and that is particularly true in this case. Before the effects of the coronavirus crisis began to be felt on European and American stock markets in the middle of February, it was business as usual for investors in the US online shopping giant Amazon. The company’s share price had already risen by about 20 per cent in 2019, and by 19 February 2020 it had gained another 17 per cent. Over the space of just under 14 months, it had outperformed the broad S&P 500 by more than 6 per cent.
Until that point, shares in American Airlines had been following a similar course – at least in terms of direction. Although things had not been looking great for America’s largest airline in 2019 (share price was down by 41 per cent), between early January 2020 and 12 February when it reached its high for the year, the company’s share price had nonetheless managed to gain more than 6 per cent – around 1.8 percentage points more than the S&P 500.
But then came the coronavirus shock. Even Amazon was unable to completely escape the sharp sell-off in the global capital markets. Its shares dropped almost 23 per cent between the high and the low point on 12 March. But American was hit even harder, losing more than 70 per cent of its value before reaching its low for the year (so far) on 15 May.
This is significant in two respects. Firstly, not only was the loss suffered by Amazon significantly smaller than that of American Airlines, but the low was reached much earlier. And secondly, the share price performance of the two companies was diametrically different, especially after their respective low points. While Amazon is now 50 per cent above its price at the start of the year, American Airlines is more than 50 per cent below the price it began 2020 with (correct as at 30 June 2020).
Figure 1: The gap between winners and losers is widening
Crisis winners pull away
The reasons are clear – at least in this extreme example. Amazon is benefiting more than almost any other company from the measures taken to contain the spread of the pandemic. Not only were its bricks-and-mortar competitors closed for weeks, but overall, people had more time for online shopping. And in the US there was an additional boost. The various support measures put in place by the government as part of the CARES Act meant that many households were, at least temporarily, better off financially than before the crisis. One-off payments of US$ 1,200 per taxpayer coupled with unemployment benefit of US$ 600 per week for those laid off as a result of the coronavirus temporarily sent the disposable incomes of many households soaring. Some of this cash was translated into consumer spending – including at Amazon.
Under normal circumstances, the airline industry might perhaps have enjoyed a small slice of this cake. But the coronavirus crisis is no ‘normal’ recession. The strict lockdown measures meant that huge numbers of flights were cancelled. In April, American Airlines was flying at around just 15 per cent of capacity. By the final week of May it was still only back up to 55 per cent. The result: liquidity crisis, a government bailout and job losses.
And of course structural factors have also had a part to play. On the one hand we have the company that has benefited from the digitalisation trend. It has substantial market power and is now also a major provider of cloud services and media content. On the other we have the ageing airline company which is battling with excess capacity and fundamental changes in demand. However, these striking examples also reveal a phenomenon that has been observed in earlier crises: the discrepancy between the performance of individual companies (and thus also their shares) is growing. There will be structural adjustments, with winners and losers.
Differences are increasing
Figure 2 shows the (average) differences between the historically most positive and most negative examples of earnings and share price performance within the S&P 500. This distribution is also known as Dispersion.
It is clear that the differences in earnings and share price performance widen sharply in times of acute crisis, and even more so in the months that follow. In 2010, when the equity markets had already moved on from the shock of the 2008/2009 financial crisis, the differences between the highest and lowest earnings per share (EPS) stood at more than 60 per cent. The performance differences were equally stark.
Figure 2: Dispersion increases in times of crisis
This observation is based on the assumption that variation between equities tends to be less pronounced (dispersion at index level is lower) when the markets are being influenced by higher-level, mostly long-term macrotrends. This could also explain the phase of relatively low dispersion seen in recent years. Although there was a structurally induced upward outlier in the form of the big technology stocks, US equities, in particular, were being driven at the macro level by the longest economic expansion in history. This also seems intuitively plausible: If the underlying trend is positive and is the same for almost all sectors – for example, due to the broad support of the economic cycle, fiscal policy and monetary policy – then the prospects of individual companies temporarily become less important.
Since mid-February 2020, however, dispersion has been increasing again for both corporate earnings and share performance. Based on the experience of the previous crisis, however, it may be assumed that there is still further to go and that earnings and share prices will continue to diverge. The events of the more recent past suggest the same thing. A comparison of the average earnings of the best and worst ten S&P 500 equities in the first half of 2020 reveals a gap of more than 120 percentage points between these two groups. In the first six months of 2019, the difference was just 95 percentage Points.
This can also be seen from the examples referred to at the start of this report. Although total lockdown and the extreme stimulus to consumer demand delivered by fiscal policy now seem to be behind us, structurally the current crisis will tend to benefit those companies that were already in a strong position before it struck, whether because of their capitalisation, their market power, or the sector in which they operate. Moreover, current developments in the US show that aside from the economic crisis, the pandemic itself is by no means over. The companies that will suffer the most from the re-imposition of strict lockdown measures are those that have already been hit hard (such as the airlines). So if the pandemic flares up around the world once again, the discrepancy between performance in individual sectors and companies is likely to increase further.
Active investment offers advantages
This also means that the opportunities afforded by active fund management and the need for this kind of service will continue to grow. With a higher dispersion and lower correlation between individual equities, stock-picking will become even more important. In times when a rising tide is lifting all boats, selection may well take a back seat. The dominant macrotrend ensures that even the weaker shares will gain – albeit not as strongly as others. But when the tide goes out, it soon becomes clear which companies are left high and dry.
Active managers can make a difference at times like this, which are generally characterised by high volatility. Through fundamental analysis, sector expertise and regular dialogue with companies, they can identify opportunities – and also weaknesses – at an early stage and grade equities according to their potential.
And when the market falls, active management has other advantages. Firstly, a fund manager can quickly switch stocks out of sectors that are particularly badly affected by the crisis (such as energy and travel in the current situation) and into more robust industries. They can also decide to move a portion of the fund’s assets out of equities for the time being, and to get back into the market once the fierce – and frequently indiscriminate – sell-off has been ridden out, i.e. once new opportunities emerge based on fundamental valuation criteria.
Ultimately, the active ‘toolbox’ contains additional tools to minimise losses – especially during volatility spikes. The keyword here is risk management. A fund manager can use derivatives such as futures to significantly reduce the dependency on general market movements without having to sell a single share. And if shares are to be sold, only relatively rarely is the manager compelled to close a position at the most inopportune time. At the peak of the coronavirus sell-off there was very little liquidity in the equity market. Even among the index heavyweights, there was sometimes a disproportionately large spread between the buying and selling price. For investors who were forced to buy because of massive outflows (which happened in the case of some passive strategies), this meant worse terms and thus additional price losses.
Growing dispersion is also opening up opportunities in Europe
The market in Europe provides an example of what an active management strategy may look like in a crisis. Although our analysis focuses on the US market, the same phenomenon is playing out in the ‘old countries’ where the dispersion has also increased sharply. The crisis has increased the differences not only between individual sectors (see Figure 3), but also within the sectors themselves.
Figure 3: Large differences at sector level – also in Europe
It is clear that the crisis is acting as an accelerant for many future-focused areas. The change in the economy that was already under way before coronavirus and could be seen in megatrends such as digitalisation, demographics, healthcare and sustainability, has gained additional momentum. The prime example of this is digitalisation. Last year, the IT consultancy firm Accenture carried out an analysis that showed that the top 10 per cent, i.e. the digital vanguard within a sector, performed twice as well as the weakest 25 per cent. The coronavirus crisis has widened this gap still further. Investors could benefit from this through an active overweight position in the IT services sector, in companies such as the French company Capgemini, the German global player SAP or ASML, a Dutch supplier of semiconductors. This is because in Europe too, the structural winners of the coronavirus crisis were initially sold off indiscriminately before recovering at a faster rate than the market average. Investors who strengthened their position after the downturn were thus doubly rewarded.
There were – and are – similar opportunities in pharmaceuticals and medical technology. The products and services of companies such as AstraZeneca, Lonza and Eurofins Scientific are very much in demand during the coronavirus crisis and also in the ‘new normal’ that has followed. Further opportunities are opening up in those sectors that are directly benefiting from the economic stimulus packages. Producers of industrial gases such as Linde and Air Liquide were already well positioned in this growing sector before the German and European hydrogen initiative was announced. The sector is likely to enjoy an additional boost as a result of the government measures.
But there are also sectors that are less well equipped for times of crisis. Manufacturers of cyclical consumer goods and energy companies are suffering from the slump in demand. Companies with high fixed costs, such as those in manufacturing, experience problems when orders drop off. And, finally, the banks have also suffered recently from the persistently low interest rate environment, which looks to have been cemented for years to come by the further easing of monetary policy.
Even during a crisis, the share price remains primarily a function of earnings, or of the expectations regarding a company’s future operating performance. The dispersion analysis has already documented this conclusion over the long term: large differences in earnings also mean a corresponding difference in the rise or fall of the share price. Coupled with the megatrends referred to above, this leads to substantial discrepancies as illustrated in a comparison between the French oil company Total and the chip supplier ASML (see Figure 4).
Figure 4: Widening gulf between earnings and performance
With an active overweight or underweight position in the relevant sectors, and targeted stock-picking within these sectors, managed funds have been able to outperform the broad benchmark indices in recent years – in some cases by a large margin (see Figure 5).
Figure 5: Exploiting opportunities through active management
Active management is certainly no guarantee of consistently good performance during volatile phases. In the current climate, there are also funds with extraordinarily high relative losses. However, the growing dispersion opens up opportunities for experienced stock-pickers to stand out in a positive way from the broader market and thus from other investment approaches with their purchases and also with their timely sales.
As at 16 July 2020