How We Are Responding To The Coronavirus Pandemic

The coronavirus pandemic is, first and foremost, a humanitarian crisis. Saving lives is being put before short-term economic considerations, although the two aren’t necessarily at loggerheads in the long run. Indeed, with companies increasingly aware of their wider social responsibilities and the impact on their finances, the CEOs that put people before profits may be the ultimate winners. But the crisis has also ended one of the longest bull markets in history and it’s natural for anyone with savings or a pension to be anxious about the impact on their finances.

Share prices have yoyoed dramatically since late February, including that of Alliance Trust. However, for more than a century, the Trust’s investment philosophy has been long term. It has been tested before in major crises, including two world wars and numerous stock market crashes, and each time the Trust has weathered the storm successfully. There’s no reason to believe it will be different this time.

GLOBAL RECESSION LIKELY

Further volatility is likely in markets in the short term until it becomes clear how quickly the virus will be contained. A significant global recession appears inevitable at this point but if the measures taken so far by central banks and governments, including vast amounts of credit supplied to households and businesses and social distancing, prove effective, then our investment manager, Willis Towers Watson (WTW) thinks a protracted and dire downturn can be avoided.

It will, however, be some time before this is known and a prolonged global recession remains a distinct possibility, especially if new clusters of the disease emerge and social distancing remains in place for several months, putting acute and sustained downward pressure on corporate earnings in the US and Europe. (See display for full scenario analysis).

STAYING CALM, AVOIDING PANICKY DECISIONS

In this environment, WTW and the stock pickers it has appointed for the multi-manager approach to investing are being vigilant but avoiding knee-jerk reactions, conscious that what they do now in the portfolio could impact returns long into the future. In general, they are remaining calm and doing very little because WTW is confident that, after reviewing the portfolio in detail, the Trust has the right managers picking the right stocks.

As part of its regular rebalancing of the portfolio between stock pickers, WTW has tweaked some of the manager weightings, marginally reducing allocations to those who generally contributing more risk. But the portfolio remains broadly neutral in terms of style exposures. With style cycles notoriously difficult to time, WTW believes that in the long run it pays to retain balanced exposure to all styles, with allocations to growth, quality and value managers, for example, remaining roughly in line with benchmark to ensure stock selection drives returns. Although quality growth managers have generally done better in the crisis so far, there have also been days when value managers rallied, underlining the benefit of diversification across styles.

GEOGRAPHIC DIVERSIFICATION IS KEY

Given that the impact of the virus is varying by country, WTW also believes it is important to remain geographically diversified. In this regard, it is helpful that all the managers in the portfolio have the freedom to invest anywhere globally, rather than being confined to designated regions, as is often the case with multi-manager global equity portfolios. If regional exposures deriving from bottom-up stock picking start to look risky, WTW can reallocate capital between managers to reduce it, although this hasn’t been necessary so far. It is, however, something that WTW will be actively monitoring and managing as the crisis unfolds.

WTW HAS CONFIDENCE IN THE TRUST’S STOCK PICKERS

WTW doesn’t see the need to change any of the stock pickers due directly to the crisis. They are all veterans of previous market upheavals, including the global financial crisis in 2008, and know how to navigate volatile markets, though all managers are kept under constant review.

The stock pickers themselves have been evaluating the near-term and long-term impacts the coronavirus may have on the companies they have selected for the portfolio, aiming to identify those most likely to be affected in terms of revenue and profitability. Some companies will be more exposed than others given their markets and business models, either directly through operations within impacted markets, or indirectly via supply chain effects.

As a result, positions in some securities have been trimmed. For example, one sold down its position in New Oriental Education, in the early days, when the virus was still contained to China, to reflect the impact of the virus on the company’s business model. Another stock picker decided to reduce its position in Ryanair, Amadeus and Inditex due to potential impacts on consumer demand for travel and clothing.

But fear and volatility also create opportunities as the prices of stocks diverge from their long-term value. It’s at times like these that the seeds of future outperformance are sewn because high-quality companies with good long-term prospects are often sold indiscriminately and can be bought at attractive prices. New purchases include Heineken which offers predictable growth, strong pricing power, a diverse geographic portfolio, 40% plus exposure to the attractive premium beer segment and 70% exposure to emerging and frontier markets and is selling at an attractive valuation. Another new stock in the portfolio is Valmet - a Finnish company that develops and supplies technologies, automation systems and services for the pulp, paper and energy industries.

SMALL ADJUSTMENTS TO HOLDINGS

These adjustments to the portfolio have, however, been at the margin. The stock pickers aren’t complacent, but they generally think the portfolio holdings are well positioned to generate strong and sustainable free cashflows (historically a strong indicator for share price outperformance) over the long-term.

Most of the portfolio holdings, therefore, remain largely unchanged. Clearly, there are many near-term challenges caused by the temporary shut-down of many of the world’s leading economies. However, unless companies have weak balance sheets which mean they can’t survive a period of economic hibernation despite life-support provided by the authorities, it should not make a significant difference to their long-term prospects.

There will undoubtedly be cases of companies in the portfolio who face challenges, profit warnings and perhaps suffer dividend cuts or suspensions to shore up finances. But the stock pickers are all long-term investors who consider the impact of a recession on every stock they buy, no matter how rosy the environment might have seemed at the time of purchase. They look for resilient businesses that can withstand a sharp downturn without suffering acute distress and survive to profit from the recovery and expansion that naturally follow.

STRONG RESERVES TO SUSTAIN DIVIDEND POLICY

Alliance Trust has a progressive dividend policy, which has seen dividends increase every year for 53 years. The Trust has strong revenue reserves, amounting to £109.2m at the end of 2019, more than two times last year’s pay-out, from which it can pay dividends if there is a shortfall in the income from the Trust’s portfolio in any year. Our revenue reserves are already among the highest in the industry and could be strengthened further if shareholders and the court approve a proposal to convert the Trust’s historical merger reserve to distributable reserves at this year’s AGM. If the proposal is approved, the Trust would have an additional £645.3m available to support increased dividend levels in the future. Although the Board currently has no intention of making immediate use of the funds forming the merger reserve, they could provide additional flexibility.

It’s one of the critical competitive advantages of investment trusts over open-ended funds that they can retain surplus income from good years and smooth dividend payments in challenging conditions. With interest rates at record lows, the income that investment trusts can provide in the current market environment could become very attractive.

GEARING HELD IN MIDDLE OF TYPICAL RANGE

The only other difference between the positioning of the portfolio before and after the onset of the coronavirus pandemic is the level of gearing. As equities have fallen, gearing has naturally risen. WTW manages gearing to a strategic position of 10% and typically in the range of 8-12%. At the start of this year, gearing was near the low end of that range as WTW viewed that the strong bull market had given rise to potential for downside risks (although did not expect a global pandemic!). Gearing rose towards the upper end of the range and, following the small relief rally at the end of March, WTW has moderated that gearing back towards the strategic target of 10%. WTW has leeway from the Board to increase the level of gearing further if it expects a sustained market recovery but, given the level of uncertainty about the economic outlook, it does not think this would be prudent at this stage. It’s already been a tumultuous time, but WTW thinks there is probably more volatility to come before equity markets make a sustained recovery. As such, WTW remain vigilant, avoiding the temptation to time the market but to potentially judiciously take advantage of further market weakness if an opportunity presents itself.

The opinions expressed are those held by Willis Towers Watson at date of issue and are subject to change.