For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Time to pack up and move out?
The recession predicted to occur in 2023 is perhaps one of the most long awaited in decades. As a result, shares of some cyclical companies – those operating in sectors which are highly sensitive to changes in the economy such as recruiters, retailers and housebuilders heavily sold off during 2022, alongside earnings downgrades by brokers.
Some of these sectors have partially recovered this year, but this could be the proverbial corporate ‘flash in the pan’ given the worsening economic outlook. Would it make sense to sell all cyclicals now? Not necessarily in my view, let’s look at why I believe that.
Valuation conundrum
To properly consider cyclical stocks today we need to marry up market expectations for their profits, current valuations and positioning – both in the economic cycle as well as the competitive landscape. Let’s look at two well-known UK companies in Next and Howden Joinery.
These companies operating in different niches within the UK both experienced significant earnings downgrades during 2022. Their respective Price to Earning (PE) ratios fell during 2022 suggesting a market assumption that any downturn in consumer spending will continue to impact their profits longer term. So, was the market right? We will come back to answer this exam question later.
Going with the flow – the cash flow
We are in a period of economic uncertainty and it is at times like this that investors tend to forget that the value of any company share is not determined solely by next year’s profits, but rather the long-term cash flows of a business.
This oversight may be driven by panic and loss aversion, if a company is going to potentially make less profit next year that must be a negative right? Investor and market sentiment tends to be focussed on downside alone, and time horizons suddenly contract, resulting in companies that might have deeper downside – such as cyclicals – being sold off. This is the common investment playbook we see in the early stages of a downturn, whether perceived or actual.
However, even analysts’ near-term earnings forecasts can be overly pessimistic. This is due to poorly understood nuances between different industries, which have been amplified by the lasting impact of the global pandemic.
The great disruption
The global pandemic has had a lasting impact on normal business cycles, particularly in capital intensive industries such as shipping, energy and mining. Production activity within energy and mining has yet to recover due to underinvestment, which even preceded 2020.
This underinvestment became more acute during the pandemic as lockdowns were imposed and appetite to invest for growth has since reduced further. This is due to more stringent environmental regulations and carbon emission goals, as well as rising costs of capital and tighter lending conditions for new energy and mining projects.
Shipping is another industry serving an integral role in global supply chains, and it too met severe disruption during the pandemic. This had a major ripple effect on other industries reliant on the transportation of goods in containers, such as retailers and wholesalers, electronics and semiconductors.
Global freight rates US Dollars – pre, during and post Pandemic (WCI Composite Container Freight Benchmark Rate 40 Foot)
Source: Bloomberg – data from 04.06.2020 to 08.06.2023. Figures are in US Dollars.
Port congestions and a shortage of HGV drivers created significant delays in the goods’ deliveries, impacting companies’ inventory levels, sales volumes and margins. In terms of margin impact, freight expense peaked at c.6.5% of Next’s costs of goods sold whereas a normal level for the company is around 2-3%. As a result, Next’s gross margin was impacted by around half a percent last year.
These supply related issues are now mostly resolved and are delivering some unexpected earnings upside so far this year. For example, discount retailer B&M reported in its recent results that lower freight rates had a positive impact on trading margins and implied that this looks set to continue. Next plc also mentioned in its latest results that it is already capturing some of the benefits from freight rates falling and is choosing to pass this onto customers this year.
The great retirement and an international page to the story?
Another pandemic driven outcome has been how markedly the UK labour market has been disrupted. Pre global lock down, people in the UK were working for longer in general – this was for a variety of reasons, including longer life expectancies and more flexible job options. As a result, the UK’s strong and vibrant pre-COVID workforce, had a very strong representation of workers over 50 years old and those numbers looked set to increase.
Post pandemic we see that a significant proportion of older workers are not returning. Although job vacancies are high, it appears that many of the over 50s falling out of work are not looking for another job. When you marry this to the effects of Brexit on the supply of labour and ‘the great resignation’, where employees have voluntarily resigned from their jobs en masse – then the overall supply of labour has been under pressure.
However, one thing to note about Page Group (and recruiters in general) is their rapid recovery between 2020-2021, which caught many investors off guard as the imbalances in labour supply and demand have led to a strong requirement for recruitment services.
So why does the Page Group stand out to us? Page Group is a British-based recruitment business with truly global operations. It is a FTSE250 constituent headquartered in Weybridge, Surrey and has diversified its business well over the years by expanding into new markets and geographies.
While based in leafy Surrey, it is this international element to its business that helps both insulate it from the UK economy’s cycles but has also been a key long term growth driver.
Page’s recruitment fees are based on a percentage of hired employee’s salary, and with wage inflation occurring globally to different extents this should provide a clear benefit to the company’s revenues. We believe Page Group can continue to grow over the next decade given labour shortages globally, highlighting the need for specialist recruitment services.
Back to the exam question
Some companies – even cyclical ones – can thrive in challenging conditions. Two examples are Next and Howden Joinery, which have both seen a significant rise in revenue and profits over the last couple of years. You could argue that these positive results are due to extraordinary customer demand for their goods and services, as well as price hikes. But that would be glossing over some fundamentally positive changes in both businesses.
There are some significant developments within Next. Good management of rent costs and overheads have worked alongside an omnichannel sales model, boosting profits. Omnichannel retail is a multichannel approach to sales that’s focused on providing seamless customer experiences, whether the customer is shopping online from a mobile device, on a laptop, or in a brick-and-mortar store.
Next have also moved into distribution and investment business lines alongside retailing, diversifying business risk away from the notoriously fickle UK fashion consumer. The company has benefitted from the demise of other high street retailers through market share gains. Its partnerships with 3rd party brands, via its LABEL division, which provides marketing and distribution services to partner brands is also a growth opportunity worth highlighting. Next also selectively takes equity stakes in retailers with strong brands, while providing logistics and other back-office services to these companies in exchange for a commission.
What’s cooking in the Howdens’ kitchen?
What about the less sartorially focused Howdens Joinery? Howden manufactures and sells kitchens to trade builders, a sector you would think inextricably linked with the ebbs and flows of the UK housing market. Howdens reported record revenues and profits in 2021, driven by an impressive increase in volume growth. This was partly due to a surge in consumer demand for kitchens during the pandemic, the kitchen after all became the centre of the home for cooking, talking, board games and the odd disco.
Much of Howdens business volume growth also came through market share gains which the company isn’t given enough credit for in our view. We believe that its market share gains can be retained. These came about due to one of Howdens’ key competitive advantages: a highly efficient inventory management system ensuring availability of stock at a time when competitors simply lacked the ability to meet customer demand. Howdens is currently deploying a programme of UK depot refits to boost sales and profits, as well as further improvements to its supply chain efficiency and infrastructure.
The final word
Companies like Next, Page Group and Howdens Joinery all meet our quality investment criteria as part of the investment strategy for the Premier Miton Monthly Income Fund. These are cyclical companies with in our view strong balance sheets, which may be able to withstand macro pressures and ultimately thrive in such conditions. What we see as their improving fundamentals over time have enabled good dividend growth. This is a key focus in our approach to income investing.
Our cyclical investments provide a means of diversifying our portfolio so that we may benefit from strong economic conditions if they arise. As seen with the previous examples in this piece, many of our cyclical holdings can also command good pricing power in a high inflation environment.
