Finding post-pandemic equity winners
The COVID-19 pandemic is altering how companies operate. It may reshape their prospects once the outbreak subsides too. What might investors expect to see in a post-pandemic world?
- Consensus appears to expect earnings to recover this year’s anticipated losses in 2021
- Lower debt-to-equity ratios may be needed, possibly cutting dividend payments and share buybacks
- A post-COVID-19 world is likely to be a place where total equity valuations are capped
- Companies with quality, earnings visibility and balance sheet strength are likely to be sought-after.
After much lower earnings expectations for this year, following the outbreak of COVID-19, consensus suggests a strong rebound in earnings next year. This implies a return to some kind of pre-pandemic normality — likely needing a vaccine — or a way to recuperate lost ground despite social distancing and other virus-related hurdles. Seeing any of these scenarios happen in the very short term seems unlikely.
That said, efforts to cope with the effects of the virus are likely to change how companies operate in the medium term. In a world where low interest rates have enabled most companies to thrive, the COVID-19 crisis has exposed some weaknesses that had been underappreciated. First and foremost, leverage is likely to be a renewed focus of interest for investors.
Balance sheet strength
In recent years, companies have often been penalised for not increasing debt-to-equity levels enough to take advantage of widely available, and cheap, funding. Balance sheet strength will likely become more of a priority for investors. This could reverse the recent trend of using debt to compensate equity holders and support share prices.
Moreover, shareholders may be asked to support bondholders with more equity-to-debt swaps likely. There would be clear repercussions for company returns, both in the form of lower dividends and share buybacks. Furthermore, depressed return on equity could then weigh on valuations.
The pandemic has accelerated many trends. Retail space, for example, has been under growing pressure from online rivals for years. In February, American online shopping in the country outsold general merchandise for the first time. With most stores forced to close during lockdown, the dominance of online retailers has been reinforced, transforming a long-term process into an existential threat almost overnight.
The same forces mean that the need for office space may be permanently impaired, global supply chains could be more at risk and spending on healthcare could soar. As a result, some business models appear challenged, while others seem ideally positioned to profit.
From an investment perspective, it is likely that the premium commanded by companies with “future-proof” business models will keep climbing. That implies that growth, or companies with strong prospects, is likely to outperform value, companies with valuations below their book value, over the long term. Also, selectivity (or active management) can help position portfolios well for what might lie ahead.
Total equity valuations are likely to be capped in a post-pandemic world. However, increasing disparities are likely between companies. Quality, earnings visibility and balance sheet strength will likely be more sought-after. Finally, it’s a world where additional risks, such as growing debt burdens, possible return of inflation or government involvement in some businesses, may need to be taken and diversified away.
Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.
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