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High expectations around reopening of the economy are mostly priced in by markets. This strengthens our cautious view on some sectors.
Over the past month, different avenues to recovery were published by the major search houses. While the majority of the analyses are still very excited about oncoming recovery, we take a more cautious stance as we consider that most of the share price upside potential is already priced into the market. It would therefore be opportune, from a tactical point of view, to reduce the exposure to high growth small caps and consumer discretionary stocks which have done both remarkably well during the past 12 months.
Why the tactical allocation change? First, on the execution front, we are hearing more anecdotal evidence that supply remains a problem for many companies, just as demand is picking up. The major issues that come to our attention supporting this are:
Valuation metrics On valuation, the risk is elevated too. But with liquidity still flush and headline indices making new highs every day, few investors seem to be worried. From a pure risk / reward point of view, equity premiums are high on the back of peaking liquidity, cost, margins, and capacity pressures.
Supply/demand equation In addition to the issues mentioned above, (shortage of labor and OEM issues), there is also the question of demand. Consumer behavior has shifted towards online, and the present expectations are calculated on this new assumption. The most unique characteristic of the present recession and recovery is the speed at which it all has happened; events unfolded in a similar manner as for a natural disaster. That said, after a natural disaster event, consumers grapple to reestablish the prior condition. In the same vein, during the pandemic, consumers moved forward into a state of survival. With this in mind, we think that some of the old consumer habits may remain. The most recent statistics available for online consumer platforms show that a good number of companies expect 0% customer growth in Q2/21 and Q3/21!
For the pure work-from-home beneficiaries, we see the latter conclusion as pretty obvious—in other words there will be no increase in demand, as the historic event is not going to be repeated. Meanwhile, for strategic service providers, the payback story looks much more exciting. There, growth opportunities still exist. For the first group, we have typically entered into replacement market schema where only the leanest companies will survive the price war, whereas in the second segment, only the most advanced technologies can keep pace with the ever-changing requirements.
Travel and leisure activities For these activities we do see an underappreciated risk—the market has priced-in a catch-up effect—but we are less certain if the catch-up will happen as COVID has hammered down the aspirations of many to travel frequently.
Certainly, people will do things they have not been able to do during the pandemic! The question that remains to be answered is, will people go back to pre-COVID travel habits? In the near term, we think this means that overcapacities will persist, which is starting to show up in the surveys. Ultimately, with fewer service providers, the industry sector may start to achieve reasonable capacity utilization ratios.
Dreaming about a successful passage to reopening is likely much easier than doing it. Equity valuations apply discounting principles, i.e., they aim at reaching a certain value at a given point in time. We believe that a good number of companies have already reached this point. Therefore, and to reduce valuation risks, long-term investors should care about travelling to the target and avoid the moment of reaching a cliff-hanger.
Knowledge is power.