Artemis’s Kartik Kumar has warned equity investors not to get seduced by the power of pessimism, as focusing on today’s poor economic backdrop means they are automatically taking their eye off the long-term nature of the asset class.
Kumar, who manages the Artemis Alpha Trust, pointed to research by Nobel Prize-winning economist Daniel Kahneman in which he noted the way humans perceive positive and negative expectations is rooted in evolution.
“Organisms that treat threats more seriously than opportunities have a better chance to survive and so to reproduce,” he said.
This is why, in the words of ‘The Psychology of Money’ author Morgan Housel: “Optimism sounds like a sales pitch. Pessimism sounds like someone trying to help you.”
However, Kumar (pictured) said that when it comes to investing, this natural tendency towards pessimism can be misplaced for two reasons: first, history has shown that it is rarely right to be pessimistic about markets in the long term; and second, equities are long-term securities, something that is often overlooked at times of distress.
“At the depths of pandemic-driven pessimism back in April 2020, we noted that short-term damage to cashflows should have a limited impact on the long-term value of an equity,” the manager explained.
“For example, if a security grows at 5% and is discounted at 10% per annum, just 4% of the equity’s value is derived from year one, and 13% in years one to three.”
“This isn’t what we are seeing at the moment. Share prices are overreacting and falling by much more than they ‘should’, given the short-term nature of the damage to their cashflows.”
As an example, Kumar pointed to budget airline easyJet. The disruption being faced by holidaymakers at UK airports has been front-page news this summer and the threat of a recession has compounded concerns. With this troubling backdrop, easyJet’s share price has halved from its February peak, and the company is now valued at £2.8bn, compared with a pre-pandemic level of £6bn.
Performance of stock over 3yrs
Source: FE Analytics
But the Artemis Alpha Trust manager pointed out that recession and short term-disruption should have less of an impact on the long-term value of easyJet than maintaining its position in slot-constrained airports.
“This is what will underpin returns over the long term by ensuring it primarily competes against disadvantaged ‘legacy’ carriers,” he said.
“For example, easyJet has increased its market share at Gatwick from 40% to 50% through the pandemic, reallocating about 20 planes from other bases.”
Kumar is also excited about the opportunities in ancillary revenues (such as charging for carry-on bags), an area easyJet has historically under-monetised compared with peers such as Wizz Air and Ryanair. The early signs are promising, with limited evidence of seat fares being “cannibalised”, and the manager said this could result in an extra £800m of high-margin revenue versus 2019.
Meanwhile, the business is undertaking a fleet-modernisation programme, which should further improve efficiencies.
For example, Kumar said replacing an A319 plane with an A321neo increases capacity by 64 seats (41%), improves fuel efficiency by 18% and reduces other costs by 10% due to per-seat efficiencies.
Just one more crew member, and no additional pilots, are needed to service that additional capacity.
Kumar said: “easyJet’s £2.8bn value today is not much above its net assets of £2.4bn, and less than capital employed of £3bn.
“The business has guided for a ‘mid-teens’ return on capital employed, which we feel has the scope to be conservative given capacity rationalisation in the industry. Based on this guidance, the company currently trades on less than 7x earnings, with capital employed growing strongly over the next five years as it invests in its fleet.”
He added that the strategic value of easyJet should be rising rather than falling, with the industry consolidating as smaller players leave.
“Our view is that easyJet’s brand, fleet and slot network should command growing value. Wizz Air made an all-share approach for it at £8 per share before it issued £1.4bn worth of equity at £4 per share, and it now trades at about £3.50 per share,” Kumar finished.