Despite a month of turmoil in markets following the spread of Covid-19 around the world, investors are still holding onto the belief that the large-cap US technology stocks that have dominated performance for so long remain untouchable by the crisis, according to trust manager Alasdair McKinnon.
Scottish Investment Trust’s McKinnon (pictured) invests in a ‘cycle of emotion’ following the peaks and troughs of an investment’s returns on the stock market, characterising the high and low points investors will experience at any particular point.
Seven weeks on from when the US market peaked The Scottish Investment Trust manager said that most investors are “in denial” having come off the ‘euphoria’ stage of the cycle in mid-February.
‘Euphoria’ is the primary stage leading up to the peak of the investment return, which in this current cycle was prior to 19 February. The other end of that is the ‘fear’ stage where investors sell out of a company as its returns bottom out.
But on the way down to that is ‘denial’ which McKinnon said many investors are still going through with US technology stocks despite markets crashing all around them.
It’s a mistake we have already seen in the current market downturn when it came to airlines, McKinnon said.
With airline stocks peaking on 20 February McKinnon said that red flags were already cropping up about airline businesses as cases of coronavirus began appearing outside of China.
“All of February flights were being cancelled, left right centre, the world was slowly shutting down. But the market was ignoring it,” he said.
“And what’s the market doing now?” McKinnon asked. “Well, it’s saying US technology is immune to the cycle, whereas we’re saying ‘no they’re not, they’re just late-stage cyclicals’. 
“All these companies that everyone’s worried about how they’re going to pay their bills, well they’re right and they're not going to be able to pay for all these software products. It’s just the next stage in a big slowdown that’s occurring.
“So that’s why we still think we’re in ‘denial’ and muddling through.”
“Just as investors were doing a month ago with the obvious cyclicals they’re now not doing it with the second stage [cyclicals] and we’re saying, ‘Well, hang on a minute. If the frontline cyclicals are basically shutting down, what does that do to the second stage? How are they going to pay their bills if they’re not going to [be able to] pay their bills?”
US technology stocks have largely driven the S&P 500 returns in recent years, as investors have sought to partake in the growth brought about by the disruptive impact of new technological innovation.
But McKinnon believes that they’re not so untouchable because they’re vulnerable to businesses closing and workers having their income reduced.
Not even a company such as Microsoft which has been pegged as a major benefactor from people having to work from home, is immune.
“Microsoft is a great company but it’s done too well,” McKinnon said, adding that investing in it now would not produce strong returns.
“The only way – from our perspective – is down because companies are going to struggle to pay their bills, so they’re not going to be able to pay Microsoft. Microsoft moved to a subscription model and people won’t be able to pay that.
“They’re not going to see the growth everyone thinks they might see, they haven’t thought that through yet.”
Although his portfolio doesn’t hold any US large-cap names McKinnon started to make changes to his own portfolio in order to deal with the impact of the coronavirus in early February before markets peaked.
He said when news of coronavirus cases reached the general public he realised that – alongside it being a human health tragedy – it’d be severely disruptive to the Western world’s supply chain.
But at the time “the stock market didn’t care,” because of the ‘euphoric’ stage they were blinkered to, he said.
As such, McKinnon said that he got rid of a lot of the “deep cyclicals” in the Scottish Investment Trust. Selling out of services, retailers and banks McKinnon explained that although they would’ve recovered if the economy picked back up, if we an economic shut down followed it becomes harder to value cyclicals, “cheapness is no measure here since the earnings potentially are going to disappear”.
But he didn’t sell every cyclical stock in the portfolio.
“We are aware that this virus will pass, although we don’t know how long,” he explained. “And a mistake I've noticed over the years, with people – and myself as well, I’ll add – is you can get too wedded to the current environment and take your eye off the prospect of change.
“We know at some point there’ll be a big down-leg, and then they’ll be recovering, just as there’s often a big up-leg, and then there's a big fall.”
As such he is holding onto supermarkets because people need to keep buying food – although McKinnon said he didn’t foresee the food and stockpiling boom people went through before the lockdown. He also added to tobacco, utilities and gold mines and held onto cyclicals which were “relatively resilient” in the current climate.
Although he admitted that making these changes so early in February he wasn’t sure if they would pay off the market went through a further two or three more weeks of rises.
Over the past five years until global markets peaked on 19 February, the trust made a return of 41.81 per cent, underperforming its IT Global peer group (78.52 per cent).
However, taking March’s heavy sell-off into consideration, the trust’s five-year return remains positive and is up by 17.21 per cent although it still underperformed the average IT Global trust (which was up by 45.09 per cent).
Performance of trust vs sector over 5yrs
Source: FE Analytics
The trust is currently trading at an 11.4 per cent discount to net asset value (NAV), is four per cent geared, has a dividend yield of 3.4 per cent and ongoing charges of 0.58 per cent, as at 7 April.