As investors grapple with how to protect their portfolios from the economic fallout caused by the coronavirus pandemic, Kames Capital’s Michael Nicol sees five major drivers for equity markets going forward.
Nicol, who has just joined the £70m Kames Global Equity fund, believes many of the post Covid-19 investment trends “will closely resemble the themes that have driven equity markets over the last few years”.
Five certain themes – technology, ESG investing, automation, healthcare spending and de-globalisation – will be “fast forwarded” as a result of the demands of the modern world once the pandemic ends, Nicol suggested.
Nicol, who joined Kames Capital three years ago to co-manage its £1.2bn European pension fund, said these themes will guide him as he starts to firm up Kames Global Equity’s portfolio.
“These themes are important if you want to pick a portfolio that will perform in the future,” he said, adding that the themes are reflected in the European pension portfolio, and that he will be taking a similar approach with the global equity fund.
Technology
Technology was the first theme Nicol highlighted, as working from home and relying on remote accesses becomes accepted as an increasingly viable way to operate normally after being put the test in the coronavirus lockdown.
“Technological development is the enabler of this progress,” he added. “Our world will evolve further into the clouds, hosting ever smarter virtual applications that accelerate corporate productivity and efficiencies.
“Ways of working and communicating with customers, suppliers and colleagues will undoubtedly change permanently into the future as the Covid-19 pandemic has forced everyone to radically adapt their working practices.”
ESG investing
Nicol said sustainability is the most important aspect of the investment case for a company and this demands “a close look” at businesses’ environmental impact and social and governance polices.
“There will be increased demand for renewable energy and products and services that will allow the world to function in a cleaner, more effective way than in the past,” he said.
Nicol believes this investment theme has been important but is still not fully understood by a significant part of the investment community, namely passive and ‘value’ investors. He expects an acceleration in acceptance over the next several years.
Automation
The third theme Nicol highlighted was automation.
“It is clear industrial disruptions, whether from a global pandemic or other economic shock, make management look closer at their business model and automation allows companies more flexibility on costs and capacity,” he said.
“This ties in with digitalisation and technology, all of which offer structural demand.”
The Kames Global Equity manager highlighting firms like multinational energy and automation digital solutions provider Schneider Electric and Swedish company Hexagon AB, which makes sensors for manufacturing, global positioning, and safety and security, as being tied in to this trend.
Healthcare spending
Nicol believes the Covid-19 pandemic has highlighted issues of insufficient healthcare capacity and resilience, “particularly in countries where the sector has seen cuts to spending in recent years”.
He expects these spending cuts to be reversed as voters demand a more resilient safety net “for the day when they come to rely on the healthcare system they have funded”.
“This may require a rethink in terms of some of the social contracts in place between the public and the health sector, especially with regards to the level of private sector involvement in healthcare provision and the size of contribution that individuals expect to make,” he said.
The manager believes there will be a focus to ensure that the public are getting value for money in areas where there is little innovation, such as generic drugs and relatively standard equipment and medical procedures.
“Expect taxpayers to also look to reduce healthcare costs that arise from modern sedentary lifestyles where significant future financial costs can be avoided by making changes now,” he added. “Meanwhile the trend towards increased health and wellbeing among some people is likely to receive more explicit support in a bid to increase exercise, activity and fitness levels.”
Nicol said that as a result, pharmaceutical companies, testing companies and medical manufacturing companies are all being closely watched by the fund.
De-globalisation
“The dangers of outsourcing the majority of production to a specific geographic area were becoming more apparent due to trade issues before the current pandemic,” Nicol said. “De-risking supply chains will now be at the top of management priority lists and probably many governments too.”
He emphasized that there is now a greater risk in terms of “concentration to production”’. “People were already thinking about this to a certain degree due to the trade war between the US and China,” he added.
For investors seeking equity portfolio protection, Nicol said it is “all about company balance sheet strength, secular or structural demand, levels of flexibility on costs, and margin protection”.
He places an emphasis on balance sheets and free cash flows, adding: “We don't invest into heavily indebted companies”
Nicol looks very closely at free cash flow and how much of dividend is payable out of free cash flow. “If they’re paying more dividend than free cash flow, they don't have any left to reinvest into the company,” he explained.
“For a consumer staple, less than 2x net debt to EBITDA, we’d like ideally about 25 per cent of free cash flow to be spent on a dividend, meaning that 75 per cent effectively can be reinvested into the business, or reduce debt, or make acquisitions in the future.
“We have very little exposure to so-called value stocks. I worry because they’re in areas that are undergoing a huge amount of structural pressure.”
He pointed to the fund’s investment in Orsted, the wind farm power generator, co-owned by the Danish government.
“You needed money to invest in that, and we’ve taken that from the oil companies. I see that being a continuing drag on so called value investments that are really struggling to put together a longer-term investment case,” the manager said.