The world has been turned upside down by this pandemic, along with the prospects of many companies.
Perhaps some of your own holdings have soared to unexpected highs, or collapsed to unexpected lows.
Several of my holdings certainly have.
However, don’t pat yourself on the back or don a dunce cap too soon.
In most cases, these dramatic moves are mostly down to luck, both good and bad.
As an example let’s take Dunelm and WH Smith.
Respectively these are the best and worst performing retailers in my portfolio so far in 2020 (ignoring Ted Baker, which I’ve already sold).
Before the pandemic I thought they had broadly similar prospects, with Dunelm performing well as the UK’s leading homewares retailer and WH Smith with an impressive travel retail business.
But since the pandemic began their fortunes have gone in wildly different directions.
Dunelm: People buy more homewares when they’re locked at home
During lockdown Dunelm closed all its stores and almost all of its operations.
As a precautionary measure, the dividend was also suspended.
And yet Dunelm’s share price is actually up almost 30% since the start of 2020.
How did this happen?
The answer is that for a retailer, Dunelm happened to be in the sweet spot.
It sells homewares, and during lockdown more people were sat at home on their tired sofa looking at their home’s tired décor.
Or they were posting pictures and videos on social media, where friends and colleagues can also see their tired décor.
Either way, lockdown meant more people wanted to spruce up their home interior and for that, Dunelm is #1 in the UK.
It also helps that most Dunelm stores are large and out of town. That makes it easy to park up, put on a mask and stay far away from potentially contagious people.
I like Dunelm and I think it’s a very good business, but most of this recent share price rise is pure luck rather than skill (on my part or Dunelm’s).
WH Smith: In a pandemic almost nobody buys books to read on a plane or train
Like Dunelm, WH Smith is a market leader with a well known and much loved brand.
Over the last decade or two it’s been wildly successful in rolling out stores and concessions in UK and international transport hubs such as airports and railway stations.
In fact the travel business is now significantly larger than the better known high street business.
But unlike Dunelm’s out of town homeware stores, travel retail outlets have been one of the worst places to be during this pandemic, for obvious reasons.
WH Smith’s travel revenues declined more than 90% during lockdown and were still down almost 60% in July.
The high street stores fared better and have recovered more strongly. Even so, high street revenues were still down 25% in July and WH Smith’s overall revenues were still down almost 60%.
A 60% decline in revenues is clearly unsustainable, so the company has had to raise additional cash, including a rights issue for £170 million.
More recently, WH Smith announced plans to reduce staff headcount by around 1,500 out of a total of 14,000.
None of this is good and it seems clear that the pandemic has put a large and permanently dent in WH Smith’s value, especially if it takes a long time for travel habits to return to previous levels.
Does this mean WH Smith is a low quality business compared to Dunelm?
Does this mean anyone who invested in WH Smith is an idiot because they could have put that money into Dunelm instead?
I think both Dunelm and WH Smith are above average businesses with strong brands, strong capabilities and lots of potential for future growth.
Dunelm just happened to operate in a part of the economy which is boosted when people are forced to or choose to stay at home.
And WH Smith just happens to operate in a part of the economy which is decimated when people are forced to or choose to stay at home.
So the huge difference in their recent performance is almost entirely down to luck, and has little to do with the skill (or lack thereof) of management or shareholders.
In other words, if your portfolio is in the doldrums because it was tilted towards travel, don’t panic. You’re probably not an idiot.
And if your portfolio has soared because it was tilted towards homewares or healthcare, don’t celebrate too soon. You’re probably not a genius (Nassim Taleb might even call you a Lucky Idiot, but that seems a bit harsh).
Here’s another example from my portfolio of even more extreme levels of good and bad luck.
Senior PLC: Aerospace parts don’t sell when planes aren’t flying
Senior is a world leader in aerospace structures and components.
It’s primary market is civil aerospace, where it has significant long-term contracts to supply parts for the latest generation of commercial airliners from Boeing and Airbus.
This is a good business to be in because civil aerospace is generally expected to be a steady growth market for the foreseeable future.
Unless, of course, there’s a pandemic.
Covid-19 shut down most global air travel for months and has left the number of scheduled flights down about 50% from a year ago (as shown in the table below).
This collapse of demand caused havoc in the aviation supply chain, with strong and successful companies like Senior caught up in the mess along with everyone else.
Here are some questions worth pondering:
- Is Senior a good company? Yes.
- Was it well-placed in a market with good growth potential? Yes.
- Was it reasonable to expect a pandemic to virtually shut down the entire aviation industry? No.
- Did Senior shareholders make an obvious mistake, without the benefit of 20/20 hindsight? No.
- Is this a good example of very bad luck? Yes.
One option would be to sell up now and try to reinvest the proceeds into companies exposed to homeworking or healthcare.
But that would mean selling Senior at a depressed price and buying popular stocks at elevated prices, and I’m not going to do that.
Instead, I’m going to sit tight and see what Senior can do with a very bad situation. There may be important lessons which I can extract and use in the next crisis.
Okay, that’s enough doom and gloom.
Let’s finish with a more upbeat example of blind luck.
XP Power: Medical component sales go through the roof in a pandemic
XP Power is one of the world’s leading designers and manufacturers of power converters.
XP’s speciality is developing power converters for original equipment manufacturers (OEMs) who manufacture devices used in critical settings such as healthcare, security or production lines.
Failure of a device in one of these settings is costly, so manufacturers are willing to pay up to work with a trusted partner like XP.
As far as the pandemic is concerned, the key part of the story is XP’s exposure to healthcare.
XP’s power converters are used in hospital beds, CPAP (continuous positive airway pressure) machines, ventilators, ultrasound and lung x-ray machines.
Demand for these has skyrocketed during the pandemic, with order intake up more than 40% from a year ago.
Was this an inspired move by XP’s management to position the business in case of a global pandemic?
Did I put XP Power into the portfolio because I thought something like this might happen?
Is XP a very good business whose operations and share price have massively benefitted from the pandemic?
Yes and yes again.
Also, if you like the look of XP Power there’s a fantastic review of the company on the SharePad website.
Coping with extreme events and extreme good and bad luck
As a long-term investor you simply have to accept that you will have good luck and bad luck.
And sometimes you’ll have extremely good luck and sometimes you’ll have extremely bad luck.
We cannot control luck, but there are some things we can do to take advantage of good luck when it happens to us, and avoid the worst impacts of bad luck.
To take advantage of good luck you could:
- Sell companies where valuations seem high, such as when investors are excited by short-term unexpected tailwinds
To take advantage of (someone else’s) bad luck you could:
- Buy companies where valuations seem low, such as when investors are depressed by short-term unexpected headwinds
To avoid the worst impacts of your own bad luck you could:
- Diversify broadly across companies and sectors so that no one company or sector would cause you to lose sleep even if it collapsed
- Own high quality businesses with very strong balance sheets
This pandemic still has a long way to go, and personally I think we’re perhaps halfway through the initial pre-vaccine phase.
However, if your investments are broadly diversified across a wide range of quality businesses purchased and held at attractive valuations, then it will take more than a bit of bad luck to keep you from your long-term financial goals.
Hi John interesting article. I think it was impossible to foresee the pandemic coming. And I think you are right certain companies have lost out to the pandemic whilst others have benefited. Therefore luck had a hand in how many companies performed.
Although if you follow Terry Smith model and invest in resilient companies that sell everyday items which have little competition, I do think you can protect your portfolio against the damage of adverse macroeconomic events. This shifted my focus on specialising in certain types of companies for the last two years:
2) Reckitt Benckiser
3) Procter & Gamble
4) Johnson & Johnson
All of these are good companies with the exception of RB due to Mead Johnson division. Unsurprisingly the business operation has remained intact for all of these businesses and the valuation is more deserved compared to tech stock. The most interesting thing I find is that these companies have all gone through significant disruptions in the past and managed to come out intact suggesting their resilient nature: WW1, Spanish Flu, Depression and WW2.
Unfortunately I still am waiting for a correction in the market to pick up a stake in quality company for a decent price. Since if you overpay for a quality company you end up losing because the returns of your investment can’t match the price you paid for originally.
John Kingham says
I agree, and although I have a broader remit that type of company is certainly on my radar (one in particular).
One thing about less defensive companies is that the pandemic has certainly thrown up some “interesting” valuations, especially if you’re willing to invest in quality companies where the dividend is currently suspended.
I’m not too fussed on the dividend according to my research if you find a company with a medium PE but a high ROCE, a low/no dividend isn’t a bad thing so long as management can sustain the ROCE in the long run the dividend payoff will be greater.
But what I would say is that currently the market premium is too high given the financial impact of COVID-19. I read in the Economist that in the 2008 the global GDP shrank by 0.8% but this time around by 8%. However in 2008 there was a massive correction in stock price. This time around the stock prices are higher. Clearly the market is detached from the real economy.
I feel like we are in a kind of ‘South Sea Company’ bubble scenario and I find it scary. Especially since globally we have so many incompetent government in place.
John Kingham says
I think valuation depends very much on the sector. US tech: Yes, some very full valuations there. UK insurers, builders, retailers or recruitment firms? In some cases the opposite, although of course COVID is not a tailwind for those businesses.
Personally I think the UK market valuation is probably quite reasonable at the moment, being somewhere close to where it was 25 years and a lot of inflation ago.
The US market is of course another matter and we shall have to wait to see if the US can produce multiple multi-trillion dollar companies, or whether China’s growing tech industry will provide the US with serious competition and seriously damage the future earnings of Microsoft, Google etc.
I have been reading your articles since last year and just wanted to show my gratitude for the work you have put into your excellent analysis.
There has been a real monetary benefit from your work for me, which I am sure you will be pleased about. Your analysis on Rolls Royce and a number of other UK listed stocks helped me come to the conclusion that they were not worthy parts of my family’s portfolio. So I decided to sell a whole bunch of these stocks last December.
Obviously I did not foresee what was to happen later on with the pandemic so the avoidance of the large drawdown that I would have otherwise experienced can only be attributable to luck.
Thanks for all your hard work and hope to read more expert analysis from yourself.
All the best.
John Kingham says
Thanks David, I’m glad somebody found some of my work useful!
I’m hoping to get back into reviewing some big names soon, so keep an eye out for that.
Bob Barnacle says
Agree very much, could not have been anticipated, nor the effect on our portfolios..
Have now divided stocks in to two to three categories :-
Cat 1 : those that will prosper in spite of pandemics
Cat 2 : those that will suffer as long as pandemics continue
Cat 1.5 : those where the picture is nuanced
Tempting as it may be to overweight Cat 1, trying to keep some sort of balance. Never has the outlook been more polarised. Way outside investment experience.
The thoughts here appreciated, now especially.
John Kingham says
Thanks Bob. I’m doing basically the same thing by categorising companies as:
1: Pandemic is a tailwind or minor headwind
2: Pandemic is a significant but short-term headwind
3: Pandemic is potentially an existential threat requiring emergency debt/equity funding
Balance is important because tier 1 are likely to be fairly or expensively valued, tier 2 probably has quite a few attractively valued situations and tier 3 is where the value traps live, and also deep value turnarounds which are outside my comfort zone.