Opportunities amid market confusion

Markets may have moved higher, but many businesses are still operating below their peak. For investors with a long-term perspective, this presents real opportunities, says Roland Arnold, Portfolio Manager of the BlackRock Smaller Companies Investment Trust plc.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

The outbreak of coronavirus, and global lockdowns which followed, can certainly be described as one of the most bizarre events of modern times, and one of the most challenging (in the short term) for many investors. The market falls that were witnessed in the first quarter of 2020 were severe and indiscriminate, with share prices completely detached from fundamentals.

The second quarter was marked by a much more thoughtful consideration of the effects of the global pandemic, including the scale and impact of the virus on various industries, both in the short and longer term. The result has been a somewhat strong market rebound, yet many businesses remain a long way off the highs from the beginning of the year as the near-term disruption to many industries remain high. However, we believe that for investors who are willing to take a long-term view, this environment presents a fantastic investment opportunity.

Zero revenues

One of the most commonly used words this year has to be ‘unprecedented’, but far from a cliché, ‘unprecedented’ is an appropriate one-word summary of 2020. These really are unprecedented times. If anyone had suggested at the start of the year that around 40% of the BlackRock Smaller Companies Trust portfolio would have gone through a period of generating zero, or close to zero revenues, we would have been astonished. But this was a reality for many businesses, and certainly not something that anyone could have foreseen or factored into company analysis.

When looking for companies to invest in, the financial strength of the business (no debt or very low levels of debt), and the ability to convert earnings to cash, are key attributes which we look for. And while this provided a buffer to many of our holdings, even a number of businesses which would have previously been seen as financially strong, have sought to raise fresh capital in the equity market. In many cases these companies are focusing on the opportunities in the future. As active investors, this is where we have been spending a lot of our time in recent months providing fresh capital to existing holdings and purchasing new holdings in businesses that have come to the market looking to raise funds.

"We believe that for investors who are willing to take a long-term view, this environment presents a fantastic investment opportunity."

A new normal

But what has been the core focus of our analysis? We have said many times in recent months that we can’t pretend to have the answers to many of the questions that have arisen as a result of the COVID-19 pandemic. What will the scale and duration of the virus be? What is the likelihood of a second wave? What will the scale of the impact be on the global economy? These are all questions that are on the minds of investors and individuals alike, with no real answer. One thing that we are sure of though, is that things will get better, and eventually return to normal, or at least settle at the ‘new’ normal.

And when thinking about what the new normal looks like, we then could begin to question how ‘unprecedented’ things really are…From what we are seeing in company trading updates and hearing from the management teams that we are speaking to; the direction of travel remains the same. In our mind the result of COVID-19 is simply bringing on an acceleration in many of the structural trends that have been happening in various industries over a number of years, whether it’s the shift to more agile/remote ways of working or falling footfall for bricks and mortar retailing as more people shop online. These changes were happening already, it’s just that now they are happening a lot faster. This environment could be perfect for well-managed smaller companies that have more agile structures that are able to adapt quickly to take advantage of these market shifts.

Management change

Take Games Workshop, for example, which is the creator of the Warhammer universe. This is a business that many people would associate with physical stores within shopping centres, clearly one of the first victims of social distancing and lockdowns. But for a differentiated retailer like Games Workshop this was not the case. With management having taken steps to reinvigorate the business in recent years, making some key changes to the games rules to broaden its addressable market, the business has repeatedly reported strong sales growth.

More importantly, despite having to cease operations for a short period when its stores were mandated to close, the business successfully transitioned sales online, and the strength of demand more than offset the lost sales in its physical stores. It is this ability to adapt quickly to changing market trends that has always been a key attraction for investing in smaller companies. Many larger companies simply lack the flexibility, given their large complex structures, to adjust quickly to changing market dynamics. In an environment such as that presented by COVID-19, it will be those businesses that can adapt quickly that will not only survive, but also thrive.

As we emerge from the pandemic, it is clear that many industries will never look the same again and it is therefore important for organisations and brands to understand these impacts on their clients and outlook for their end markets. This is where a business like YouGov, previously a UK political polling business, but now a data analytics group comes in. When time is of the essence, YouGov’s vast amount of consumer data and market leading analytical tools, make them a key partner for their clients that are trying to understand changing industry dynamics in order to adapt ahead of the competition.

One thing that we are sure of though, is that things will get better, and eventually return to normal, or at least settle at the ‘new’ normal.

Valuation opportunities

Now think about pubs that were closed for what seemed like a lifetime, and now have to operate at much lower levels of capacity in order to maintain social distancing for patrons. There are multiple businesses impacted by these new rules, whether that be pubs themselves or their suppliers. Unfortunately, there will be many that go out of business in a very short space of time. However, as we have seen in recent weeks, people will return to pubs, and as this happens, those that survive will gain market share as weaker competitors exit the market.

More importantly, the indiscriminate market reaction has resulted in the shares of some pub companies trading roughly at the value of the freehold value of their properties, meaning that we have effectively acquired the ‘pub business’ for free! Suppliers to pubs have their own challenges, but where a company has the flexibility to shift sales to another channel, they can limit the impact. Stock Spirits may not be serving the UK market, but the dynamics in the Czech Republic and Poland are not that different; as bars and restaurants close, home consumption increases.

Therefore, while the outlook for many industries looks very unclear, there are many businesses that can use change to their advantage, and we therefore look to the future with optimism. Vladimir Lenin once said, “There are decades when nothing happens and then weeks when decades happen.” We believe that this is exactly what is happening right now. It is simply the pace of change that has accelerated, and dynamic, nimble smaller companies could be best placed to adapt to the new normal, see their competitive positions enhanced, and could thrive as we emerge from this pandemic in stronger positions than ever before. These are the types of businesses that our investment process has always focused on, and we believe this environment will prove to be a fantastic opportunity for our strategy, and in turn, the BlackRock Smaller Companies Trust.

Risk: Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy and should not be construed as investment advice or investment recommendation of those companies.

The opinions expressed are as of August 2020 from BlackRock and are subject to change at any time due to changes in market or economic conditions.