I picked up my bike from the office garage the other day. It was the first time I had been into the City since lockdown had begun. It felt almost nostalgic, as I cycled from the office back to my flat in northwest London. It was great to see activity; with vehicles on the roads and lots of people on bikes and in the parks. It reminded me of how much a city, like London, offers when it is in full swing. It is not just a place to work, but a centre for arts, culture and socialising. In the new world I can see the desire for more space, and technology has facilitated increased working from home, but I believe cities will continue to be attractive places to live.
The market has continued to chug up over the month, but virus data has been mixed.
In Europe, the virus seems to be currently more under control. The majority of countries have eased restrictions significantly. Thus far, easing has not led to widespread spikes in infection rates. There are local outbreaks, similar to those we have seen in parts of Asia, but the broad trend appears downward. This is brilliant news, it suggests that even as we return to normalcy the virus can be kept in check through learned behaviours, testing, tracing and adhering to sound medical guidance.
There are countries, for example in the Americas, which are struggling to control the virus.
In the US, infection rates have rapidly increased in the second half of the month of June. This has been driven by states in the South and West of the country. There is some evidence that those getting the virus are younger than in the first wave. However, it will be a few weeks before we see whether mortality rates are materially different to the first wave or if younger carriers subsequently infect vulnerable cohorts. A renewed lockdown seems unlikely given how politically charged it would be, but we are seeing states impose increased restrictions which are a speed bump to the economic recovery that has been evidenced by the data so far. If infection rates continue to soar and hospital capacity is stretched, more drastic action, politically unpopular or not, may be required.
The political implications of the second wave in the US are intriguing. Through this crisis, president Donald Trump has lost ground to his Democrat rival Joe Biden in polls (big pinch of salt required). Trump is widely regarded as a formidable campaigner and his well-attended rallies were a key part of his 2016 win. The virus is not only impeding his ability to get his campaign going, but the flare ups are in some of the key swing states (Florida and Arizona). As the election approaches, keep an eye on Democratic policy towards the following areas, including corporate tax, tech, pharma, banks, energy and trade policy. All of which could have implications that go far beyond the US.
Looking at the US equity market, one could be forgiven for thinking it has got ahead of itself. This seems to be not true for the UK equity market, which has underperformed most other equity markets year to date. The usual arguments on composition and Brexit can be rolled out. However, the majority of sectors in the UK are trading at a discount to their long-term average price-to-book multiples and the market in aggregate is as cheap as it has been in the past 30 years, which suggests there is a broad opportunity in the UK equity market.
The mood music on Brexit will wax and wane for the rest of the year; negotiations inevitably involve brinkmanship. I have faith that each side can compromise and come to a solution that is mutually acceptable and not inherently destructive for either side.
A lot of investors have sat out of the markets over the recent volatility. An article by the Wall Street Journal suggests cash piles are at a record high US $4.6tn (£3.7bn). Equities are about the only asset class that has a real yield, which suggests it could well be top of the investor shopping list when confidence in assets improves.
The long and the short
Team17 and Codemasters are video game developers and publishers. Prior to the current crisis, gaming was an area of structural growth. We think the crisis has augmented this trend. Lockdown has driven free customer recruitment as those looking to alleviate boredom have turned to gaming. Some of these new recruits will be transient, but some will have been hooked and continue to game even as restrictions lift. At the same time, the way we consume games has changed. The days of buying a CD are numbered. Increasingly games are being purchased through downloads or streaming from the cloud. This has a material margin benefit for video game companies as the cost of goods of a downloaded game is immaterial compared to manufacturing a CD and giving away some of the margin to the retailer. The economics of a successful game are extremely attractive. Once the cost of development is covered, the incremental margin on selling an additional unit, particularly if it is downloaded, is near 100%. Team17 owns a number of successful franchises including the Worms series, which has sold over 70 million units, and Codemasters has a range of successful driving franchises, such as the official Formula 1 series. We think that both can continue to grow and expand their margins.
Restaurant Group does what it says on the tin. About a third of its revenues come from Wagamama, which it acquired in 2018. This is one of the most successful casual dining chains in the UK and was priced accordingly when Restaurant Group levered up its balance sheet to acquire it. The rest of the revenue came from a selection of mediocre pub and restaurant brands, some of which are facing terminal decline. We put the short on in May 2019 as we felt the casual dining space was so competitive it would be difficult for the company to earn a return over their cost of capital and that the balance sheet was too levered for a company facing weak growth prospects. The recent crisis has clearly been awful for restaurants. We closed our position in March as felt the market was pricing the company to go bust, despite there being levers they could pull.
Sources: Datastream, Morgan Stanley Research. Data from 1 January 1980 to 23 June 2020, Wall Street Journal – ‘Investors Are Sitting on the Biggest Pile of Cash Ever’ 16 June 2020