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Three types of companies to avoid after Covid – Beyond just high debt.
by Stephen Yiu

03 Jun 2020

 

Around the world, many companies suffered heavy losses as the full effect of a global lockdown became apparent. Many are speculating that these companies, now at bargain basement prices, should recover to their pre-Covid levels and therefore represent extraordinary value for investors.

While this may be the case for some companies, at Blue Whale we do not think this is as prevalent as others would have you believe. In fact, we see many reasons why a lot of companies should be avoided as they are unlikely to deliver either growth or income for investors.

One commonly expressed view is that, provided an investor steers clear of highly indebted companies they should be alright. While we agree that these companies present risks that are best avoided at this time, we think it should go further than this. Below we outline three types of companies that we think are best left alone for the time being.

 

1. Low Quality “Bargains”

Obvious examples of low-quality bargains are aplenty among cyclical companies with levered balance sheets and poor pricing power – the likes of miners and energy companies. These companies tend to perform poorly in any downturn, so are not directly tied to the specifics of this global pandemic.

However, a more insidious species of low-quality companies is those that we believe have “Old World” business models. We define these as companies that have failed to adapt to changing customer expectations and whose growth and profitability are structurally challenged – high street retailers and banks are key examples here. Often their branding can trap investors into thinking they are valuable companies, but they end up delivering, at best, stagnant returns over the long term.

In both cases (cyclical companies and structurally challenged “Old World” incumbents), Covid-19 was simply a catalyst to accelerate their inevitable decline.

 

2. Post-Covid Quality Traps

These are companies which, prior to the outbreak, would have been considered as having high-quality business models, but have since been rocked by the new-normal of social distancing and government mandated lockdown.

Falling under this category, we include coffee chains, hotels and children’s themed holiday parks. These sectors are seeing longer term revenue growth coming into question with social distancing protocols reducing their ability to operate at full capacity. In addition, compliance with more stringent public health standards means that margins become squeezed for the foreseeable future. All of this signifies poor returns for investors – regardless of their perceived brand value.

 

3. Bubble stocks

With the new-normal setting in, many of us have taken to video conferencing, increased streaming of entertainment and exercising from home. In return, a number of companies which cater specifically to these examples have seen their share prices rocket as they are perceived as beneficiaries of the post-Covid world.

While home exercise machines and streaming services have certainly had their moment in the sun during this pandemic, quite often their business models simply do not hold up to the great expectations heaped upon them, with little to no ability to turn a profit over and above cash needs.

In the three examples above of the types of businesses we are avoiding, we need to be clear on one thing – we’re not forecasting that they disappear into oblivion. We are simply sharing our view that we see little chance of outperformance from these types of businesses, where underperformance is the more likely outcome.

 

We will shortly be releasing another article about where we are finding great opportunities. The article will be a written collaboration between myself and Peter Hargreaves, Chairman of Blue Whale Capital. So that you do not miss out, please sign up to our mailing list below. You can view our latest Factsheet, including our Top 10 holdings, here:

 

Please note that the information provided in this blog is not to be construed as advice and any views we express do not constitute investment recommendations and must not be viewed as such. If you are unsure as to the suitability of an investment for your circumstances, please seek independent financial advice. Investments can go down in value as well as up so you may get back less than you invested. Your capital is at risk. Past performance is not a guide to future performance.

 

 


 

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