When I started investing professionally in the early 1980s, I would constantly hear tales of the 1973-4 crash. It was one of those events seared on the corporate memory, just as the financial crisis of 2007-8 would be for subsequent generations.
Fifty years on, there are still lessons to be learnt from that two-year bear market. For me, the enduring one is that companies often lay the tramlines for a successful future in the most difficult times.
The past few years may not have been as calamitous for investors as that spectacular crash — the London stock market (the FT30, as it was then) lost three-quarters of its value in 1973-4 — but they have been seriously challenging. Covid, supply-side shocks, double-digit inflation, sharply rising interest rates and recession concerns have been a lot to overcome. A prolonged period of stress can be the opportunity for a reset.
Rising prices
Inflation is a major influence on asset prices and an important consideration in investment decisions. When UK inflation spiked last year it was a good time for companies to bury the bad news of their own price rises. Those that failed to pass on costs sufficiently will have seen margins squeezed. That reduced profitability may now be baked into their financial infrastructure, because customers become less tolerant of sharp price rises as inflation falls — and, despite the recent uptick, I believe inflation is falling.
Technology was a big driver in containing inflation over the 20 years that preceded the recent spike. One product was particularly important — the smartphone. Though expensive, it replaced the need for a host of other things, such as a watch, a diary, a map, a camera and so on. It also gave us ever-ready access to pricing information that shaped the rest of our spending. Price comparison websites and search engines left no hiding place for uncompetitive businesses.
Other online developments created excess supply. For instance, Airbnb meant there were many more “hotel rooms” in every town. As the textbooks teach us, a rapid increase in supply will lower prices if demand does not keep up.
The next wave of technological advance is coming. Artificial intelligence will allow many companies to reduce the workforce while still enhancing services. The transition to a low-carbon world is lifting infrastructure spending and technology investment — which is initially inflationary, but change will come.
I have previously expressed my enthusiasm for companies working to produce and store electricity from hydrogen — a sector that could benefit hugely from the drive to a low-carbon world. Nuclear power may hold opportunities too. Scientists have achieved ignition by a nuclear fusion reaction, which generated more energy than it consumed.
An interesting business working in this area is First Light Fusion, in which quoted company IP Group has a stake. It aims to build a power plant producing 150 megawatts of electricity — enough to power 300,000 homes — and costing less than $1bn.
The ingenuity of those working in this sector means energy will eventually be more abundant, cleaner and cheaper — bolstering economic growth and adding another deflationary force into the mix. But what about the more immediate future?
The pricing-power test
It is worth looking at companies and whether they have been able to increase their prices. Be careful about top-line nominal revenue figures when checking shareholder updates — price rises can mask falls in sales and may still not be sufficient to cover raised costs.
Remember, although we think of it as an aggregate figure, inflation is a composite of many elements. Some costs are rising faster than others. Take wage inflation. Annual wage growth in the UK from September to November 2023 was 6.6 per cent at a time when inflation generally was 3.9 per cent.
That is a challenge for labour-intensive businesses like pub chain JD Wetherspoon, where labour constitutes over 30 per cent of costs. But it might be good for a company like the Gym Group, which has relatively low staff numbers and has successfully raised prices almost in line with inflation while its biggest cost — rent — has remained flat.
Companies in cyclical businesses may recover some lost ground on pricing when the market picks up, as I believe it will when inflation stabilises at a lower level and interest rates fall. More immediately, though, they can offset price pressure by implementing difficult decisions to reduce costs.
Building materials supplier Marshalls has exited its Belgian operation and streamlined manufacturing to save £9mn a year in costs, closing a plant near Glasgow. Last month, a trading update from brickmaker Ibstock showed it had cut jobs and closed a second factory, which will help save £20mn a year, while it continues work on a more efficient plant, based in the West Midlands, which will produce the UK’s lowest-carbon bricks when it opens soon.
Another well-run company, ceramics specialist Morgan Advanced Materials, closed a lot of its facilities during Covid. The business was just coming out of the other side of that and was regaining momentum when a cyber attack dragged earnings down again.
It has now got through this and its balance sheet is in a much better place. It has reinvested in R&D and is lean on costs. Its share price is weighed down by negative sentiment towards industrial companies, but that makes it cheap. And it is yielding around 4.5 per cent.
Indirect winners
Crises can create indirect winners by taking out weak competition. At least three Italian budget airlines have folded since 201, as well as Flybe, which once provided more than half of UK domestic flights outside London. They have left companies such as Ryanair and easyJet with a clearer field.
The rise in bond yields benefited many companies, sending their pension schemes into surplus. One of our holdings, logistics specialist Wincanton, is no longer pumping over £20mn a year into its pension fund to plug a deficit. This has freed money for vital investment and to repay shareholders, which is what may have persuaded a recent bidder to offer a premium of 50 per cent on the share price.
During the Covid crisis, energy group Shell was one of many companies to reset dividends. It had been handing out too much cash to shareholders and, because of its reputation as a dividend darling, was loath to stop. Because of the pandemic, it was able to slash dividends and invest in projects like decarbonisation. At just over 4 per cent — from nearer 10 — its dividend looks more secure and is supplemented by a $3.5bn share buyback programme.
The move by companies to reset dividends — at all levels — is one reason for optimism about the dividend prospects of the UK. The FTSE All-Share is yielding 4.8 per cent. And smaller companies are also generating handsome yields. Weakness in the smaller companies markets means there are many businesses in the UK with strong recovery and growth prospects paying well. Ibstock pays about 5 per cent now; Marshalls 3 per cent. We consider these both good companies that are well placed to thrive when housebuilding recovers, as it must.
Falling interest rates will diminish returns on cash savings and make these dividends look increasingly attractive. That means the chance to secure this dividend income at such appealing prices will not last for ever.
Just as the tramlines for success are laid for company managers in times of stress, so for investors. Markets bounced back strongly in 1975. UK shares may do the same this year. And if I am wrong? At least we are being well rewarded in dividends for our patience.
James Henderson is co-manager of the Henderson Opportunities Trust; Law Debenture; and Lowland Investment Company
