Dr Niall O’Connor explains why he is looking beneath the surface of what may be a gradual economic rebound
As the manager of Brooks Macdonald's Defensive Capital Fund, which celebrated its 10th anniversary this year, Dr Niall O'Connor is used to developing a view across a range of asset types. He thinks that the damage to business models and the continuing threat of the virus means economic recovery might look like the Nike ‘swoosh' symbol - rapid descent with a very gradual recovery like that now emerging in China, as fear slowly ebbs away.
Defaults may remain surprisingly low, relative to the 2008 global financial crisis, due to government and central bank support, he says, but the equity market recovery looks fragile. "Retail investors have extra money in their pockets because there's been nowhere to spend it and no sports to bet on," he says, "so investing in stock markets has become a bit of a game - for instance, buying leveraged call options in stocks at all-time highs."
He points to similarities between now and 1999, before the dot com bubble burst, "including tech companies spending money to gain market share and high stock price dispersion."
He's not too worried about the frothiness in relation to the fund, because he does not invest directly in tech giants: "we tend to be more a value-oriented fund." But he thinks investing may face a turning point.
"Investors haven't yet got the message that you can't really get ‘safe' yield anymore," he says. "Everyone thinks UK equity dividends will be low this year and next year back to 4-5%. But dividend futures are suggesting sub 3% in 2025."
While equity upside remains important to consider, he thinks "there are still a lot of convertibles where you can get both equity optionality and decent yield."
If safe yield is out, he thinks stress-tested yield can be found in some lending funds and real estate investment trusts (REITs). "Things like student accommodation REITs, where stocks sold off very heavily. Even on a stressed basis you may be able to expect yields of up to 5%, for example, after haircutting the rents they're receiving at the moment," he says. He avoids retail REITs - everyone is shopping online - but wonders if office REITs also sold off too sharply. After the threat of Covid-19 eventually recedes, "there will be more home working than before but the office, as a melting pot of ideas and collaboration, is far from dead."
That kind of macro call is important because at critical points, "stock picks are pointless unless you've got the macro direction roughly right," says O'Connor. But most of the time, his fund is "very much a bottom-up construction with a top-down overview."
The team started serious stock picking again in May, "earlier than other people due to some interesting market anomalies," as investors deserted whole sectors without reference to the strong positioning of specific stocks. He says the post-Covid market is driven by overarching stories - ‘Amazon good, lending bad' - whereas "we like to dig beneath the surface and invest in places others have given up."
Click here to learn more about Dr Niall O'Connor's strategy for the recovery period
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