June 22: In the Markets


It’s been a brutal start to the year for anyone picking stocks. Fears about rising interest rates have reversed the speculative stock hype in the US, and put a dent in the broader bubble in dicey assets. Worries about recession have led to terrible equity performance across the board. In the short term, liquidity and sentiment drive asset prices – and sentiment is terrible. April saw the largest outflow from UK equity funds on record.

There is some logic to this fretful atmosphere. High inflation leads to an increase in future interest rate expectations, and rising rates are bad for stocks. From a demand perspective, higher rates mean less consumer spending, and less spending means less profit. But it also works from a relative pricing perspective. If you can only earn a 0.8% yield lending to the UK government, you’re much more likely to dive into stocks than if you can get 2.7% on your risk-free bet.

This has hit stocks on both sides. People expect lower future profits, and they want to give those profits a lower multiple.

I am, as always, less concerned on all fronts the market worries about. My biggest ever ‘buying’ month was March 2020, which I think shows some capacity for calmness while folks are panicking. I’m equally sanguine now, though we’re not at the extremes of valuation we saw then, so I am also not wildly bullish.

I trace most of our current woes back to the global response to COVID-19.

Let’s take a step back and consider what’s happened in the last three years. We have seen the biggest supply side shock in modern history. Billions of people globally have been unable to work or – if they can – forced to work in a wholly different and less productive environment.

Businesses responded to this: they shelved expansion plans, cut capacity and cancelled shipments. They reduced inventories, and started redundancy processes. In short: on top of the government-mandated reduction in supply, there was also a rational, business-led one.

What we then saw, though, was the biggest concerted global effort to stimulate the economy we have ever seen. Investors in 2019 and 2020, remember, were more worried about deflation and anaemic growth than inflation. In the US, we put money straight into the hands of consumers. Elsewhere, furlough and Kurzarbeit schemes protected jobs and real incomes for millions, while tax cuts reduced expenditures.

It seems obvious, then, that we have created an enormous economic mismatch. We curtailed supply – the sort of supply that cannot come immediately back on stream. Semiconductor shortages mean that new car sales across Europe are still far below pre-pandemic levels, despite huge demand. Home furnishings have unprecedented wait times. Legal professionals have long backlogs for routine transactions, like residential real estate deals.

We overcharged future demand. We gave consumers money, and even apart from that extra dough, they saved at rates never seen before. Without the prospect of visiting restaurants, going on holiday or needing to pay to get to work, they propped up their household balance sheets.

What would we expect to see as this scenario unwinds?

Well, I daresay we would expect to see inflation. More so, if we were to lob in other supply side shocks – like a huge increase in the price of oil. Oil bleeds through to all sectors of the economy through embedded transport costs and production inputs. Given that little complicating factor, we might get rather a lot of inflation.

Now, do I know how we will exit this scenario? Of course not: I don’t know if inflation will be persistent. There are some sensible-sounding arguments that it might be. When inflation embeds itself in the minds of employees, it’s hard to dislodge. They start to ask for mitigating wage rises, which feed into input costs for businesses, which must increase prices. This is a wage-price spiral. I have no idea if this will happen in reality.

On the other hand, recessions are inherently disinflationary, and there is a historic amount of slack in corporate margins, which are at all-time highs. Anyone who invested through 2021 will remember the good times: waking up every day to see yet another massive beat-and-raise on the earnings front, often to well above pre-COVID levels. There is space to fall without disaster striking and the sky caving in. It’s as if people have forgotten how to deal with earnings which don’t go up in a straight line. Not every cloud on the horizon has to be the spectre of the global financial crisis.

I take everything I read with a huge pinch of salt. The vast, vast majority of commentators on these topics fall into two camps. They are either stopped clocks, who have been calling for inflation for over a decade, and who now find themselves vindicated.  Boy, are these guys desperate for you to know it. Or, they are dazzled by market sentiment, stuck in a bubble chamber of re-confirming evidence. These were the people panicking about a Japanese-style deflationary scenario in 2019. Now they are panicking about a 70s-style inflationary period.

If you want to find data to support any point of view in macroeconomics, you can do it. And you’ll look bloody persuasive. It’s a doddle. If you throw in a few scary looking market charts, even very intelligent people find their perspective slowly, subtly shifting.


Where the rubber meets the road for equity investors, then, is in valuations.

Environments like this one always lead to impassioned and impossibly technical discussions about the valuation level of the broad market. To what extent are earnings declines priced in? How far behind the curve are analysts? Will we use the CAPE – a long-term average earnings comparison – or a forward or backwards looking number?

As in macro, you’ll find a thousand views in either direction. You can find a chart showing that the market is getting rather cheap, and you can find a chart persuading you that everything remains expensive.

This is further complicated by where you are looking. Most of these discussions centre around the US. It’s fair to say that after a decade of global dominance by American businesses, valuation levels there are starting at a higher base. So you dive head-first into the next conversation. To what extent is that justified? Should we see normalisation? Would you rather be in cheaper European equities, or higher quality US ones? Large caps, or small?

The trouble with that last distinction is that all small-cap indices are flawed. Even the AIM Index is useless. Like all market capitalisation weighted indices, a small number of very large names dominate the rest. The relevance of Abcam, Asos and Breedon to my portfolio seems minimal.

What a pickle. What is the beleaguered small-cap equity investor to do?

It’s simple: ignore the macro, top-down noise. You can’t predict it, you can’t influence it, and any view you have has probably already been priced in. Admit you’re not a macro stockpicker. If you are a macro stockpicker, stop wasting your time picking stocks, and start leveraging up futures. You’ll make a thousand times more than you could ever make playing around with tiny companies.  Unless we’re living in one of the extremes: an obvious market implosion, or a land of irrational exuberance, tune it out. Look at your stocks on an individual basis, look at your opportunity set on an individual basis, and come to conclusions which make sense to you.

Being a bottom-up investor is a blessing at times like these.

You have a real edge if you focus on the actual valuations of businesses you own and know well. They serve like a lighthouse in a storm – something to look at aside from volatile and sentiment-driven share prices. Even better, if you know a whole range of businesses, you can form a informed view on how you think valuations look in your little universe. You don’t need to rely on dubious top-down valuation statistics.

The key starting point to this is thinking from a long-term expected return perspective. How much value are your companies fundamentally creating?


I’ll start with a predictable example. As I’ve mentioned before, I am heavily invested in S&U Plc.

Everything I invest in is much, much more resilient than the average listed business. S&U has been profitable for longer than I have been alive. Indeed, it has grown profit for nearly all that time, and even through the GFC. With the same management team at the helm and with the market share they currently command, they can continue on that path.

The current earnings yield of the company is circa 14%. It’s around 15.4% backward looking, but that’s a little elevated.

The return on equity of the business in the past has been around 16%. Let’s assume it deteriorates a little in future, to 13%.

Let’s make the assumption that nothing catastrophic will happen, and the business will not shrink. In that scenario, those two figures – the 14% earnings yield and the 13% return on equity – provide bounds to our returns, if we ignore multiple contraction or expansion.

You can decide whether, at ~7x earnings, I have more upside optionality to multiple expansion or downside risk from contraction. S&U has traded at 16x in the past. If it gets back to 14x, and it takes 5 years to get there, you can throw another 15% on the CAGR.

You can also decide how large you deem that ‘catastrophe risk’ which I’ve so brazenly glazed over. I find it very hard to come up with a number which I think is reasonable and which makes the stock not a bargain.

Macfarlane is similar. I am confident they will do better than £20m of profit this year. That suggests a 10.7% earnings yield. Return on incremental equity is trickier to calculate, but we can conservatively say it’s been 15%. We’ll assume a little deterioration with scale, and call it 12%.

Again, then, I think I’m buying at double-digit expected returns, without any multiple expansion. It’s a sub-10x P/E for a packaging distribution business with incredibly low revenue and profit variability. Unless the markets implode, the skew on my returns when it comes to multiple expansion must be positive. I think mid-high teens would be fairer, in the fullness of time.

I can see value in things I don’t own, too. We discussed Schroders REIT on Twitter. At the current price, you are getting a circa ~6% cash flow yield on an underlevered REIT, made up of mostly industrial assets. The debt they do have is long-term and fixed rate. If you assume some real estate price gains in an inflationary environment, you can underwrite 9-10% annual returns. And, again, your skew on the entry valuation is, I think, rather positive. It would have to gain 50% to trade at book value. Making a likely  high single-digit return, with the option of big upside, is a lovely trade in such a low risk vehicle.

Redrow, Bellway, and other housebuilders look interesting to me. You are paying a 10-20% discount to tangible book value – which is understated, unless house and land values collapse. These businesses have earned a 15% annualised return on equity, with almost no leverage, for over a decade. Both businesses will earn a circa 20% free cash flow yield next year. UK housing supply is a broken oligopoly, with many issues… but it is not a market downturn that concerns me. If house prices fall, land prices fall (with a lag), there’s a few years of painful adjustment, and then returns come roaring back. These are unlevered, land-owning, government protected oligopolies at below book value and almost 20% free cash flow yields. Say what you like about the UK housing market, but that has to be interesting for all but the uber-bears.

I can keep going!

I find it rather astounding that Halfords has dropped to a £320m market cap. It’s one of the more eCommerce-resistant retailers in the UK, and less discretionary, to boot. Pre-COVID it made £40-60m of net profit, with most of that converting into cash. In 2022 it made almost £80m (a quarter of the current market cap). Everyone knows there will be a slowdown: but will it be as catastrophic as implied by the 67% fall in their share price over the last year? Even if this year is tough: is Halfords structurally damaged and permanently impaired?

Sticking to the motoring theme, Vertu continues to gobble up its shares, somewhat ameliorating my long term concern about capital allocation at the group. You get the business at roughly half of its book value (stated, including intangibles and goodwill) and ~3x historic earnings. Analysts think earnings will decline by 50% next year. If they’re right, you’re paying 7x earnings. I don’t think they will be right, though. Vertu’s profitability will stuff that balance sheet with more assets and cash than they expect. Maybe it’ll deteriorate next year. In any case: that low net profit figure would imply a return on equity of less than 8%, which is below the pre-COVID average. There’s no silly optimism here. It’s cheap on pessimistic numbers.


All these quick-fire opinions tie back to my broader point. If you know a lot of businesses, you can form a view of how valuations look in your universe. You get to know them through time and you get some sense of how prospective returns look.

I’m not telling you that these are the best stocks in the world, and you’ll make loads of money holding them. What I do think, though, is that there’s very little naivety left in the market. The market has slammed stocks with substantial earnings risk, and investors have started to price in not only normalisation, post-COVID, but a protracted recession.

It’s easier than it’s been for many years – with the exception of COVID – to construct a portfolio where I think your medium term fundamental returns are double digit, with further upside coming from multiple expansion.

I get it. You’re still bearish. The economy looks worrying. I’m implicitly assuming we don’t get some sort of catastrophic recessionary decade, with high inflation to boot.

And, as I said above, I genuinely don’t know on that front. But that’s why I’ve focused my actual portfolio on resilient businesses. Packaging demand, which Macfarlane serves, is stable through the cycle. S&U, which many will tell me is a cyclical business, is a business which grows its intrinsic value best in poor times. They grew profits through ’08 and ’09, and the downturn in the economy allowed them to write the best loans they ever have, leading to exceptional profitability on the other side. If you can hold through predictably pessimistic market sentiment, it’s a lovely business.

I also own Belvoir, which is somewhat economically sensitive, but beautifully inflation resilient. Their lettings business earns a percentage of rents, their sales business earns a percentage of house prices, and their mortgage business earns a percentage of mortgage volume. There are few businesses which can more easily rebase their earnings to an inflationary environment than this.

Still, a recession will hurt. Recessions always hurt, and so do stock market downturns. You can tell yourself that you’re in resilient businesses and you’re better positioned than most, but you’ll lose money. The question you have to ask yourself is whether you want to let fear of a recession drive you out of positions where you think you’re likely to make strong returns in the medium term. It’s an expected value bet. I take the overarching view that I should be worrying about recessions a lot less when everyone else is (since it’s probably priced in) and a lot more when no-one else cares.

So if you’re feeling lost, look at your portfolio. Form a real view – or, better yet, a range of scenarios – showing where these businesses will be in 5 years’ time. Look through the noise to see that outcome. If you genuinely can’t see a scenario where you’ll make decent money, pack it all in. Either re-jig what you own, or exit the market. I find it very hard to end up there in my universe, but my universe is mine alone, and my broader market opinions are not yours.

In either case – most importantly – let me know in the comments below if you have any ideas you love!


  1. kab60

    Great post as always, Lewis.

    For an outsider, with little knowledge of the UK housebuilding sector, could you expand on your point on the “UK housing supply” being a “broken oligopoly”? I don’t really see why there would be barriers to entry. And do you prefer Bellway due to valuation or how do you rank it qualitatively versus peers?


    • Lewis Robinson

      Let me preface by saying that there are a whole range of opinions on UK housebuilders. Some people think the sector is fine. I think it must be structurally broken. Land prices continue to inflate, houses trade at way over their replacement cost, and our housebuilding sector has earned a 15% RoE over the last decade building a crap product with zero innovation.

      I think it is because of the UK planning system, which is complex and bureaucratic. It is a huge disincentive to innovation and small builders in the space. You don’t know if the parcel of land on which you want to build will get permission – even if it meets all the stated criteria – and it can be held up by local authorities for very long periods of time. This creates lumpiness and unpredictability which you can only get around by being a much larger organisation, with a land department and options agreements over many plots in many regions.

      With the UK housebuilders, you have to wonder how much money they actually make building houses, and how much money they make simply on embedded land price appreciation. Persimmon holds 4-5 years supply of permitted land, and ~7 years supply of ‘strategic’ (i.e., not yet permitted) land in its control. If you are buying land to build on in 8 years, and you make a 20% margin 8 years’ later, how much margin are you actually making on the house – and how much are you simply making because the cost price of your raw land inventory is artificially low?

      This is why I think the real threat to the housebuilders is regulatory, not economic. We saw this in the recent cladding scandal. It was found that there was flammable cladding on many buildings, with many parties potentially responsible. The Government basically pushed all the cost to the housebuilders, because it was the easy option politically. Every prime minister acknowledges that planning needs reform – though none of them do anything about it. Personally, I would favour a land tax and a fairer redistribution of the planning uplift.

      The problem is – people have been making variations of these arguments for ages, and UK governments tend to like rising house prices, as it makes voters happy. So the housebuilders march on, making their supernormal profits with no change and no incentive to improve.

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