With the triggering of Brexit already more than 50 days old, the two-year window to officially divorce from the European Union feels more akin to a Usain Bolt sprint than a Mo Farah jog.
As sprinting tends to be more exciting than the longer-distance varieties, it is understandable that the attention of market participants appears to be exclusively focused on the Brexit “event”. Yet, in reality, returns to investors will be driven by underlying fundamentals over a longer time horizon and it seems irrational to expect 65 million people to slump to their knees before they cross the finish line. Or to put it another way, we must adopt the attitude of the marathon runner rather than the sprinter.
As any experienced marathon runner will attest, it is the consistent maintenance of energy levels that gets the best time. Both the government, via fiscal measures, and the Bank of England, via monetary measures, will have a big role to play in this respect, as they want to keep the British population optimistic enough that they can see the big picture but not so overly optimistic that they spend all their fuel. While in a marathon we call it “hitting the wall”, in economic terms we call it a “recession”.
Economy Surprises on the Upside
Many were expecting the economy to hit the wall in the aftermath of Brexit, and have been pleasantly surprised that the economy has continued to run near its desired speed. In fact, the U.K. economy has thus far been quite resilient, growing by 0.5% in the third quarter of 2016, 0.7% in the fourth and 0.3% in the first quarter of 2017 – roughly in line with the average quarterly growth rate since 1955, average has been 0.61%. This, along with a much lower sterling, has seen the U.K. equity market outperform Europe since the Brexit vote.
The problem is that we don’t know the amount of energy a marathon runner will have left at the 22-mile mark. We can gauge the way the runner looks – but more often than not, a blow up can emanate from left field. One can’t get away from this fundamental uncertainty when running for the long-term, and the same can be said for financial markets.
Therefore, while everyone is closely watching for any changes in the way the runner looks, any changes to the economy in the short-term, they could be better placed paying closer attention to the fuel intake and the amount of energy the runner expends relative to that fuel. In financial market terms, we know this as the “fundamentals” and “valuations”.
The Importance of Fundamentals and Valuations
The fundamentals are the baseline that provides the energy or sustenance for the market to keep running beyond the finish line. For U.K. investors, it is things such as return-on-equity, dividend sustainability, payout growth and profit margins. Without them, the U.K. investor risks falling flat on their face.
Valuation, on the other hand, is the amount of energy a runner expends relative to the fuel they have. We have all seen those dreaded moments where a runner gets the fuel intake right but goes too hard during the big event and runs out of steam. In financial terms, this can be best gauged as the price relative to the fundamentals, including an assessment of ratios such as the cyclically adjusted price to earnings (CAPE), price to free cash-flow (PCF) as well as any other value metric. The idea is that the harder a runner perspires relative to their fuel, the more likely they are to run out of energy.
Getting Practical
Turning the analogy to the prospects for the U.K. equity market, we will avoid any comment on the short-term outlook for the economy but will instead focus on what we believe is more important - the long-term fundamentals and valuations.
On the fundamental front, return on equity and profit margins have been known drags for U.K. investors in recent times and are currently lagging behind the world average by approximately 2.5% each over the past year. While the composition of the U.K. market means we would not necessarily expect this to ‘normalise’ relative to global averages, we do need to acknowledge that these metrics tend to have mean-reverting properties and may go some way in explaining the inferior earnings cycle. To say this in the context of Brexit, ‘normal’ profitability metrics in the U.K. could see stronger earnings numbers and fundamentally offset any downside risk to revenues.
On the valuation side, the U.K. also appears to be keeping a reasonably steady pace, relative to its fundamental baseline, while other key markets such as the U.S. continue to sprint ahead. This is reflected in our valuation-implied return framework below, where we see the relative attractiveness of the U.K. to other developed markets. While it is wise to factor in the uncertainties Brexit brings – including the currency implications – we find a margin of safety continues to exist.
