UK investors are being forced to contemplate some incredibly difficult decisions. With Brexit a major fundamental risk to the economic and equity market outlook, nervousness is taking hold and outflows are mounting.
This comes at a sensitive time as the Bank of England recently voted 7-2 to raise interest rates for the first time in 10 years. The question is whether this is more likely to reflect a contrarian opportunity or a justified concern.
Speculation and volatility are friends to a valuation-driven investor. Without them, contrarian opportunities cease to exist. We also know that speculation is typically driven by an emotional response, often misjudged and to the detriment of good intentions. For this reason, a rational investor should be trained to view fear as opportunity to capitalise on overreactions to risk.
We can assess fear in several ways, but one of the more well-defined ways on our contrarian checklist is to assess fund flows. The majority of individuals are increasingly moving their investments away from the UK.
Valuations Under the Microscope
Valuation-implied returns are improving. The UK multinationals have become more attractive in recent months and the UK now tops our list of the major equity markets.
The UK market is often considered a combination of the FTSE 100 and the FTSE 250. These are the top 100 companies, which are primarily multinationals, derive approximately 70% of revenues offshore, and the next 250 biggest companies, which are domestic-oriented derive closer to 40% offshore. The two of these are best considered separately, as they each have distinctive fundamental drivers.
We have a strong reason to believe that multinational earnings have been hampered by factors outside the realms of Brexit. External influences, including the commodity price slump and banking concerns, may no longer impact earnings in a forward-looking context.
For example, by splitting the market into multinationals and domestics, we know that a major restraint of FTSE 100 companies, especially relative to FTSE 250 companies, has been the lack of progression in profit margins. The FTSE 100 has experienced a significant decline, acting as a headwind to earnings, while the FTSE 250 has experienced a gradual improvement in margins, acting as a tailwind to earnings.
The importance of this development in profit margins should not be underestimated, as the rate and level of any reversion influences our conviction. For instance, if the impact of the commodity price decline unwinds and margins in FTSE 100 companies rise back to global norms gradually over the next decade, earnings growth will likely accelerate and should support share-price growth. Yet, if they stagnate – or worse, deteriorate further – earnings could slump and put prices under pressure.
The Dangers of Brexit
Given the unprecedented nature of Brexit, many investors struggle to comprehend how to price it into asset values. The fund flows appear to show that managed fund and ETF investors are erring on the side of caution and investing elsewhere, which is no doubt influenced by the noise of daily politics.
However, what would happen if these investors instead focused on the fundamental inputs? For example, what if they considered the downside risk Brexit could have by looking at domestic profit margins? How likely is it that pay-out growth becomes permanently impaired? And most importantly, how much is already priced into assets? By thinking about these inputs comprehensively, one can overlay the dangers Brexit may pose and conduct scenario analysis to help articulate whether a margin of safety exists in current prices.
In assessing this, we believe the below are reasonably well recognised as being among the key risks:
- A lack of confidence in the UK economy could result in capital outflows and reduced investment
- The labour force could fall, and household consumption could decline, lowering domestic revenues
- Profit margins could compress on the back of lower sales and higher import costs
- Dividends could become unsustainable, as pay-out ratios are already high
- Investors could price in a de-rating of quality, which could increase the cost of equity
- Exports to Europe could be hampered by higher tariffs, and imports could become more expensive due to a lower sterling
The overall intention in undertaking this analysis is not to scare oneself out of an asset, but to better grasp the potential range of outcomes and understand reward for risk. Doing this puts an investor in a good position to take a probabilistic view of whether the fear of Brexit is warranted or not.
While nothing is certain, there is sufficient reason to believe that permanent impairment is unlikely. This acknowledges that a short-term impairment is distinctly possible following Brexit, but the UK is not about to structurally decline forever.
Drawing Conclusions
The first thing to acknowledge is that the UK economy is not the UK equity market. Approximately 70% of the FTSE 100’s earnings come from overseas, and one must appreciate that the fundamentals of corporate Britain have been reasonably resilient. If anything, earnings of the FTSE 100 have actually started to rebound in 2017 after steadily falling by as much as 20% in the five years prior.
When reflecting on this earnings upside, one should also remember that a lot of the prior earnings decline was wrapped up in the commodity price weakness affecting large energy and mining companies, as well as a struggling banking sector, and had nothing to do with the Brexit vote.
The last, and most important, point is to acknowledge valuations. As investors become fearful, we should be trained to see opportunity. Sentiment has clearly turned negative for the multinationals, and this negativity is being priced into the asset class. Therefore, while the economic relationship with the UK’s largest trading partner will remain unclear for some time, we are pragmatically and patiently growing more positive on multinational UK equities.
