With Brexit continuing to be a major fundamental risk to the economic and equity market outlook, nervousness is taking hold and outflows are persisting. This comes at a sensitive time as some economists predict an impending global downturn, often citing trade wars, a global housing slump, high household debt, an inverted yield curve in the US and cyclically-high corporate profits.
But, we believe true investment risk is a function of three key inputs: valuations – overpaying for an asset, fundamentals – asset quality deteriorates, and financing – gearing, redemptions, crowded trades.
Let’s bring this to the present discussion, where we find UK equities to be somewhere between 30% to 45% cheaper than the US market on a combination of valuation metrics. Asset quality in the UK has a long history of durability, and we see no evidence of change. Leverage is under control and below pre-crisis levels. Plus, excitedly for our contrarian hearts, it is one of the least crowded trades in the marketplace.
Valuation Risks
Let’s start with the fun realities. What if we said that the UK is not only cheaper than the US, China, and Switzerland, but also Portugal, Ireland, and even Mexico.
Most prominently, the UK market is often considered a combination of the multinationals, which derive approximately 70% of revenues offshore, and those lower down the market capitalisation scale, which are far more domestic-oriented and derive closer to 40% offshore. Based on current valuations, we note that the UK opportunity is most pronounced among the multinationals, especially given the added benefit of a currency buffer.
Corporate Profits vs. GDP
The first thing to acknowledge about the fundamentals is that the UK economy is not the UK equity market. We do not need to predict the UK economy to know what might happen to UK stocks. In fact, we are avid believers in anti-forecasting, resisting the urge to predict and preferring to look instead at what is actually happening to the drivers of those returns.
In this sense, revenue and profit growth of UK companies have lagged global peers in the recent past, however remain fundamentally durable.
One should also remember that a lot of the prior earnings declines were wrapped up in commodity price weakness affecting large energy and mining companies, which now account for a smaller portion of the UK stock market. One can also see that the Brexit vote has had a muted impact on company fundamentals thus far.
Leverage and Turnover Risks
A lot of hype surrounds the high levels of household debt and the flow-on effects this could have on the banks. This is a valid concern, but it is important to reiterate as a global phenomenon rather than an isolated one. What we really care about here is the health of corporate Britain. We can measure this in many ways, but one of the more effective ways is to look at the difference between profit margins and return on equity.
Specifically, a high ROE relative to profit margins can raise alarm bells about any underlying leverage or turnover risk. As you can see below, in the UK we simply don’t see this risk.
The UK as One of the Least Crowded Trades
Last, we want to show the extent of the dislike and fear being priced into the UK market. We believe that the most dangerous time to be invested in a market is when optimism meets disappointment. We rarely know when the disappointment will hit, but we do know when investors are overzealous.
One of the more well-defined ways to judge this is to assess fund flows. The majority of individuals are increasingly moving their investments away from the UK equity market, likely meaning that largely value-oriented and institutional investors are on the other side of the trade.
From the data, we recognise significant concern is getting priced into assets by these investors, which offers the potential for an independent investor to go against the herd and patiently wait for the masses to return. Moreover, as the supply of these assets exceeds demand, we have the opportunity to buy them at a discount.
The Dangers of Brexit
Given the unprecedented nature of Brexit, many investors are understandably erring on the side of caution. This means they are inclined to invest elsewhere, which is no doubt influenced by the noise of daily politics.
Yet, the truth is that the Brexit uncertainty is well recognised, so while people are confused on how to price it, we have reason to believe it is a fear-driven response.
What people ought to be thinking about:
- Domestic profit margins could compress on the back of stagnating sales and higher import costs
- Dividends could become unsustainable, as payout ratios are already high
- Investors could price in a structural de-rating of quality, which could increase the cost of equity
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. 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.
While nothing is certain, there is sufficient reason to believe that permanent impairment of the equity market is unlikely. Fundamental uncertainty is ever-present, but often overhyped. While the economic relationship with the UK’s largest trading partner will remain unclear for some time, we are pragmatically and patiently positive on multinational UK equities.
