A Brexit bargain
“You can be highly selective in UK equities today. You don’t need to compromise, really, on quality because there’s so much value around”
Brexit uncertainty does not diminish the fact the UK continues to be one of the most important equity markets in the world.
Its significance has been overlooked of late as foreign investors have shunned UK equities following the shock referendum result in June 2016, with investors leaving the asset class in their droves after the UK voted to leave Europe. According to the most recent figures from the Investment Association, around £2.1 billion was pulled from UK funds in November 2018, the worst month since the Brexit vote. This outflow lifted total withdrawals since the referendum to above £10 billion.
Those stocks more sensitive to the health of the UK economy have been hit hardest, with the local index comprising of stocks that generate the lion’s share of their revenue domestically losing up to a fifth of their value following the vote. After the huge de-rating of UK stocks last year as the prospect of a ‘no-deal’ Brexit grew, some commentators noted UK shares were trading at their cheapest valuation for almost 100 years. The FTSE All Share yielded 4.3% in February and gilts 1.2%, the biggest yield gap since the First World War.
UK equities: a value opportunity?
Cyclically-adjusted price/earnings (index price to 10-year average real earnings per share)*
**SOURCE: MORGAN STANLEY. PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE RESULTS.
RIPE FOR PICKING
This value opportunity has not escaped the attention of Allianz Global Investors portfolio manager Matthew Tillett, who manages the Allianz UK Opportunities fund. ‘If you look on a long-term view, the relative valuation is at 30-year lows versus the rest of the world. Part of that is to do with the index composition. We tend to over-index in some of the “sunset industries” that have been less in demand in recent years,’ he says.
‘UK equity values are at 30-year lows versus the rest of the world. Obviously, the other factor is the Brexit effect, which has led to significant outflows from the asset class and significant under performance of the domestic area of the stock market. That makes it quite interesting. You can be highly selective in UK equities today. You don’t need to compromise, really, on quality because there’s so much value around.’
While the broader international investment community has dumped UK equities over the past few years, closer to home, UK wealth managers have maintained meaningful exposure to the market. Aberdeen Standard Capital head of investments Darren Ripton is ‘cautiously optimistic’ on UK equities, especially on a long-term perspective in sterling terms.
‘If you look at it from a very long-term perspective, so 10-plus years, and you look at the valuations today and the expected returns you can get from UK equities over the next 10 years, they look very attractive on that basis,’ he says.
UK equities play a core role across the portfolios managed by EQ Investors, with the FTSE constituents’ global reach a major influence behind this allocation. ‘Within UK equities, you’ve got a lot of international revenues, whether you’re talking about large caps with about 70% overseas revenue or, indeed, midcaps with around 50% overseas revenue,’ EQ portfolio manager Kasim Zafar says.
Traditionally there has been a domestic bias towards UK equities in the global portfolios of wealth managers, with the security of sterling exposure a factor behind this. But with the pound crashing around on Brexit uncertainty and a plethora of companies now earning revenues overseas, the case for this leaning is perhaps not as compelling as it once was.
While taking into account this evolution, UK shares remain a key cog in the sterling portfolios run out of Barclays. ‘UK equities are a core part of our domestic clients’ sterling portfolios,’ says Barclays portfolio manager Stephen Peters. ‘The UK exposure has historically been focused on the larger-sized companies within the UK market and, generally, invested on a more strategic basis than a tactical basis.’
While Connor Broadley Wealth Management chief investment officer Chris Wyllie is overweight UK equities, running an 18% position in medium and high-growth mandates, he does not believe UK shares should be the default option in portfolios. ‘We take the view they don’t have any birth right to be in portfolios strategically and we look at the world as global investors. Tactically, we are quite interested in UK equities at the moment and we are overweight what we would normally have,’ Wyllie says.
‘There are two reasons why people tend to over-represent UK equities in their portfolios. First of all, the currency argument, which I think is open to misunderstanding because, actually, foreign exposure is a good risk hedge in portfolios. The other reason, which might be a bit controversial, is because UK equities are large in most UK wealth manager portfolios because most asset allocation in these houses is done by UK stock-pickers.’
Brooks Macdonald investment director Michael Toolan agrees the UK does not have a right to be the core element of a portfolio. However, in a similar vein to Zafar, the international reach of market means it serves as a pillar to his firm’s portfolios. ‘You can build your UK exposure in different ways, depending on different client requirements and objectives, starting with core equity income products with a healthy dividend yield and the healthy dividend growth, if you choose the right managers around that,’ he explains.
After the slump in the pound, Coutts associate director of fund research and investment strategy, Edward Heath-Thompson, is more than happy to have a home bias currently, with his balanced and growth portfolios running exposures of 20% and 30% respectively. ‘We are actually overweight UK equities. The reason we’re doing that is we’re not just buying large-cap, we’re not just buying trackers, we have a strong view that sterling is undervalued and we want to play that via UK equities,’ he says.
TUNING OUT BREXIT
Yet for all this measured confidence in UK equities, it is impossible to ignore the elephant in the room: Brexit. Three years on from the referendum vote, the world is none the wiser on what the UK’s exit from Europe will look like and whether it can strike a favourable trade deal with the continent, let alone those nations beyond it.
The uncertainty has put British companies under pressure, with many building contingency plans to protect their interests.
Wealth managers, while not exactly deaf to Brexit, are not allowing all the noise to sway them from their conviction in UK equities.
Tillett does not believe we will see a market shock similar to the one experienced in the aftermath of the vote three years ago, when the stock market and pound crashed during a period of severe turbulence over a two-month period. ‘One of the big differences between where we are today and what happened in 2016 is, back then, it was a big shock to everyone and it was not priced in, which is why a lot of active fund managers got hit by Brexit, whereas today the situation is more evolutionary.’
Peters does not believe fund managers will repeat the mistakes of the past. ‘I think people are quite keen to learn the lessons of 2016. My perception is that a lot of active managers investing in the UK weren’t correctly positioned, and the subsequent months were quite painful for fund performance. We want to watch and wait and not have too extreme a position until we have greater political clarity.’
From a political news-flow perspective, Toolan feels markets are fairly efficiently priced based on the current information available. However, he warns that while the risk factor has created some value in UK equities that are not present in other markets, those who pile in could end up looking silly. ‘This isn’t the sort of market to try and be a hero in because you could easily be on the wrong side of it, as was demonstrated a couple of years ago,’ he warns. ‘None of us have any more expertise in relying on or working out the way politicians are going to go.’
Mazars Wealth Management senior economist George Lagarias views a hard Brexit as a 5%-to-10% downside event, but admits ‘the reality is, you cannot price in a tail risk. No one has ever done this successfully. So, it’s very difficult to say we think everything is priced in. Once you get into that tail, things start to look weird.’
Zafar has four funds in his UK equity portfolio, all of which play a role to ensure his exposure is not too heavily skewed one way to a particular Brexit eventuality. ‘We’ve taken a very active approach to not have a significant bet one way or the other,’ he explains So, by looking through our portfolio manager holdings and tweaking our portfolio allocations to them, we have made sure we’re balanced across sectors, across market caps and across investment styles so we’re as neutral as we can possibly be when it comes to UK equities. Because we don’t think the outcome to Brexit is predictable.’
While parliament is still trying to figure out exactly how it will leave Europe, Wyllie believes it is possible to make some reasonable assumptions. ‘One is that most outcomes are likely to be mildly positive for the pound [so] we have raised exposure to UK equities, but we’ve also been hedging out the forex and the international equities, which I think is really important and, arguably, the cleanest way of doing it,’ he says. ‘The best thing we’ve done this year so far is to buy more European equities hedged into sterling.’
Tillett does not base his investment decisions on what direction the pound may take, although it is something he is cognisant of when putting his portfolio together. ‘Any active UK fund manager has to know what their domestic exposure is. That’s really the factor you’ve got to be aware of, because if the currency moves aggressively one way and you’ve got loads more domestic earnings than you realised, that’s going to affect you. I think that’s what happened after the referendum vote.’
UK shares may offer some of the best bargains on the market at the moment, but trying to convince asset allocation committees to commit significant money to the country is a challenge at the moment. Wyllie believes that when a catalyst – which is likely to be a positive outcome to Brexit negotiations –arrives, a flood of money could return to UK equities.
Peters is adopting a wait-and-see approach before upping his conviction towards UK shares. ‘The house view is a preference for an asset class that was pretty unloved for a couple of years and has rehabilitated itself in the mind of investors since, with a bit more of a preference for domestic European equities over the UK from a global asset allocation perspective,’ he says.
‘I would imagine some certainty after a period of flux would see UK equities become more attractive to equity investors and private equity investors, but we’ll see what happens.’