Is the UK still a contrarian bet for DFMs?

Investment industry reveals stocks and funds it’s picking in Brexit fog

The wave of uncertainty unleashed by the Brexit referendum on 23 June 2016 has crashed over the UK’s domestic economy and stockmarket, leaving fund selectors wondering if now is a good time to invest in UK assets.

Since the vote, politicians have been playing fast and loose with the country’s future: the European Union withdrawal agreement has been rejected three times and the date of departure has been pushed back – yet again – to 31 October 2019. This has left the country’s fate unclear.

The ongoing chaos in government over the negotiation of the withdrawal agreement has dominated investors’ thinking towards the UK. Some are deliberately avoiding the arena altogether because of the uncertainty, while others see opportunities to pick up cheap assets.

Split decision

The FTSE 100 Index includes the largest companies listed in the UK and is known for its international exposure, but despite deriving a quarter of its revenue from the domestic economy, it has done well as sterling has suffered.

Meanwhile, the FTSE Local, made up of large- and mid-cap firms that generate 70% of their revenues from the UK, has struggled over the past few years. This is largely due to Brexit, the upheaval in domestic politics, low productivity and cautious consumers.

Ahmer Tirmizi, investment manager at 7IM, says companies that are exposed to the UK will remain under pressure from domestic headwinds for the foreseeable future and as such believes it is best to seek opportunities elsewhere.

“The recovery in global equities has been strong. While we remain constructive on global equities, we are still cautious on UK equities despite the global nature of the FTSE 100,” he says.

“Until some of the domestic political and macro headwinds have subsided, we prefer Japan and emerging markets over the UK.” However, according to the latest quarterly asset allocation survey by Last Word Research, fund buyers were showing a growing confidence in UK equities in Q1 of this year with more than half expecting to increase their UK equity allocations over the coming 12 months.

Source: Last Word Research

Caution remains, however, with Ryan Hughes, head of active portfolios at AJ Bell, sitting on the fence when it comes to making a specific call on the UK, opting for a broader approach to the asset class.

He says: “It is important to try and disassociate events at a political level from a corporate level. It is easy to be overcome with the emotion of politics and Brexit and forget that good companies are simply carrying on, delivering profits and paying dividends.

“At the same time, it feels almost impossible to try and predict what will happen with Brexit. I prefer to look at fundamentals and valuation from an investment perspective, still making the UK market an attractive place to invest in my opinion.”

Hughes explains it is difficult to ignore the impact of currency, particularly when looking at companies in the FTSE 100 where investors have benefited from sterling weakness in the years following the referendum.

“As a result, we have continued to take a fairly broad approach to the UK with exposure to defensive large caps through the Troy Trojan Income Fund and core large caps via Investec UK Alpha,” he says.

“Recognising there is likely to be some volatility, we also hold the Man GLG Undervalued Assets Fund, which is multi-cap and quite pragmatic in its approach with a little more emphasis on trading.”

Clarity brings opportunity

Investec Diversified Income Fund portfolio manager John Stopford argues that the ongoing uncertainty around Brexit has made it difficult to allocate significant exposure at this stage.

“We think there will likely be a buying opportunity once the outcome becomes clear. A soft Brexit or no Brexit is expected to favour domestic exposure, which generally offers value, but would probably see some further sterling recovery, which would act as a drag on the share price performance of multinational firms.”

By contrast, Stopford says, a hard Brexit would be expected to cause sterling to weaken and would hurt the UK’s near-term growth opportunities, favouring the multinationals over domestic plays.

“After a short while, however, we would expect investors to look for oversold opportunities in the UK and add exposure,” he adds.

Therefore, Stopford has limited exposure to the UK while the “uncertainty persists” and more balanced international and domestic exposure, “leaving us less vulnerable to the shifting sentiment around Brexit”.

“Ultimately, we prefer to take a patient approach, waiting for greater clarity, before potentially adding more to UK equity positions,” he says.

But not everyone is as cautious.

Home and away

Self-confessed contrarian investor Alex Wright (pictured), portfolio manager of the Fidelity Special Situations Fund and Special Values Investment Trust, believes opportunities can be found across the market, among international as well as domestic businesses.

“Following the further deterioration in sentiment towards the UK in Q4, I increased exposure to domestic UK stocks, recycling capital primarily from US-facing businesses. We now have 33% of portfolio revenues from the UK, an 8% overweight relative to the FTSE All Share.

“We continue to hold positions in the UK banks. However, position sizes reflect the fact that while trading at attractive valuations, banks are cyclical and have been in a relatively benign environment for loan loss provisions.”

Similarly, Oliver Brown, investment director at RC Brown Investment Management, argues that there are opportunities in the UK to pick up a few bargains.

“The UK market is cheap relative to other developed markets largely due to the Brexit fog. If you believe in a UK recovery then buying the UK domestic names, many of which are mid and small caps, would be a sensible strategy,” he says.

“We do see value emerging in the UK with domestic-focused large caps such as Lloyds and RBS. Also, Sainsbury’s is on a lowly valuation following the collapse of its merger with Asda. Having just announced an 8% dividend rise and a yield of 5%, this represents solid value and a way of playing domestic UK exposure.”

Despite limited exposure to the UK, Stopford also believes some of the banks are looking favourable.

“We are stockpickers and look for companies with a reasonable yield, supported by resilient cash flows, which are attractively priced. Domestically, we see opportunities in names such as Lloyds and Next, while holding internationally exposed names such as GSK and Unilever, as well as some positions in mining and energy.”

Meanwhile, Brown also highlights the upcoming IPO of Essensys, a software provider for the management of serviced, multi-occupancy shared offices which is going public to raise money for expansion.

“It is a company we expect to perform well,” he adds.

Quality over quantity

There are other opportunities in the UK aside from the banks, Wright tells Portfolio Adviser.

He owns three UK life insurers – Phoenix Group, Aviva and L&G – where the average dividend yield for 2019 is over 6%. This is well above historic averages “reflecting the market’s concerns around asset quality and the effect of widening credit spreads on balance sheets”.

Wright explains that work done by Fidelity’s insurance specialist suggests the assets held by UK life insurers are significantly higher quality and more internationally diversified than the market is discounting.

“The dividends should be payable even in a downturn, and the long-term growth opportunities for the life insurance sector remain attractive, both in terms of organic growth and consolidation,” he says.

Build or bust

While the UK has some buying opportunities available, managers have argued that housebuilders and retailers are sectors to steer clear of, with or without Brexit.

Wright says he continues to avoid UK housebuilders as most have all-time high profit margins, which gives them significant operational leverage to any deterioration in demand for new houses.

“I prefer the two Irish builders Cairn and Glenveagh, which enjoy significantly better industry fundamentals, rising returns, and lower valuations,” he adds.

“An Irish recession caused by Brexit remains a risk, though given most of Ireland’s trade with the UK is in agricultural products, the Irish economy may prove more resilient than many seem to think.

“We continue to tread cautiously among the retailers, where low valuations give us no comfort if we feel the business is structurally compromised.

“As a contrarian, some clients seem to expect me to have a higher weighting to this sector. However, with such a wealth of valuation opportunities across the market, there is no need to buy structurally compromised businesses. There are much more attractive opportunities elsewhere.”

Brown adds: “I would continue to avoid high-street retailers and am yet to be convinced that housebuilders have reached attractive enough levels following a period of above-average margins aided by the government’s help-to-buy scheme.”

That said, Brown says that Watches of Switzerland, best known as the owner of Mappin & Webb jewellers, recently launched on the stockmarket and looks like an exciting prospect despite the difficult retail environment.

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