One of Warren Buffett’s most famous investment sayings is “Be fearful when others are greedy. Be greedy when others are fearful.” If this sentiment is true, then one would assume the UK is offering a smorgasbord of investment opportunities.
The pound is hovering at its lowest level in 10 years – with the exception of 2016/2017 when the implications of the Brexit vote started to trickle through.
At the same time the UK’s large-cap index, the FTSE 100, a good barometer of market sentiment, has fallen sharply from its May 2018 highs.
Driving the negative sentiment is the ongoing political paralysis over Brexit and the possibility of a no-deal scenario that could yet cause challenges for the UK as well as European and world economies. Investors, already spooked by US and China trade tensions, have responded by selling out of sterling and the FTSE.
Yet the UK economy continues to tick along, albeit not at the speed of the US economy. It grew at 1.3% in 2018, and the European Commission predicts 1.2% growth for the coming year.
While the journey to the March 29 deadline for Brexit negotiations will continue to be a thrill ride no UK citizen anticipated, global investors are watching events with interest.
“We have a larger exposure to UK market than many of our peers, but I would not say that we have taken a massive bet,” says Douw Steenekamp, portfolio manager, global equities at Denker Capital. “The Brexit negotiations will be crucial. Politicians appear to be playing high stakes poker. A nation’s biggest trading partners are those that are closest to it. This fantasy that the UK can replace the EU with Japan, Australia or even the USA is just crazy.
“If UK plunges out of the EU it will not be good news in the short term; if they tear up article 50 and remain part of the EU, the market and currency will rebound; and the middle road – an extension of the deadline to May will just prolong the uncertainty.”
As a result of the uncertainty, some stocks have been derated to the point that they are looking attractive.
“If one looks at the broader market on a price-to-book basis, it has been this cheap less than 10% of the time over the last 20 years,” says Nic Norman-Smith, CIO at Lentus Asset Management. “And every time it has been this cheap, the market has followed with solid returns over the next five-year period, historically by between 5% and 10% per annum
“We don’t know how this will play out, but it does seem that some of the negative outcomes are now priced in.”
‘You need to dig deep’
Zain Wilson, a portfolio manager at Old Mutual MacroSolutions, adds that while the market looks cheap it is not a wholesale buying opportunity. “Often, when assets are cheap they are cheap for a reason. There are opportunities in the UK, but you need to dig deep to find them.”
Like the JSE Top 40, the FTSE 100 is not an accurate reflection of the UK economy. Many of the large-cap stocks listed in the UK are global companies that are not that exposed to the underlying UK economy. Unilever, for instance, generates 5% of global sales in the UK, BP even less.
The FTSE 250, home to more mid-cap and domestically focused stocks, is a better reflection of the UK market. It fell 25% between June and December last year, before rebounding slightly in January, compared to the FTSE 100, which fell 17% in the same period. “The whole market has come under pressure, which is somewhat illogical, but UK stocks have been hammered worse,” says Steenekamp.
“At the end of the day, it comes down to your investment horizon and appetite for risk. In the short-term, it is a bit of a binary decision, based on the outcome of Brexit, but in the longer-term, it might just present an attractive opportunity.”
In the short term, his preference is to avoid companies that are tightly integrated into European supply chains such as motor component manufacturers whose principals are in Europe or companies that supply components to Airbus, like Rolls Royce.
UK companies that export and can benefit from the cheaper pound, or which occupy niche positions in the domestic economy, are attractive.
One example is Victrex, a spinoff from ICI in 1993 and now one of the world’s largest suppliers of high-performance polymers. “The share has fallen in a heap [45% since October] and we are watching it closely,” says Steenekamp.
Another is UK homebuilder Taylor Wimpey whose share fell 58% last year but has recovered and is down 24% down on last year’s high. “This company is dependant on the UK economy, but the UK homebuilding industry is perennially undersupplied – land is scarce and planning permission is slow. So the industry has a structural underpin which is attractive if one takes a longer-term view.”
Globally banks are quite cheap, but in the UK this is more pronounced. “A rally in the pound would support UK banks, as would a rise in interest rates,” says Wilson. However, he is concerned that over a five-year view the UK consumer does not look great. “Leverage is high, the retail savings rate is at its lowest in 30 years and public sector spending has been tightening. It’s hard to see what levers will drive a strong consumer recovery.
“It goes without saying that the only banks worth looking at are those with strong capital levels and good balance sheets.”
Look for the less vulnerable
Lentus, says Norman-Smith, is invested in external facing companies – such as those in oil, tobacco and consumer staples – which are less vulnerable to any UK domestic blues. But it is also invested in selected domestic stocks, such as retailers Sainsburys and Marks & Spencer.
“Not all retailers are offering value, but these have a food component, strong brands and have been heavily derated which provides some downside protection even if things do prove to be tough,” Norman-Smith says. “When everything is as negative as it is, it doesn’t take much to spur a rerating.”
However, of the sectors facing challenges that have nothing to do with Brexit, retail is one. “There is massive disruption underway in the UK retail sector,” says Wilson. “Online penetration has gone from 10% to 25% in 10 years, it’s one of the highest penetration rates in the world. Valuations are cheap, but it’s hard to get excited about retail.”
It’s clear that while lower prices offer opportunity in the UK, getting it right is not as simple as just picking the index.
Read: Brexit: What happens next?