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Should investors punish UK stocks as we near ‘hard’ Brexit?

Written by: Paloma Kubiak
The markets failed to predict the Brexit vote and in the aftermath it’s been an uncertain time for UK domestic-facing companies. As we head towards a ‘hard’ Brexit, should investors turn their backs on UK stocks?

Sterling and commercial property were the main victims of the surprise Brexit vote in June 2016. Since then, sterling has recovered some lost ground, commercial property funds have re-opened after temporarily closing and the FTSE 100 has reached record highs.

Darius McDermott, managing director of Chelsea Financial Services, says UK stocks have performed “surprisingly well” on the whole.

“Large caps and small caps are up by 20% and even mid caps – which had the worst sell-off in the immediate aftermath of the referendum – are up 16%,” he says.

Richard Penny, senior fund manager with the High Alpha team at Legal & General Investment Management, agrees. However he cautions that the UK stockmarket is not the UK economy: “The FTSE 100 sources only 24% of its revenues domestically. Domestic demand has held up well anyway, but for overseas earners the weakness of the pound has meant more earnings when dollars are converted back to pounds.”

He adds that commodity price rises and the US interest rate rise have been positive for miners, oil companies and banks.

While the market has performed better than expected, Julian Chillingworth, chief investment officer at Rathbones, says investors have started to penalise UK-focused stocks as Brexit negotiations approach.

“Certain sectors like leisure and retail have underperformed versus other sectors and sterling’s slide down has meant those companies with earnings outside of the UK have bounced quite hard.

“Because of the sterling weakness, in the retail sector clothing could cost substantially more and this will be passed on to the consumer, meaning price inflation, so the consumer may pull back from purchases. This will lead to a slowdown in sales, adding to their problems.”

The impact of Article 50 and ‘hard’ Brexit

McDermott believes investors may be worried for UK stocks after Article 50 is triggered, and as we move towards a ‘hard’ Brexit. However UK domestic equities are possibly the most hated of all equities around the world right now so there is still some value to be found. He adds the good companies will be able to withstand our exit from the EU.

“House builders are probably an area to avoid as are retailers. The latter have done a little better in recent weeks, but consumer debt has continued to grow at an unsustainable level and any growing fears over the economy could easily lead to consumers quickly halting their spending.”

Penny says historically when shares have been at today’s valuations (in P/E terms), they have delivered a 5-6% return over the following three-to-five years. “This is an average number, and of course, outcomes have varied.”

He adds that historical measures suggest the pound is undervalued.

“While this may persist, it is entirely possible that a cheaper pound makes UK companies attractive bid candidates for overseas businesses that can access cheap debt funding and have a shortage of non-acquired growth projects.”

What approach should UK investors take?

Penny adds: “There is a famous quote from Warren Buffett: ‘In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.’  This essentially advocates investing in equities for the long-term. It is quite possible that the UK market will be volatile, so in our view investing a little money each month is a sensible approach.”

He lists the following companies that were impacted by currency movements post-EU referendum: Dixons Carphone, whose shares have been sold down because of sterling weakness; Prudential, which benefits from the dollar and rising interest rates; and First Derivatives, a software business with a UK cost base and growth opportunities in overseas locations.

McDermott says that defensive, more global companies such as Unilever, AstraZeneca and Merlin Entertainment will be able to weather the Brexit storm.

“Unilever is a multi-national company and the vast majority of its earnings come from outside the UK. A weaker sterling is helpful to the company and it’s one of those stocks people like to hold forever. It’s extremely well diversified in terms of products and markets, there is potential for future growth into emerging markets and it has pricing power.

“Astra Zeneca has a good dividend yield (about 4%) and a good and exciting pipeline in oncology. Some 90%-plus of its earnings comes from overseas and the sector as a whole has been out of favour, so it looks better value than the wider market. It has barriers to entry and is less cyclical than many stocks. With a weak sterling it could also be the target of a takeover bid as we have seen before.

“Merlin Entertainment has theme parks all around the world and a solid pipeline of future builds. Only about a third of its revenue comes from the UK. It plays very well to the growth of middle classes in Asia, especially.”

Chillingworth shares the view that investors should consider companies with overseas earnings. He says: “A good balance is to pursue a portfolio of overseas earnings, plus consumer defensive names that are unloved in the major drink brands, personal hygiene goods and companies that are selling other consumer products with most of their sales coming out of the UK.”

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