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OPINION

Brexit: Reality check

Brexit: Reality check
June 28, 2016
Brexit: Reality check

What was not widely anticipated in financial markets, which had rallied in the run-up to the EU referendum, was that the Leave vote would actually win the day. Indeed, investors who wagered over £100m on the result on Betfair’s betting exchange had driven the odds of a remain win to a ‘racing certainty’ seven to one on probability as the voting closed. When the stakes are so high, the fallout is always more extreme especially when sentiment is weighed down by a multitude of factors, some of which are not mutually exclusive, but all of which increase uncertainty, the one thing markets hate most.

For starters, it’s unclear who will lead the Conservatives into negotiations with Europe over the UK’s exit, or for that matter how the country will fare when it goes it alone. The political instability is not just Tory centric as calls for the resignation of Labour party leader Jeremy Corbyn are mounting by the day. It’s also unclear whether other EU states will follow the lead of the UK and call for a referendum on their membership, so heightening the risk of both political and economic contagion spreading across the Eurozone.

Indeed, recent surveys show that levels of euro-scepticism in France and Spain are even greater than those in the UK, and rightwing parties in the Netherlands and Italy have not only praised the UK’s decision, but given hints of follow-on referendums. The risk is that an EU exit of a member state of the euro and Schengen agreement would dramatically shorten the odds of a break-up of the European project, and one that carries significantly greater risk to financial markets than the UK’s vote to leave. We don’t have to look far back in recent history to see how markets reacted to this possibility as the euro crisis in 2011 and 2012 is still fresh in the memory. Interestingly, the falls in European stock markets post the Brexit result have been far greater than in the UK, partly a reflection of the high level of imports flowing into the UK and the risk to these trade flows, but also perhaps a reflection that investors are now considering the risk of political turmoil spreading across the region.

A more pressing concern for investors in UK equities is whether or not these uncertainties will lead businesses to rein in investment decisions, postponing them until they can plan with greater certainty; make consumers more cautious as they did post the Lehman’s banking crisis and stock market crash in the autumn of 2008; and dampen demand to such an extent that the Brexit shock pushes the UK economy into recession as some economists predict even if it’s only a technical one. Given the level of uncertainty, expect the spike in volatility to continue for some time yet, an environment that also offers favourable investment opportunities as well as shares worth avoiding.

Currency market rout

There is also the issue of foreign exchange movements and the 11.5 per cent devaluation of sterling against the US dollar, and 7.7 per cent decline against the euro since early Friday morning. If the falls were contained at current levels then frankly there is not an issue here as the cross rate with the single currency is only back to where it was in the spring of 2014, although it’s now at its lowest level against the greenback since 1985. However, the risk to thousands of businesses is that sterling continues to fall. That may be great news for UK exporters, but it also increases import costs and not all companies will be able to pass these on.

General retailers and food retailers are most exposed as they may have to face the triple whammy of an economic slowdown if both business and consumer confidence is undermined by the Brexit result, softening retail sales as a result, and slowing real wage inflation. To compound matters, they are competing in cut-throat retail conditions which limit their ability to pass on higher input prices. It seems inevitable to me that 'Brexit' profit warnings will emerge from a host of large retailers over the rest of this year as margins take a hit. I would also flag up that logistics costs are a major factor in the variable overheads of retailers. That’s worth bearing in mind given that the sterling cost of a barrel of oil has increased by 3.5 per cent since last Friday, adding further margin pressure.

But as always it's reaching a balance between price and trading prospects to determine whether the savage de-ratings we have seen have gone too far. Interestingly, although share prices in car dealers have gone into reverse, another proxy for the health of the economy and consumer confidence, it’s worth pointing out that the currency gains made on millions of new cars shipped over from Europe to the UK in 2014 and 2015 when sterling was strong against the euro, helped boost the profits of the large carmakers, and German and French ones in particular. True, UK consumers were offered cheap finance deals subsidised by carmakers, but the strength in sterling did not lead to a commensurate drop in dealership prices. In other words, there is a ‘margin’ here that the carmakers can absorb as sterling retreats against the euro. I also feel that if the impact on consumer confidence from the Brexit vote is not as bad as the share price markdowns imply, then the heavily asset-backed and lowly rated UK car dealers are being seriously undervalued.

To put the ratings into perspective, shares in Cambria Automobiles (CAMB:62p) have lost a quarter of their value in the past seven weeks and are now rated on 7.5 times earnings for the year to end August 2016 and 60 per cent of the share price is backed by leasehold and freehold property. Vertu Motors (VTU:41.75p) has freehold and leasehold property worth £158m on its balance sheet equating to 39p a share, and net funds of around £12m, worth a further 3p a share. This means cash and property backs its market capitalisation in full. The shares have fallen by a third since investors backed a £35m share placing at 62.5p in March and are rated on a miserly 6.5 times last year’s earnings. That’s a recessionary rating. If you can ride out the short-term volatility I would be a buyer not a seller of both companies at this level.

Gilt yields plunge

Forecasts of a UK economic slowdown have dramatically shortened the odds of the Bank of England’s monetary policy committee (MPC) restarting its quantitative easing programmes and cutting bank base rate too. Indeed, some economists believe further easing could happen as early as August’s meeting of the MPC. The fact that 10-year gilt yields have fallen below 1 per cent, their lowest level on record, is a fairly accurate signal of what the money markets are expecting.

The sharp move in government bond yields, coupled with expectations of weaker economic conditions, may be good news for homeowners on tracker mortgages, but not for banks’ net interest margins as it makes life far harder to make profits. UK banks and the FTSE 350 housebuilders have been two of the worst performing sectors since Friday, registering eye-watering falls in excess of 40 per cent and 33 per cent, respectively. Airlines have fared little better, not helped by a profit warning from budget carrier EasyJet (ESJ). The point here is that consumer-facing cyclical companies, with high UK sales exposure, are most exposed to any deterioration in the domestic economy, a risk I highlighted in a Brexit equity market overview last month. Investors are likely to remain cautious in the near term, but at these distressed levels I feel bottom fishers in the listed housebuilders in particular should do very well.

How much of the share price drops can be attributed to hedge fund short-selling activity will become clearer in time, but the scale of the markdowns has potential to create a negative wealth effect across the market and one that can only increase the likelihood of the Bank of England loosening monetary policy in the coming months. Talk of rate tightening by some commentators in a risk-off environment in response to currency-induced inflation on UK imports is hugely wide of the mark.

Further monetary easing is worth noting for bargain hunters in the Reit sector, which has been derated by around 23 per cent since last Friday and now trades a third below spot net asset value. With leverage levels low, Brexit likely to reduce demand for speculative development, sterling’s devaluation supportive of inward investment and government bond yields now likely to remain 'lower for longer', then current valuations are already discounting a massive yield shift which is highly unlikely to materialise.

M&A activity set to spike

Another point worth raising with regards to the devaluation of sterling is that it makes UK assets far more attractively priced to international buyers. I would anticipate a spate of merger and acquisition activity if the falls in sterling we have seen turn into a rout, especially in sectors that are Brexit winners. Primarily, I can see an uptick in corporate activity targeted at companies in the technology, healthcare and industrial sectors where bid targets have heavy transactional exposure. Namely, whereby revenues are earned in dollars but costs are in sterling, so a sharp fall in sterling against the greenback will drive significant earnings upgrades.

In the technology sector, Arm Holdings (ARM), Aveva (AVV) and Micro Focus (MCRO), all of which have low exposure to domestic sales, immediately spring to mind. Analysts at investment bank UBS calculate that every 10 per cent decline in sterling against the US dollar and euro boosts Arm's EPS by 14 per cent, Imagination Technologies (IMG) by more than 20 per cent, Spirent (SPT) by about 5 per cent and Laird (LRD) in the order of 12 per cent.

Chemical companies that generate a high proportion of revenues from overseas based customers are all major beneficiaries of a weakening of sterling too. For instance, Victrex (VCT) has significant transactional exposure, whereas the upside to earnings for Johnson Matthey (JMAT) and Croda (CRDA) is largely from currency translation on overseas earnings.

Small-caps

Although there have been some nasty price falls in the small-cap space, the de-ratings of Vertu and Cambria Automobiles being a case in point, by and large the small-caps I follow have fared better than their larger rivals. This is in part due to the fact that I target special situations and primarily adopt a value-focused approach to investing. It’s served me well over the years and I see no reason to change this approach now.

Indeed, in Monday’s column this week I highlighted Gresham House Strategic (GHS:800p), an anomalously priced Aim-traded investment company that’s heavily cashed up to exploit the opportunities resulting from the market rout (‘Exploiting a pricing anomaly’, 27 June 2016). I would also recommend keeping an eye on opportunistic director share buying, a good signal that trading prospects are better than ratings would imply. For instance, the chairman of student accommodation developer Watkin Jones (WJG:103p) snapped up £96,700 of shares last Friday and above the 103p level at which I first recommended buying in at ('A profitable education', 5 Apr 2016). I will endeavour to continue to highlight further anomalously priced special situations with decent investment potential irrespective of the market backdrop.

An obvious one is Aim-traded Burford Capital (BUR:310p), the world's largest provider of investment capital and professional services for litigation cases to lawyers and clients engaged in major litigation and arbitration. The company reports in US dollars and the sharp falls in sterling means that 2016 EPS estimates in sterling are now around 28p a share, rather than 26p a share a month ago, up from 22p last year. The forecast 25 per cent rise in the payout implies a dividend yield of 2.5 per cent. For good measure the shares have a beta close to zero. Having first recommended buying at 146p ('Legal eagles', 8 Jun 2015), the investment case remains as strong as ever.