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Surviving Brexit

Our Brexit-proof portfolio has outperformed the market since its inception 18 months ago, but is it still in shape to protect investors from political uncertainty
January 18, 2019

More than a year-and-a-half since we compiled our ‘Brexit-proof’ share portfolio, the exact terms under which the UK will leave the European Union are yet to be secured. Investors have hardly warmed to the enduring uncertainty. Indeed, increasing fears that the UK could crash out of the trading bloc without a trade deal in place have contributed to a sharp deterioration in domestic equities in recent months.

After Theresa May's withdrawal agreement was resoundingly voted down on Tuesday – by a record losing majority of 230 – attention has increasingly turned to a potential ‘Plan B’ to the prime minister’s deal. Alternatives to the draft agreement fleshed out in November range from a second referendum to a no-deal Brexit, under which the UK would eventually seek to negotiate a trade deal, perhaps akin to the EU-Canada pact.

Beyond these polarities are other options, all of which assume not only that an extension to the current negotiation process is possible, but also that there is the will among both the UK parliament and citizens – as well as the 27 members of the EU – to return to the negotiating table. Downing Street believes there can be little hope of an improved deal.

Others see things differently. Chair of the Treasury Select Committee, Nicky Morgan, has argued that a ‘Norway-plus’ option would allow the UK to remain as a “rule-shaper”, since it would have a vote and ability to refuse to implement future regulations, while also continuing access to the European Economic Area (EEA) and financial services passporting arrangements. 

However, the proposal might not provide the electorate or investors with much of an alternative pathway, and Aberdeen Standard Investments' political economist Stephanie Kelly says the ‘Norway-plus’ solution creates as many issues as it solves. “EEA membership implies single market access without customs union; so, the ‘plus’ is a customs union to ensure free movement at borders,” she says. Yet countries inside the EEA but outside the EU – a group that comprises Iceland, Norway and Liechtenstein – are members of the European Free Trade Agreement (EFTA), which makes its own free trade deals. “So it is not clear that EEA members would excitedly welcome the UK to their group as they would not be partaking in the trade strategy of EFTA”, Ms Kelly says.

 

The market impact

In short, uncertainty prevails, and from an economic point of view, the yardsticks for this deadlock have been numerous. Stalled corporate investment, deteriorating property valuations, rising government borrowing, and even flatlining consumer spending have all been cited as signs of trouble within the UK economy. But the most watched measure of the UK's blurry road ahead has been its currency, which will remain under pressure so long as a no-deal Brexit remains a possibility. Should the UK fall out of the trading bloc without a deal, the Bank of England expects the pound to plunge.

A lot of those fears are already reflected in currency markets. After regaining some of the ground lost in 2016’s sharp sell-off, fears of a no-deal Brexit mean sterling has weakened 10 per cent against the US dollar since reaching its post-referendum peak last April.

Limiting exposure to sterling was a key consideration in our 2017 ‘Brexit-proof’ share picks. Though ultimately something of a blunt measure, our original portfolio screened for companies – traded on London’s main and junior markets – that generated non-sterling revenue and mostly reported in other currencies. The theory was that it seemed likely those would be better protected from disruption centred on the UK-EU trading relationship and would therefore suffer less in the event of further sterling volatility. Given the threats to internal investment, the outlook for the domestic economy, and the possible threat to supply chains, we also focused on companies with a non-existent or small UK corporate reporting segment. Finally, we discounted any stock that was rated a ‘sell’ by the IC, with most ‘buys’.

The approach appears to have had some merit, with our ‘Brexit-proof’ portfolio generating an 8.3 per cent return, excluding dividend payments, since 30 June 2017. That represents an outperformance of both the FTSE and Alternative Investment Market All-Share indices, which have declined by 5.2 per cent and 6.1 per cent, respectively, during the same period.

There is always an element of luck to stockpicking, and the takeover of media and events group UBM by rival Informa (INF) in January last year helped boost overall returns by 1.6 percentage points. However, picking companies that sell predominately to markets outside the UK has proved a sound choice. For instance, shares in Scotland-based Craneware (CRW) have risen 92 per cent during the past 18 months, as sales of billing and revenue analytics software to the US healthcare market have soared.

Some companies within the portfolio – including Standard Chartered (STAN) – have been hampered by geopolitical machinations elsewhere, namely the ongoing US-China trade war and slowing economic growth in the latter. However, US dollar earners have benefited from an appreciation in the currency, which was buoyed by an acceleration in gross domestic product (GDP) growth. Admittedly, the pace of that growth slowed during the final two quarters of 2018, as the effects of President Trump’s tax reforms in buoying economic activity have eased. But a strong dollar has certainly been a big contributor to the portfolio's success, and has even helped to mask a mixed period for industrial commodities, which in other circumstances would have dampened the sterling-denominated shares of BHP Billiton (BLT).

However, the greenback could come under pressure this year if the Federal Reserve follows through with dovish comments made at its most recent meeting, and pauses rate hikes. Sterling has strengthened modestly against the dollar since the start of January, but is nevertheless still weaker over the past 12 months and, given the uncertainty that abounds over the shape of any Brexit deal, market signals are pointing to further pain for sterling.

UK break-even inflation rates – the difference between nominal yields and the amount index-linked debt pays – have been steadily rising since the end of last year, with five-year rates standing at 3.21 per cent compared with 2.97 per cent at the start of 2018. That suggests investors expect a further deterioration in the value of the pound, reflected by a rise in the average level of inflation expected over the life of government bonds. With that in mind, continuing to back non-sterling-earning companies looks like a safer bet, and so we leave much of our Brexit-proof portfolio unchanged in the updates below. The one exception is InterContinental Hotels (IHG), which steps in for the de-listed UBM. With minimal exposure to the UK, we think the stock could benefit from the company's steady transition to a more capital-light business. 

Although our picks represent a broadly bearish take on the trajectory of Brexit negotiations, and a concerted bias towards the greenback, they are at least varied in terms of sector. Diversification will be key to any portfolio this year, whichever way the political string ultimately untangles itself.

Our selections are also predicated on a near-term view. The outcome of Brexit is, of course, a critical question for markets and investor sentiment, and is one that is yet to be answered – if the current deadlock is broken, the clouds might begin to lift, and domestic UK stocks might start to look a lot less precarious, and a lot better value. But that could still be some time away, and in the meantime investors should still consider the reality that sentiment is disproportionately-weighted to a likely troublesome year ahead. EP & AN

 

Brexit-proof shares revisited

Bango

While mobile payments group Bango (BGO) reports in pounds, it has a strong international presence with accompanying non-sterling revenues. Thus, it’s possible that a so-called ‘hard Brexit’ – which might trigger further sterling weakness – could be helpful for the fees that it charges clients. Alternatively, a ‘soft Brexit’ could have the broader effect of allaying the uncertainty that has impacted many companies.

But Bango still faces challenges, even if these aren’t, seemingly, tied to Brexit. Its shares have fallen considerably since the original version of this feature, and – at around 100p – are down by more than 50 per cent over the past year. This does represent a slight recovery from 27 December 2018, when they took a whack on the news that cash profits would be positive for the fourth quarter, but not for the full year – therefore sitting below market expectations. Management had opted to take revenues on various new contracts for subscription services as “long-term, higher value annuity revenues rather than one-time, up-front fees”.

That said, 2018’s end-user spend (EUS) looks set to more than double against FY2017, exceeding £550m. And management still expects “significant revenue and EUS growth” in 2019. For Bango, the key will be to ensure that it can convert its sizeable EUS pipeline, while shifting into profitable territory. HC

 

Beazley

US markets continue to be the key driver of profits at Lloyd’s of London underwriter Beazley (BEZ). As a result of claims paid out in 2017, premiums last year hardened, jumping by 18 per cent in the nine months to the end of September. And more increases are expected to be pushed through. Recent wildfires in California are expected to generate claims of around $40m (£32m) net of reinsurance, but this has to be put in context of the $5bn that Beazley holds in investments and cash.

The insurer also benefits from a diverse revenue stream, which includes professional indemnity, property, marine, reinsurance, accident and life, and political risk. Speciality lines remains the largest division, and premium growth in the first nine months of 2018 was 11 per cent at $1.03bn. Investment returns continue to be affected by higher interest rates driving down the value of US bonds, and the annualised rate of return was running at just 0.6 per cent. However, the resulting higher yields will help to boost returns in the future. At 502p, the shares are trading at 2.2 times forecast net tangible assets for 2019, which looks about right, given the double-digit premium growth. JC

 

BHP Group

There have been some changes at BHP (BHP) since its inclusion in our Brexit-proof portfolio 19 months ago. The ‘Billiton’ suffix has gone, along with the serially-underperforming US onshore oil and gas division, which was sold to BP for $10.5bn in a successful pitch to placate the deserved criticism from activist investor Elliott Management.

The greatest change has been seen in the UK-listed stock. While trade war and oil market-induced wobbles have held the share price in check for much of the past year, anyone who took heed of our Brexit portfolio will be sitting on a total return of more than 50 per cent, including reinvested dividends.

Then again, as you’d expect of a massive resources outfit, much has remained the same. And for those seeking insulation from the effects of Brexit (and a potential hedge to weakness in sterling), that’s a good thing. While BHP’s annual report suggested a protracted Brexit could “materially and adversely” affect its cash flows and asset valuations, these prospects are pretty slim; almost all of BHP’s assets still sit in Australia and the Americas, and just 4 per cent of last year’s $43.6bn top-line was booked in Europe.

Whether falling sales into China prove a greater headache is another concern altogether, although BHP’s balance sheet, cost profile, portfolio and more cautious approach to M&A should collectively provide far better protection from commodity price headwinds than they did in 2014 and 2015. AN

 

Centamin

For UK investors, Brexit essentially stands for three pressure points: the pound, the domestic economy and UK-listed equities. Gold, as was immediately apparent after the referendum result in 2016, can act as a hedge against negative swings in each.

For those looking for a yield and the prospect of capital appreciation (rather than a lump of shiny metal locked in a safe), the gold miners are a logical place to turn to. Within that sub-sector, Centamin (CEY) is the largest UK miner entirely focused on the yellow metal, following Randgold Resources’ de-listing.

We initially picked Centamin – operator of the Sukari gold mine in Egypt – for its discounted valuation to peers, and a track record of outsized dividends and guidance-beating earnings. And in theory its low-cost operations should have insulated it from last year’s downturn in the gold price. Unfortunately, the company has failed to repeat the trick, as persistent low grades at Sukari, on-site issues with equipment and a swell in costs led to three production downgrades during 2018.

Still, we are prepared to view the past year as a blip, and expect the promise of a normalising cost base and mine expansion to lead to a rerating in the shares, regardless of the near-term outlook for gold. And should the UK tumble out of the EU without a deal, Centamin is one of the few stocks investors are almost guaranteed to flock to. AN

 

Craneware

Though headquartered in Scotland, Craneware (CRW) provides billing and revenue analytics software to the US healthcare market. And it reports sales and earnings in dollars. Both factors should offer some protection to the group, in the instance of further political or economic tumult as the UK-EU divorce looms ever closer.

Craneware also offers high levels of revenue visibility, arguably providing an extra layer of reassurance – or at least predictability – ahead of the impending Brexit date. Indeed, the group signed contracts worth $98.6m in total during the year to June 2018, up 82.6 per cent. This was buoyed by both new contracts, and renewals among existing hospital customers.

The resultant long-term visibility was highlighted again within Craneware’s half-year trading update in December, and the company also added that it expects its 12-month operating cash conversion to be over 100 per cent. Another positive sign.

Moreover, spurred by regulation, the US has been moving towards value-based healthcare – whereby physicians are required to focus on value of care over volume, while proving that they are utilising resources efficiently. Systems like those offered by Craneware should, thus, enjoy continued demand. Still, Craneware operates in a competitive space. And its shares trade on a lofty forward multiple, which might deter some from actively buying in at this point in time. HC

 

Elementis

Not a great year for speciality chemicals group Elementis (ELM), whose shares sagged in the second half over a chaotic acquisition of Mondo Minerals BV. A $600m (£470m) deal was reached for the producer of industrial talc additives in June, before pressure from “major shareholders” forced a delay that was announced just minutes before the release of results in July. The markets were unimpressed with a deal that valued Mondo at an enterprise value/cash profits multiple of 17. A $500m agreement was hastily arranged and completed in October.

The acquisition of an Amsterdam-based company has increased Elementis’s exposure to Brexit, particularly given the uncertainty surrounding the regulation of chemicals companies operating in Europe and the UK. As things stand, the Department for Environment, Food & Rural Affairs expects to introduce UK legislation that will replicate European law as closely as possible, in order to allow European companies to continue to sell here, so Mondo shouldn’t really experience much disruption to its UK operations come April. We expect the benefits of the acquisition to outweigh any political problems as they feed through this year.

Elsewhere, analysts at Berenberg expect Elementis to benefit from pricing momentum in chromium. This would be welcome, given the production outage at the company’s chromium division as a result of bad weather last year. AJ

 

Ferguson

As 90 per cent of group profits are generated in the US, the big unknown for Ferguson (FERG) is how well the economy there will perform in 2019. The initial prognosis is not that good. Tax cuts and other measures to stimulate economic growth are starting to wear off, while the Federal Reserve looks likely to push interest rates higher this year. On top of this comes the disruptive effects of a trade war with China, and President Trump’s protectionist leaning.

The shares performed strongly in 2018, but fell towards the end of the year, and are now lower than they were at the start of 2018. And although accounting for just 5 per cent of group turnover, business in the UK continues to suffer due to the tough trading environment. In the US, revenue has continued to grow, albeit at a slightly slower pace, while margin growth has been affected by increased input costs.

However, organic growth will continue to be supplemented by further bolt-on acquisitions, while there is a low exposure to new-build housing. Following the recent decline, the shares trade on 19 times historic earnings, but with the economic outlook likely to create headwinds, share price growth could be muted. JC

 

InterContinental Hotels

InterContinental Hotels’ (IHG) resilient business model looks increasingly attractive against the Brexit backdrop. Unlike many hotel groups, the company’s exposure to the UK is relatively minimal, especially when contrasted with its footprint in the US, continental Europe, the Middle East and even Greater China. What’s more, the strategy to transform itself into a “capital light” business – thereby selling off almost all its hotel assets and significantly reducing its fixed cost base – has made it less susceptible to sudden changes in a cyclical market. Its new guise as a hotel manager rather than an owner makes it less vulnerable to swings in profit, and much more easily rewarded by increasing sales.

Its geographic spread makes it far less dependent on the strength of sterling, and more of a natural beneficiary of the stronger US dollar. Threats to tourism and leisure travel – such as terrorism or poor consumer confidence – are also less relevant to a company like IHG, which garners more interest from business commerce. In the meantime, the asset-light model, combined with continued cost-cutting, should allow for continued returns. Since 2003, shareholders have received a whopping $13bn (£10.3bn) via ordinary and special dividends, with another $500m dividend due to be paid in early 2019. HR

 

NMC Health

The continued crisis in the UK’s public healthcare system – not to mention the debate on possible privatisation – encourages us to look elsewhere for investment opportunities in this sector. Indeed, trends in parts of the Middle East continue to underpin potential growth opportunities for private healthcare operators there. NMC Health (NMC) – an Emirates-based hospital operator – is primed to benefit from the unfortunate rise in lifestyle diseases across the region, including diabetes, heart disease and stroke. The introduction of mandatory health insurance has also forced a rapid increase in the targetable patient population.

NMC has capitalised on these opportunities in a variety of ways, including via acquisitions and joint ventures. Last summer it announced a new joint venture in Saudi Arabia with Hossana Investment Company, the investment arm of Saudi’s largest pension fund, General Organisation for Social Insurance (GOSI), to take advantage of the expected privatisation of healthcare across the Kingdom in the next few years.

True, NMC isn’t alone when it comes to recognising the growth potential across Middle Eastern countries, but its decision to focus on specialist or under-served fields – including neurology, maternity and long-term home care – have helped it maintain its competitive edge. HR

 

Standard Chartered

With Europe and the Americas the smallest of Standard Chartered’s (STAN) four geographical operating segments – accounting for just 4 per cent of overall underlying pre-tax profits during the first half of last year – the banking group is the least exposed to any economic fallout from Brexit. More than half of profits were generated in Greater China and North Asia during that period, which means the shares have unsurprisingly come under pressure over the past year as global trade tensions and concerns over high Chinese debt and a wider economic malaise have heightened.

That decline has left the shares trading at just 0.6 times adjusted net tangible assets at the end of December, according to Investec’s forecasts – an undemanding rating given the progress being made by the lender. Regulatory capital levels and returns on equity have been improving, with the latter up 150 basis points to 6.7 per cent at the half-year mark and closing in on management’s 8 per cent medium-term target. Loan impairments have also been falling rapidly, boosting profitability. Whether Chinese loans turn bad remains one of the biggest risks to Standard Chartered’s improving profitability, but at present we think the value argument remains intact. EP

 

CompanyTIDMSectorMkt CapPriceFeature priceChangeFwd NTM PEDYEV/EBITPEGP/BVFY EPS gr+1FY EPS gr+2
BeazleyLSE:BEZFinancials£2,746m525p488p8%192.2%190.722.46-37.4%189.3%
BHP GroupLSE:BHPMaterials£86,356m1,707p1,176p45%125.2%828.712.1610.1%-8.1%
CentaminLSE:CEYMaterials£1,358m118p155p-24%178.1%6-1.41-20.8%23.0%
CranewareAIM:CRWHealth Care£658m2,465p1,283p92%461.0%443.2116.5715.4%17.0%
ElementisLSE:ELMMaterials£1,114m192p294p-35%123.6%163.171.66-2.9%10.0%
NMC HealthLSE:NMCHealth Care£6,209m2,982p2,186p36%250.4%351.156.9949.0%19.0%
Standard CharteredLSE:STANFinancials£20,330m615p777p-21%10-01.140.5155.1%4.9%
BangoAIM:BGOInformation Technology£65m92p173p-47%--NM-4.00--
FergusonLSE:FERGIndustrials£12,072m5,239p4,975p5%132.8%121.533.9018.9%5.1%
UBM*LSE:UBM--865p704p23%-------
*Current price calculated to reflect the terms of the company's takeover by Informa, which gave 163p plus 1.083 Informa shares for each UBM share owned. Replaced in the portfolio by InterContinental Hotels  

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