The long-term economic impact of the UK’s decision to leave the EU is highly uncertain and well outside the predictive powers of politicians and so-called experts. However, shorter term, it is clear that confidence is taking a body blow.
Over the next weeks and months we can probably expect both internal and external investment in the UK economy to continue to decline. Beyond that, anything is possible.
The market’s reaction to the referendum result so far seems to have been to sort companies into two baskets and buy one while selling the other. Companies with diversified, predictable and defensive cashflows have made significant gains in absolute terms, while domestic cyclical stocks or anything with greater uncertainty has seen a large increase in their discount rate and falls in prices, as a result of their perceived exposure to the uncertain economic and political
environment in the UK.
This is effectively a continuation of the momentum trade that has been leading the market over the past three years and, along with the translation benefits of falling sterling, has allowed the market to make new highs for the year.
With the market almost exclusively focused on the referendum result, investors now have an extremely difficult job to carry out disentangling the politics and uncertainty from the long-term profitability of businesses.
However, for those able to do the work and put fear to one side, some very attractive opportunities will materialise amid the high levels of volatility.
If the UK economy is able to find a stable footing, then many stocks that have been sold most aggressively will appear significantly undervalued.
The UK stockmarket is highly diversified, with around two- thirds consisting of internationally exposed companies. The significant falls in sterling post-Brexit should actually lead to revenue upgrades in the reporting currency for the overseas revenues of many of these. The current environment really highlights the need to separate out short-term economic noise and remain focused on company fundamentals and bottom up research.
As part of the preparation work undertaken leading up to the referendum, I identified a small number of companies I would want to reduce exposure to in the event of a vote to leave. Primarily, these are companies whose balance sheets may begin to look compromised in the event of a severe short-term downturn in trading, which of course is by no means inevitable. I plan to reduce positions in these companies providing the valuation supports this decision.
As previously mentioned, the UK stockmarket is highly international with two thirds of earnings coming from overseas, but a large percentage of this comes from defensive stocks with bond-like characteristics, which I believe to be expensive and will become even more so as investors flock to safe haven assets.
In terms of opportunities, a contrarian investor will not be short of ideas or temptations. The market’s focus on politics has created an attractive buying opportunity in companies whose products and services will not be structurally compromised by an exit of the UK from the EU.
In the healthcare sector I have removed Glaxo and initiated a new position in Shire, a stock we have followed for a long time. While valuations have come down more generally across the healthcare sector, Shire looks considerably cheaper than Glaxo.
When the dust settles I do not expect the fund to look radically different from how it looked a few weeks ago. I invest in companies when I believe they are undergoing a positive change in their operating environment that is not reflected by the share price. These changes are not contingent on the UK’s membership of the EU.
Alex Wright is manager of the Fidelity Special Situations fund