Brexit: which impact on our investment strategy?

250516 Market Commentary

Brexit: which impact on our investment strategy?

As the fateful date of June 23, date fixed for the referendum on UK membership of the EU, is approaching quickly, we think it is appropriate to analyse our portfolio to determine the potential risks in case of Brexit. At ECP, our approach is purely bottom-up and, in our quest of undervalued earnings power, we typically focus on individual companies without taking into account macroeconomic aspects. However, this is a very specific case as this binary event (“stay” vs. “leave”) with an uncertain outcome could have a huge impact on the financial markets that we, as prudent investors, cannot ignore.   Should I stay or should I go? Last February, the UK Prime Minister David Cameron obtained some guarantees from the European Council of Minister on the adjustments of various important EU policies in order to meet British requirements. The date of the referendum has then been fixed for end of June. Since then, the polls fail to distinguish the supporters of the “stay” or “leave” options leading to an unclear picture… These uncertainties have spread on the financial markets which are struggling to properly assess the potential impact of a Brexit on the UK economy and its stock market. What is however clear is that recent elections in Austria have demonstrated the powerful forces that are currently in place in Europe pushing for retrenchment and nationalism. While economic logic favours communitarianism, we see a rise in populism and a strong move against the globalisation seen over the last decades…In this context, a Brexit vote is not unrealistic! If the British population votes in favour of a Brexit, the doom scenario is a weakening UK economy, weaker consumption and sentiment and last but not least imported inflation due to a weakening GBP.  Volatility should also remain high until the uncertainties about the future relationship between the UK and the EU are lifted.   How is our portfolio positioned to deal with this Brexit risk? The first risk we see for Equity investors is the direct exposure to UK stocks. The UK market currently represents approximately 30% of the European stock market as measured by the MSCI Europe. ECP holdings in the UK account for only 9% of our portfolio through 3 holdings:
  • Aberdeen Asset Management (Financials): this Scottish asset management company with a strong brand in Emerging Markets will probably suffer from a Brexit at least until the uncertainty towards the status of the UK outside the EU is defined. It might also be impacted by further negative sentiment if Scotland decides to organise a new referendum. UK revenues account for 52% of the total revenues in the last fiscal year and access to the single European market of financial services is key for the company.
  • Rolls-Royce (Industrials) manufactures aero, marine and industrial gas turbines for civil and military aircraft. We see rather limited risk for the company as the UK only represents 13% of overall revenues of which a majority is for the UK army. On the contrary, a weakening local currency would represent a competitive advantage for Rolls Royce as its cost base is largely GBP-denominated.
  • Smiths Industries (Industrials): Smith is an engineering conglomerate which business is global. Actually, only 4% of its activity is in the UK while the US represent 47%. We would argue that the outcome of the US presidential election is much more relevant for Smiths than a Brexit vote.
  A second risk for our portfolio could arise from Continental European companies with significant revenues generated from the UK. These companies would suffer from weaker UK revenues due to more challenging economic conditions as well as from the currency impact when converting back their UK revenues into euro. Here again, the non-UK companies we have in portfolio have usually a low exposure to UK; Deutsche Boerse having the highest with 25% of its revenues coming from the UK; followed by Europcar with 21%.   Is there some value to find on the UK market? This volatility and negative sentiment in place since a few months regarding UK stocks have created some opportunities that are worth to analyse. In our initial screening, we find that the number of UK companies qualifying for further research has significantly increased over the last months. We are therefore currently working on a number of interesting UK investment cases. Top-down valuations confirm our view that UK Equities are currently looking quite attractive compared to their 20-year history on measures like P/BV or Dividend Yield. Sources: MSCI, Datastream, SG Cross Asset Research/Equity. STDV: Standard Deviation.   To conclude… We think that the risks of a significant impact on the earnings power of our portfolio due to Brexit is rather limited. However, the overall market sentiment could lead to an increased market volatility. From this low UK exposure as a starting point, we view uncertainty and volatility in the UK around Brexit dilemma as an excellent opportunity to find new investment ideas. Should the “stay” camp win, volatility will go down with a strengthening of the GBP and a possible rally of UK stocks that have been under pressure for so long. Our Hedged strategy (MH share classes) has recently increased its net market exposure to reach currently 44%. This recent increase can be explained by the lower volatility of our book of companies compared to the overall market. We feel comfortable with this net exposure as the referendum is approaching but will of course monitor closely the situation and will react accordingly should our proprietary hedging model points towards a higher volatility.