This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
The recent spike in volatility is a timely reminder to investors who have enjoyed the benefits of an extended bull market that all good things must come to an end. Global markets surged to all-time highs at the start of the year, only to pare back sharply on the back of heightened geopolitical tensions.
But unloved UK stocks offer compelling opportunities for stock pickers.
Brexit Blues
We are now approaching the two-year anniversary of the decision to leave the European Union, during which markets have been buffeted by protracted and often openly hostile negotiations between London and Brussels. The marked volatility in the currency has been an additional distraction, with sterling falling nearly 20% vs the US dollar and the euro in the second half of 2016.
Whilst the pound has recovered against the dollar since the beginning of 2017, the increased volatility has led many investors to take a bearish stance on the UK economy. But despite the overcast conditions, there are reasons to be optimistic, especially for active managers in the small and mid-cap arena.
Whilst it is impossible to gauge the impact of Brexit, we do have certainty on the exit date of March 29, 2019. However, what happens after is open to much conjecture and this uncertainty will continue to unsettle markets. In light of this, there is likely to be little appetite for companies to want to invest in their businesses and employees, especially given the confusion over the free movement of labour.
However, investors who have a long-term outlook and are prepared to scrutinise the overlooked and often under researched parts of the UK market, there are several small and mid-cap engineering companies that are leading the way in providing high quality products and services into lucrative end markets.
Best of British
The rationale for investing in these companies is very much focused around their market leading positions within their respective niches, allowing them to absorb any short-term shocks to the economy. In addition, they are assisted by strong management teams, who are often long tenured, and high barriers to entry.
In many instances, the products and services are often mission critical and benefit from being low cost, but vital to operational efficiency. This expertise, sold into the international market, often leads to very high levels of recurring revenues.
One example is Porvair (PRV), an international leader in the development and supply of high performance materials and solutions in filtration applications. The company’s products are used in a variety of end markets, including life sciences, water and aviation. Their aviation filters are specified on almost all commercial airframes.
Porvair earns 85% of revenues from outside the UK, with the US dominating at close to 50%. Over the last decade the company has returned 19% a year, almost three times the FTSE All-Share on a total return basis.
Trifast (TRI), which was founded in 1973 as a fastener distributor in East Sussex, has now become one the leading specialists in the engineering and manufacturing of high quality industrial fastening, supplying the automotive, domestic appliance and electronic sectors.
Trifast delivers 150 million components daily via a lean global supply chain that is supported by a multi-location, low cost manufacturing model. The company now employs 1,300 staff across 30 global locations and has returned over 18% a year over the past decade, which again is nearly three times greater than the FTSE All-share.
Leading the Way
The attractiveness of UK engineering assets has been recognised, with several companies being bid for, including Fenner, Atkins and Cookson. Those firms – for example Johnson Matthew and Halma - which have escaped M&A attentions, have managed to transform themselves from small enterprises to FTSE 100 companies.
The UK economy is often characterised as having a declining manufacturing base, but it is worth noting that the engineering expertise built up since the beginnings of the industrial revolution still leaves investors with excellent businesses, which are now acknowledged leaders in their respective fields.
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