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UK Domestic Stocks to Weather Brexit Britain

UK stocks have been heavily sold off thanks to Brexit uncertainty, particularly those exposed to the domestic economy. But this throws up value opportunities

David Brenchley 17 January, 2019 | 8:45AM

Greggs, pasty, Greggs pasty, UK stocks, FTSE 100, FTSE 250, AIM, Brexit

Uncertainty continues to reign over the UK economy and its investment markets, after Parliament’s widely predicted rejection of Prime Minister Theresa May’s Brexit deal on Tuesday.

Ever since the 2016 referendum global investors have withdrawn billions of pounds from the UK in favour of adopting a wait-and-see approach to Brexit. This has led to depressed valuations in UK stocks, leading some contrarian investors to see attractive value opportunities.

For UK-focused fund managers, it’s been a case of choosing between overseas earning companies, which have seen sales boosted by the slump in sterling, and domestically focused firms, which have struggled thanks to a weaker pound and less-than-helpful economic data.

Most have tended to favour the former, which tend to reside in the blue-chip FTSE 100, which is up 10% since 23 June compared to the mid-cap FTSE 250’s 8% gain. But that could all be about to change.

No Brexit at All?

Colin Morton, lead manager of the Morningstar Silver Rated Franklin UK Equity Income fund, notes that domestic focused stocks have actually started 2019 better than their overseas-leaning counterparts.

That could be as a consequence of the threat of a no-deal Brexit seemingly diminishing. It seems as though Parliament will ensure the UK does not crash out of the European Union. While a soft Brexit seems the most likely outcome, some, including Richard Stone, chief executive of The Share Centre, believe we will end up with no Brexit at all.

Morton agrees. He thinks one of the reasons domestics have outperformed in the year-to-date is because people hare starting to believe that Brexit might not happen at all. Clearly, that would be a boon for domestics, with the pound likely to rally rather quickly.

Therefore, building exposure to those stocks a such low levels seems a prudent tactic. Certainly, for the long-term investor that should very much be the case. The type of Brexit deal we leave with is very much a short-term choice and Morton is hopeful, over five to 10 years, everything will work out fine.

He has recently been “nibbling away” at selective domestic stocks, and balancing that with stakes in quality overseas earning businesses like Unilever (ULVR), Diageo (DGE), Compass (CPG) and Bunzl (BNZL). “I’m trying to have a foot in both camps and be driven by where the value is in the market,” he explains.

If you don’t position yourself in advance and the Brexit deal is not as bad as expected, domestic stocks “will rally so quickly and so hard that you’ll struggle to buy them”.

With that in mind, we asked a selection of UK equity fund managers which domestic-facing companies they like right now.

Housebuilders

One hunting ground for many, including Morton, is the housebuilder sector. These are some of the most-exposed stocks to both the UK economy and UK consumer strength. Sentiment towards the property market – both commercial and residential – has been at the mercy Brexit gyrations ever since June 2016.

Housebuilders were the fastest to fall immediately post referendum but, equally, the fastest and most aggressive to recover in the following days, weeks and months. Indeed, after Tuesday’s vote, housebuilders were amongst the best-performing FTSE 350 shares in Wednesday morning trading.

At the back end of last year, with shares down 30% on the year, Morton bought a position in Bellway (BWY). Shares had de-rated not because of changes in earnings expectations, but because of Brexit.

In fact, the firm in October said it had sold a record number of properties, more than 10,000, in the year to July. It pays a good dividend yield at around 5%, has net cash on the balance sheet and trades on a single-digit price/earnings multiple.

Another threat to the UK is a potential change in Government. While a Jeremy Corbyn-led Labour Government would be negative for many industries, some would be more resilient. Housebuilders are one of those areas, as measures to improve housing supply has cross-party support.

That said, Alexandra Jackson, manager of the Rathbone UK Opportunities fund, thinks “a Corbyn Government could have a detrimental effect on willingness to buy a house”. Therefore, she favours the private rental sector. “Housebuilders focused on developing houses for middle-income families to rent rather than buy could be in something of a sweet spot.”

Retailers

Another area Morton has been topping up is in the retail space, which has had well-publicised issues, some of which have little to do with Brexit. Still, many tend to be directly exposed to the UK consumer and the amount of cash they have in their pockets.

Morton added to Dunelm (DNLM), and bought Greggs (GRG), another with a strong balance sheet, after its May profit warning. Since bottoming at an 18-month low of around 950p in July, it’s now at a record high 1,500p – up 58%.

As mentioned, the retail sector is also undergoing a structural shift, with e-commerce players and discounters rapidly taking market share. With this in mind, Nigel Kennett, senior manager on LF Canlife UK Equity, likes growth areas including the ‘athleisure’ market.

JD Sports (JD.) is an example of this, with it and other companies in the space having “scope to expand the number of stores, combined with strong finances and management teams aligned with shareholders”.

Meanwhile, Jon Hudson, manager of the Premier UK Growth fund, likes the disruptors. “Discounters, such as B&M (BME), have historically benefited from when the consumer is squeezed,” he explains. “And, whilst more discretionary, we’d also expect online fast-fashion retailer Boohoo (BOO) to outperform peers as consumers ‘trade down’.”

Value retail is important to Gary Channon, chief investment officer at Phoenix Asset Management, too. Mike Ashley’s Sports Direct (SPD) is the second-largest position in his Aurora Investment Trust (ARR) at 8.6%. Sports Direct is the lowest-cost operator in its market. “This should protect it from being undermined by an online competitor,” he says.

Supermarkets

On a similar line of thought, supermarkets also have headwinds. Again, online players like Ocado (OCDO) and discounters like Aldi and Lidl are aggressively challenging the incumbents. However, products they sell – groceries and the like – are non-discretionary items.

They will also benefit from inflation, says Jackson, and is a sector she favours due to it having its own drivers aside from the macro-economic outlook, in case the Brexit is not favourable to markets.

While Channon says Aurora has modestly trimmed its positions in both Tesco (TSCO) – 8% of the portfolio – and Morrisons (MRW) – 3.8% of the portfolio – due to seeing lower upside to intrinsic value, he still expects them to thrive.

That said, should Morningstar analysts' worst-case, no-deal Brexit scenario play out, they would have to cope with a further headwind in tariff and currency-induced food-cost inflation.

Associated British Foods (ABF) would be the best placed in the food space, due to its Primark brand which is the lowest-cost clothing retailer in the UK.

Financials

One long-term theme Morton likes is predicated on the fact that UK consumers will need to keep upping the amount of cash they save and/or invest in order to have a comfortable retirement. This leads him to “asset gatherers”, like life assurers and financial service companies.

These companies were hit in the last six to three months of 2018 on a perception that no-deal Brexit would be the most likely outcome. Weak stock market performance hasn’t helped, either, as their products are mainly tied to how equities perform.

As a result, the likes of Aviva (AV.) and Schroders (SDR) have seen their share prices fall around a quarter since mid-May, tempting Morton in.

Ken Wotton, manager of the LF Gresham House UK Micro Cap and Multi Cap Income funds, likes asset manager Impax (IPX), a company we’ve highlighted previously in our AIM series. The growing trend for asset allocators to increase exposure to environmental and sustainability strategies should drive asset flows for years to come, he explains.

They do, though, have scope to grow into the US market, now, through their acquisition of Pax World. Overall, he adds: “Impax has a business model with strong operational leverage that drives profit margins, cash generation and dividend growth as assets under management scale.”

Morningstar analysts noted last month that Lloyds (LLOY), the most pure play on the UK in the banking sector, may weather their worst-case scenario best of the five banks in its coverage universe. That's due to its market-leading current account franchise, which provides it with a steady and cheap funding base that will benefit from higher interest rates.

Other Sectors and Stocks

One trend some of our managers are looking to take advantage of is that of health and wellness, which Jackson says shows no sign of abating. Therefore, she likes low-cost gym operators. As does Hudson, who invests in The Gym Group (GYM) for the same reason as Boohoo – consumers trading down from more expensive brands to value-for-money creators.

Funeral businesses also have a long-term revenue driver, with death an inevitability. Still, the UK's leader in this industry, Dignity (DTY), has seen its share price decline by over a quarter over the past couple of months.

Channon says this is due to the contradictory combination of increase scrutiny and an increase in competition from new entrants into the market. "For a long time, the leaders in this field persistently raised prices ahead of costs," explains Channon. "In doing so, they increased their vulnerability to competition."

As a result, they are now facing a loss of market share, declining volumes and, consequently, having to lower prices. Despite the prospect of lower future margins, Channon still thinks Dignity's shares are worth three times as much as they can be picked up at today.

Elsewhere, Jeremy Lang, partner and co-founder of Ardevora Asset Management, says his firm has moved away from overseas earners, particularly commodity stocks, as anxiety towards them has turned to confidence.

The proceeds have been recycled into domestic names, like builders’ merchant Travis Perkins (TPK), which has almost halved since mid-2015.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Associated British Foods PLC2,448.00 GBP0.00
Aurora Ord210.00 GBP0.00
Aviva PLC435.10 GBP0.00
B&M European Value Retail SA378.00 GBP0.00
Bellway PLC3,249.00 GBP0.00
Boohoo Group PLC262.50 GBP0.00
Bunzl PLC2,061.00 GBP0.00
Compass Group PLC2,017.00 GBP0.00
Diageo PLC3,109.00 GBP0.00
Dignity PLC552.00 GBP0.00
Dunelm Group PLC818.50 GBP0.00
Franklin UK Equity Income W Acc2.15 GBP-1.26
Greggs PLC2,064.00 GBP0.00
Gym Group (The) PLC246.00 GBP0.00
Impax Asset Management Group PLC265.00 GBP0.00
JD Sports Fashion PLC751.40 GBP0.00
LF Canlife UK Equity C Acc121.01 GBP-1.23
LF Gresham House UK Micro Cap C Acc169.35 GBP0.23
LF Gresham House UK Mlt Cap Inc C £ Acc123.94 GBP0.26
Lloyds Banking Group PLC58.54 GBP0.00
Morrison (Wm) Supermarkets PLC198.05 GBP0.00
Ocado Group PLC1,102.00 GBP0.00
Premier UK Growth C Inc234.49 GBP-0.35
Rathbone UK Opportunities I Inc462.28 GBP-0.56
Schroders PLC3,203.00 GBP0.00
Sports Direct International PLC322.40 GBP0.00
Tesco PLC237.70 GBP0.00
Travis Perkins PLC1,490.50 GBP0.00
Unilever PLC4,613.00 GBP0.00

About Author

David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk

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