JOHCM's Leyland: UK Stocks Aren't Really That Cheap

Ben Leyland at JO Hambro Capital Management thinks claims that UK plc is cheap are misleading and that some stocks are lowly valued for fundamental reasons

David Brenchley 27 March, 2019 | 2:48PM
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Claims that UK stocks are really cheap are “misleading”, according to JO Hambro Capital Management’s Ben Leyland who thinks the domestic market is only cheap "optically", not fundamentally.

Leyland, manager of the JOHCM Global Opportunities fund, accepts there are some cheap stocks in the UK large-cap universe. However, he notes that there are reasons other than Brexit for this. “We haven’t really found much opportunity in that fabled internationals versus domestics-type trade,” he says.

Indeed, he notes that the UK-listed airlines are cheap, but US-listed airlines are cheap, too, so that’s probably more sector-specific than because they’re listed in the UK. Similarly, while UK banks are cheap, so are European banks, “so what’s the difference,” he asks.

“Johnson Matthey (JMAT) looks cheap relative to Umicore (UMI), but Umicore are very well invested in battery technology and JMAT are just starting [to invest in this area],” he continues.

If Johnson Matthey’s investment into this area doesn’t work, “then they’re not cheap at all because they don’t have any terminal value”. The terminal value of a stock is the present value at a future point in time of all future cash flows assuming a stable growth rate forever.

Clearly, if its foray into battery technology fails and electric vehicles are the future, then JMAT’s reliance on internal combustion makes it prone to becoming redundant.

“So, when you examine individual names that appear to be cheap and appear to back up [the thesis that the UK market is cheap], we don’t find much evidence for it generally,” adds Leyland.

US Tobacco Looks More Interesting

There’s a similar argument on tobacco companies. Many fund managers have argued the likes of British American Tobacco (BATS) and Imperial Brands (IMB) are now too cheap to ignore, despite regulatory worries.

But Leyland owns Philip Morris (PM) in the US, a position he has been topping up, instead. One reason for favouring the US giant is its portfolio of reduced-risk products being superior to Imperial. But the main reason is because both the UK names have “very weak balance sheets because of deals they’ve done in the US recently”.

Allied to that, both BATS and IMB now have an “over-reliance on the US”. As a result, their regulatory risk is very much centred around the US Food & Drug Administration, which is the authority that is clamping down the hardest.

“That’s one of the reasons they appear to be very cheap,” says Leyland. “One of our priorities when you come to a sector like tobacco, given the amount of country-specific regulatory risk, is diversification. BATS’ consolidation of Lorillard and Reynolds undermined the investment case there a bit.”

The fund has 16% of the portfolio in UK-listed names, although most are not exposed to the UK economy. These include Australian miner Rio Tinto (RIO), US building supplier Ferguson (FERG) and Dutch consumer goods giant Unilever (ULVR).

2 UK Stocks to Watch

The fund did buy one UK stock last year and that was accounting software firm Sage (SGE). Leyland describes Sage as “very boring”. “It sells accounting software to accountants, so it’s never likely to be exciting,” he adds.

“But you have periods where the market gets very excited for some reason about its growth prospects to an unreasonable degree.”

That happened from the start of 2015 to mid-2018. Leyland had bought the firm at around 300p when the fund was launched in June 2012 before selling out at around 550p in May 2015.

The stock continued to rise as investors’ expectations got ahead of reality, “egged on by [CEO] Stephen Kelly, who talked a very good game about accelerating organic growth and expanding margins”.

Sage traded at what Leyland thought was an unreasonable valuation until an unexpected profit warning in January 2018. The share price fell from 820p to 640p in the space of two months and continued to slip to a three-year low of 525p by late October.

“Cracks started to appear, not in the way that undermined the franchise strength, but just in the way that it disappointed expectations.” By June 2018, it was back at an interesting entry point. Leyland bought then, at around 550p, and topped up as the stock continued to weaken.

“Now it’s bounced back to £7, we’re a little more cautious on it so it joins the long list of things we’re reducing rather than adding to at this stage.”

The one part of the portfolio that does have exposure to the UK economy is its longstanding holding in National Grid (NG.). “Even there you’ve got 50% of the asset base in the US, which is where the growth and the value really comes from,” Leyland counters.

Still, there’s political risk in the form of a potential Jeremy Corbyn-led Labour Government that might look into nationalising National Grid’s UK business. While Leyland accepts there’s the risk of a “nightmare scenario” where shareholders get zero compensation, it’s highly unlikely.

The worst-case scenario in Leyland’s view is that shareholders receive compensation at the market value of the firm’s regulated asset base, which is the company’s invested capital on which it can earn a cash return. “So, you get no premium for the UK assets and you’re just left with the US business, which is growing pretty well.”

In fact, Leyland doesn’t think National Grid is particularly susceptible to nationalisation, because the focus is likely to be on service business that directly touch consumers’ bills. “The Daily Mail never has a story on how extortionate National Grid’s prices are; it’s always about Centrica, SSE and Npower,” he explains.

Meanwhile, the opportunity in the north east and south west US utility market is very strong, growing mainly in the high-single-digits, but in some cases low-double-digits. That’s because networks are under-invested. They’re now investing more and looking to future-proof them, for example putting in electric vehicle networks.

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.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
British American Tobacco PLC2,425.00 GBX0.66Rating
Ferguson PLC15,810.00 GBX0.29Rating
Imperial Brands PLC2,001.76 GBX0.41Rating
Johnson Matthey PLC1,560.00 GBX1.04
National Grid PLC878.00 GBX0.25Rating
Philip Morris International Inc100.93 USD-1.10Rating
Rio Tinto PLC Registered Shares5,180.00 GBX-0.02Rating
Sage Group (The) PLC1,072.00 GBX1.28Rating
Umicore SA Ordinary Shares13.99 EUR3.86
Unilever PLC4,437.00 GBX0.07Rating

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David Brenchley

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