Simon Brazier discusses the investment opportunities that exist amidst the volatility surrounding Brexit negotiations.
Lindsay Williams: Around 28 months ago, the people of Britain voted to leave the European Union. It is known as Brexit, of course, and that unleashed political and economic uncertainty. On Wednesday, 14 November, Theresa May, the UK Prime Minister, announced a draft Brexit deal had been approved by her Cabinet but then she faced questions in Parliament the next day in one of the most important parliamentary debates since World War II and it didn’t go well for Theresa May. The situation changes hourly, of course, so rather than focus on negatives and predict political outcomes, let’s focus instead on positives and opportunities.
With me is Simon Brazier. Simon, with adversity comes opportunity so, in a perverse way, I suppose, as a Portfolio Manager, it must be quite exciting to watch periods of panic, as we have seen this week, and pick through the bones of that panic.
Simon Brazier: Yes. I think volatility always gives opportunity. We have been saying since the Brexit vote actually that we found it was going to be very difficult for Theresa May to get a deal that would get ultimate approval by Parliament and we will wait and see if that happens and hence we have been somewhat positioned for the uncertainty that [we are in] and so we will wait and see but the reality is that I do think the next 3-6 months leading up to the proposed exit date is going to have a significant impact on currency, equity, bond markets and that will provide some opportunities.
Lindsay Williams: Yes, indeed. We saw the pound at one stage during the parliamentary debate falling around 1.5%, its biggest 1 day fall in 2 years but, as I said in my introduction, I don’t want to try and make political predictions here much as I would love to hear your views. I want to ascertain what you have been doing since the whole Brexit process started or rather non-started. What has been your attitude towards FTSE 100 companies, for example?
Simon Brazier: Well, I think you have already hinted at one of the main issues for me, which is currency. Until Brexit, of course, one took into account currency moves with regard to certain companies but, actually, the moves we have seen, sterling from going almost as high as 1.6 prior to Brexit down to 1.2 against the dollar, have meant we have seen almost like emerging market volatility in sterling and sterling has a significant impact on the UK equity market. Nearly 70% of revenues of UK companies come from outside the UK. That is why actually, despite all the turmoil yesterday in markets, the FTSE All Share was actually up on the day because weaker sterling ultimately is a beneficiary for the market as a whole.
What we have been doing over the last 2.5 years is we have been preparing for what we thought was going to be quite volatile times. There are 2 things relating to currency. The first is that we have been increasing the large cap exposure in our portfolio. This is because, typically, the large caps are more globally diversified but, not only that, you find a variety of them which actually have, for example, their dividends denominated in dollars. Some of the largest companies in the market, like BP, like HSBC, their dividends in pounds are improved with weaker sterling. So we have been moving further up the market cap spectrum to the point where in the fund we are well over 80% in FTSE 100 or equivalents today.
The second area has been in that overseas earnings exposure and I have come down from nearly 40% domestic revenue exposure in 2016 to less than 30% today. So you have a nearly 10, 12% reduction in that partly because:
(1) we wanted to get less exposure; we were wary of weaker sterling; but also
(2) the Brexit vote itself and I think whatever deal comes out of this has meant the UK is growing slower as an economy than we were predicting 3 years ago before Brexit and, hence, we have reduced some of our domestic cyclical exposure, again which you find more in the small and mid-cap stocks and hence the reduction there.
Lindsay Williams: Okay. So to summarise then, you have gone more for large caps because of the diverse nature of the portfolios in geographical distribution. You have also had a look at the currency and made a correct call on the currency from your colleagues I have been speaking to over the last couple of years and you have gone down from 40% to less than 30% of domestically-focussed stocks, UK domestically-focussed stocks. When you say 10, 12%, actually, if you take 40% and take 10%, you have actually reduced that exposure in percentage terms by round about 25%. That is quite a big call.
Simon Brazier: Yeah. I mean what I would say, just to be clear, it is not the number of stocks; it is the actual exposure of the companies [that I own] but the reality is that we were looking at 3% plus GDP growth forecasts prior to 2016. A big chunk of that was coming from business investment growth in the UK, which was nearly double-digit. The UK, prior to the Brexit vote, was seeing significant foreign direct investment because it was a fantastic place to base your businesses in order to get access into the European single market. Not only that, a lot of people wanted to buy houses, they wanted to buy UK equities, UK Government bonds.
We were an attractive area and the reality is the UK needed to attract that foreign direct investment because we have a current account deficit. We still need to fund it but the reality is today the clearing rate, i.e. where the pound is versus the other currencies to attract that investment, is certainly lower because external investors see risk and business investment growth today is basically flat, which means GDP growth is lower.
We took that view that that was going to be the case and many of the domestic companies in, for example, the property sector, the housebuilding sector, retail, leisure, industrials that we have sold, I would say roughly 15-20% of my cyclical exposure as a whole of the portfolio has been reduced over that 2.5 years. It is because purely of the economic outlook and what that means for the individual companies. We don’t take top-down views in the fund. We do it at a stock basis but we are cognisant of the wider environment and we predicted, and up till now it has been helpful to us, that things will be slowing.
Lindsay Williams: Without giving too much away, can you give us some company examples? You have given the theory now but I love examples. Can you give us some?
Simon Brazier: Yes. Well, I am always loathe to talk about companies we have sold. I will talk you through some of the sectors but the reality is, if you take – you know, a lot of people have been very wary of consumer staples because, as I said, in a rising interest rate environment, these are more difficult companies. I disagree with that.
Good, quality companies like a Unilever or a Reckitt Benckiser that are globally diversified, cash-generative, that actually have been around a long time, these companies have lived through wars, they have lived through worse things in some respects than Brexit, these are companies that are continuing to grow their revenues and their cash flows. They are able to reinvest their cash flows at high rates of return and, no matter what the economic environment is, I believe these companies can continue to grow and, actually, I am prepared to pay a decent valuation for those businesses because my end clients, back to them, I believe it is good certainty and these companies generate the cash.
Lindsay Williams: There is a danger, of course, that other people have the same thoughts as you and the same process as you. Is it becoming an overcrowded trade, for example, the Unilever trade?
Simon Brazier: Well, just taking a step back, the one trade that is certainly not overcrowded in the UK equity market is around large cap. I mean the reality is you have seen significant inflows into small and mid-cap funds in recent years, partly because that area of the market has performed well and, not only that, it is difficult to find UK funds that have over 50% of their exposure to these larger companies.
So I would say that, as a whole, the direction of travel I have been moving in has not been the direction of travel of the rest of the market. I would say more value-based funds have certainly been moving in this direction as well and what I would say is that two-thirds of my fund typically is in these higher quality names like Reckitts and Unilever but I do have another third of the fund that, based on valuation, is either more focussed towards growth or more focussed towards value and, more recently, the last years it has been more focussed towards value. It is the sectors like oil and gas, food retailing – Tesco is one of my biggest positions – those types of sectors are where we have been adding.
Lindsay Williams: Let’s look forward now. The volatility that has hit the markets since the parliamentary debate and since the draft Brexit deal was approved by Cabinet has not been unprecedented but it certainly livened the market up a little bit and it is difficult to make predictions and I promised we wouldn’t make predictions but you have to manage not only currency and your equity portfolio but also have a look at the macro picture when it comes to UK GDP growth. There are undoubtedly going to be concerns because, when there is uncertainty, people go into their shells. You are cognisant of that, of course.
Simon Brazier: Definitely cognisant. I mean one of the things that I have been talking about is the fact that the largest component of UK GDP is domestic consumption spend. It is nearly two-thirds of GDP and there are only two ways you can grow domestic consumption spend in the UK. You either have real wage increases so people have more money to spend year-on-year or people spend more and save less and my argument has been that there is significant risk to this because I don’t see real wage increases coming through. We have some positivity recently because the wage cap on the public sector has come off but that is a short-term dynamic once that comes through in the numbers.
So I don’t see real wage growth coming through and the reality is the savings ratio today is back at the very historical lows. If I look back at history, 2008 you had a savings ratio that jumped from about 1% to 7%. That is about 4% of GDP. My concern would be to your exact point, if we were to see uncertainty, political uncertainty in the UK, economic concerns, Brexit concerns, then consumers may just rein back on that spending and that just takes GDP down straight-away because it is such a large part of GDP.
So don’t worry about government spend, don’t worry about net exports or net trades – the biggest issue is consumer spending and any slowdown in that certainly would push the UK into recession because we are already at just over 1% GDP growth as we stand today anyway.
Lindsay Williams: Simon, these are fascinating times, perversely satisfying in many ways. Are you looking forward to the next few months?
Simon Brazier: I think you are correct that it is perverse, particularly because, yes, there are risks to the UK economy, there is risk to the UK consumer, as we have discussed, but, for me, my priority is to make my clients money and, as you say, it is perverse because, as things get weaker economically and as sterling weakens, it actually strengthens the hand of the UK equity market due to that overseas earnings nature of the market and weak sterling, as one translates returns from overseas earnings back, means you do get better profitability for many of these companies and, actually, the market does seem to do well in that type of environment.
So there is almost a natural hedge to the UK equity market. We can own great businesses that do well if the world is fine but, if things get a bit more difficult, we are not 100% domestically exposed and, actually, the UK equity investor gets that nice hedge.
Lindsay Williams: Simon, thanks very much for your insight. That is Simon Brazier, Portfolio Manager responsible for the UK Alpha Strategy.
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