The UK stock market: beyond Brexit

Louise Kernohan, Investment Director, Dunedin Income Growth Investment Trust PLC

  • Brexit is more than just noise, but it is a sideshow in the day-to-day running of our business.
  • There are steps we can take to navigate some of the more significant problems associated with the current political upheaval.
  • A focus on quality, balance and looking at what the market may have missed are important.

Today, the UK stock market is viewed through the prism of Brexit. The questions are what will happen to sterling; or to the UK economy, rather than the nitty-gritty of corporate activity. Yet it is clear that there is much going on for UK companies that has nothing to do with Brexit.

That said, Brexit is more than just noise. It may have a meaningful effect on the earnings and dividend payments for certain companies that depend on EU markets or supply chains. For others, the currency is a key issue. For dollar earners, a weak sterling flatters their income, while other areas struggle in relative terms because their income is in sterling. However, for most it is a sideshow in the day-to-day running of their businesses.

This is a difficult path for a UK fund manager to navigate and we don’t pretend any unique insight into the Brexit outcome. However, we do believe that, as investors, there are things we can do to side-step some of the more significant problems associated with the current political upheaval.  

The first is a focus on quality. This has been a priority for the Dunedin Income Growth Investment Trust in recent years. We have placed an increased focus on higher quality companies with reliable dividend growth, believing those companies will be more resilient whatever the broader economic or political environment. For us, quality means strong cash flow and balance sheets, combined with good long-term growth prospects.

The second is to ensure balance. The trust is managed on a bottom-up basis, focused on picking individual companies. However, we strive to ensure balance at all times and that the trust is not too exposed to individual risks. With Brexit, the problem is that a resolution could send sterling significantly higher, while a ‘no deal’ could send it significantly lower and we would rather the trust were not vulnerable to this type of volatility.

With this in mind, for much of 2017 and 2018, the trust had been overweight to international companies with overseas assets, and underweight sterling. However, today we see some value emerging in domestic UK businesses which have been sold down a long way. As such, we have moved to invest in some higher quality businesses, focused on the domestic economy. This creates balance in the portfolio.  We may not know what’s going to happen with Brexit, but we believe quality will outperform either way and we now don’t have a skew on sterling.

We believe it is also important to look at what the market might have missed. Any kind of market upheaval creates mispricing and investors often overlook the reality of a company’s situation. We see this in housebuilders such as Countryside Properties. In reality, only half the company’s revenues come from traditional housebuilding. Even here, there is a lot of pent-up demand after a difficult time in the housing market and there remains an ongoing supply and demand imbalance.

The other half of its revenues come from the partnerships business. This sees the company working in partnership with local authorities and housing associations. Over the last 30 years it has collaborated on more than 45 regeneration schemes across the UK. This is much less sensitive to the strength of the economy and has more attractive financial returns than the conventional housebuilding business.

Another example would be the reintroduction of WH Smith into the portfolio. Why bring in a tired old high street retailer? Yet the group’s high street business is a relatively small part of its profits – around one-third. Certainly, it’s not particularly attractive, but the group is good at category management. The travel business is the vast majority of its profits and it is growing strongly. It is benefiting from growth in travel generally; WH Smith is now found after passport control in most airports and major train stations and is perfectly geared to impulse buys.

We always invest with an awareness of the dividend implications. The dividend is well-underpinned in the trust. At the moment we have reserves equivalent to around a year of payouts. This means we can prioritise dividend growth over higher yielding companies where dividends may be more at risk. While this may mean less income coming into the trust in the short-term, we believe companies will deliver stronger income in the longer-term. This is particularly important today. We see more companies where the dividends are at risk: there is weakness in some retail names, for example, even in some of the online names.

Brexit is dominating the conversation around UK equities. The key is to try and steer a course through it, rather than position for either outcome. It is a difficult line to hold, but we believe a focus on quality, balance and a realistic appraisal of what the market might have missed is the right path.

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Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments.

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