The UK is leaving the EU, economic growth is slowing, household disposable income is being squeezed and interest rates only have one way to go. The case for UK domestic cyclicals – those businesses whose earnings rise and fall in-line with the broader economic cycle – could be considered as poor as a Conservative election campaign. Indeed domestic cyclicals have materially underperformed since Brexit, but is it all doom and gloom or has it created a longer term buying opportunity for some good quality albeit cyclical businesses?
One of the key considerations in our investment process is valuation; or in other words, what the current share price implies about the quality of a business and its future prospects. I agree that the outlook for the UK is uncertain but I would also argue the risks are already well known and hence valuations reflect this uncertainty. The chart below shows the valuation of UK domestic cyclicals compared to the UK market. As you can see domestic cyclicals are the cheapest they have been relative to the market since the last recession. Remember that was the worst recession for a number of decades. Are things really that bad? Unemployment is low, consumer leverage remains below previous peaks while there seems to be signs of wage growth.
In recent weeks we have seen results and trading updates from domestic companies such as Next and Pets at Home. Both delivered what can only be described as remarkably in-line statements with no change to analysts’ earnings forecasts. Despite this, both share prices were up strongly on the day of their results showing how far sentiment and valuations had fallen for these companies.
Although the fears over the UK economy may play out, I feel the share price underperformance in certain domestic companies has presented an attractive buying opportunity for some good quality albeit cyclical businesses.
Two examples are Whitbread and Lloyds. Whitbread, owner of Premier Inns and Costa Coffee, has leading market positions, strong brands, a robust balance sheet and is underpinned by freehold property. The company still has good opportunities to expand the business through the roll-out of its key brands which should drive higher profits over the longer term. Although short term trading concerns have put pressure on the share price this has created a compelling chance to own a high quality franchise on an attractive valuation.
Lloyds has transformed itself from the previous downturn into a well-capitalised bank generating good returns and attractive cash flow. Despite fears over pressure on margins given the low interest rate environment, the bank continues to grow net interest margins – the difference between the interest it pays to its lenders (i.e. depositors) and the interest it receives from its borrowers – while producing excess capital. With the management team promising the return of this excess capital via special dividends, shareholders could be in line for a cash return of close to 8%. Not a bad starting point even if the UK economy slows.
So while there are uncertainties around the UK economy it’s important not to throw the baby out with the bathwater. The underperformance of domestics has created good buying opportunities in some good quality UK companies, and we hope our investments in these areas will enable us to deliver long term performance to our clients.