‘Cheap quality’ – How Brexit has created long-term opportunities

04/01/2019

The dreaded ‘B’ word has cast a blanket of negativity over investors’ outlook for the UK stockmarket.

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Among so much uncertainty and gloom surrounding the UK’s imminent departure from the EU, conventional pricing of company shares has been turned on its head.

The UK stockmarket, as measured by the FTSE All-Share index of UK company shares, was on course to suffer its worst year since 2008 as of the end of November 2018.

Total returns (being the combination of income and capital growth) from the FTSE All-Share in the first 11 months of 2018 were -5.9%, compared to a positive return of 3.8% for the global stockmarket, as measured by the MSCI All Country World index. Put in US dollar terms, total returns from the FTSE All-Share were even worse -11.3% over this period.

This is not to say that all UK stocks have fared badly. To the contrary, many large companies that derive most of their earnings from overseas have outperformed, as have those seen as ‘defensive’ stocks that are widely expected to hold up well throughout the economic cycle.

The obvious beneficiaries have been companies in the energy, materials, utilities and healthcare sectors, despite the first three of these sectors in many cases demonstrating limited growth, poor returns on capital, and low dividend cover.

Quality in the UK has rarely looked cheaper

On the flip side, UK companies that operate in more cyclical sectors or are domestically-focused businesses have suffered indiscriminately. Among these are some high-quality companies, in my view.

For us, quality is not about any single metric, but a blend of characteristics that allow companies to deliver growing value for their shareholders over time. A quality company should, among other things, be able to deliver sustainable growth with a healthy balance sheet and strong corporate governance.

Our recent analysis of stock valuations across the FTSE All-Share index reveals that many companies we judge to have high quality characteristics have borne the brunt of investor pessimism.

Amazingly, stocks appear to become better value as you move up the quality spectrum. In other words, we as investors are being paid to increase the quality of assets we hold, at least up to a point – the highest quality stocks, unsurprisingly, remain among the most highly prized by investors. Companies in the second quartile of quality seem to be the sweet spot, according to our analysis.

Keeping long-term perspective

Every stock must be evaluated on its own merits, of course, but it seems clear to me that there are exciting opportunities among those quality UK companies that are currently unloved by most global investors.

Brexit, for all its unintended consequences, has opened up rare possibilities to buy stakes in quality companies at attractive valuations. By comparing share prices to company earnings, UK stocks overall look less expensive than their counterparts elsewhere in the world – especially in the US.

The abandonment of logic in the face of short-term concerns over the UK economy has created particularly fertile hunting grounds for long-term investors. The beauty of an active investment approach is that we have the freedom to go against the grain to pursue these opportunities.

The views expressed by the author should not be taken as a recommendation, advice or forecast.

The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.