The reaction of markets to the EU referendum result clearly indicated that a ‘Leave’ vote was a surprise. The mid-cap and small-cap indices fell 15% and 10% in the first two days respectively, before both rallying to about -6% as at the time of writing. The immediate response we sensed from markets was that this was a really ‘bad’ outcome. While the result was unarguably less positive than a ‘Remain’ vote, our job is to try and quantify how much worse this outcome may be; we are coming to the view that it may not be as bad as first feared.
While there are a number of likely paths along which the effects of the result might tread, in our mind, the key one is likely to be the impact of uncertainty on decision makers, particularly in light of the political vacuum we are currently experiencing. This must have some negative ramifications for UK economic activity, although precisely calibrating them will be difficult until more clarity is provided by politicians. Until or unless Article 50 is triggered, it is important to remember that from a regulatory position, nothing has changed yet for our investee companies.
Given the importance of single market access, and some of the commentary emanating from politicians, our central case is that the UK is unlikely to sign up to a deal that materially alters the current status quo. With this in mind, our working assumption is that the UK faces a likely slowdown in GDP growth, to around 1% (plus or minus 0.5%), from a previous level of about 2%. This is likely to provide a headwind to domestic earners, but should not be a catastrophe.
ACTION AROUND THE REFERENDUM
As the polls began to narrow in the days leading up to the vote, we took the decision to raise cash by selectively selling down some domestic cyclical holdings, such as Crest Nicholson, Workspace, JD Sports and Big Yellow Group. This took cash from roughly zero to around 4%. Going into the referendum, we were still overweight housebuilders, but neutral retailers and underweight financials (within that, overweight banks) and real estate.
In the immediate aftermath of the Leave decision we sold down further our domestic cyclical names, as well as trimming some out-of-index holdings, such as Paysafe and Just Eat, resulting in cash rising to about 9% by end of play on 24 June. However, given the speed at which some of the domestic cyclicals fell, we relatively quickly halted any further trading thereafter.
Unsurprisingly, housebuilders, real estate, financials and retailers bore the brunt of the selloff, with falls of 20-40% across a number of names. In our view, these levels were beginning to reflect recessionary conditions for a number of companies, which is not our central case.
Near term we are likely to hold a bit more cash than usual, as we assess the likelihood of any redemptions, which so far have been immaterial. So given more interesting valuations, we are likely to begin to look to put money back to work as opportunities arise.
POSITIONING AND OUTLOOK
Pre-‘Brexit’ our view was that we are currently in a world of generally positive, but subdued, growth. Against this backdrop, the portfolio was skewed to structural growth and cash flow investment themes, with balance offered by strong domestic cyclical ideas. Given the outlook for the UK has probably softened, we feel this broad positioning still holds. Where possible, we have looked to sell any lower conviction cyclical ideas, such as Morgan Sindall, but the structural growth / cash flow focus will continue to form the core of the portfolio.
Given the recessionary valuations priced into some stocks, we have selectively used weakness to add to certain holdings, particularly in the challenger banks space. In our view, both Shawbrook and One Savings Bank look compelling investments at these levels, and the fund has added to positions. So saying, we recognise there may be challenges to our base economic case, so are proceeding with a degree of caution.
Our analysis suggests the portfolio is capable of delivering 18% and 13% earnings growth over 2016 and 2017 respectively, which is likely to be materially higher than that available in the wider market. Based on consensus forecasts, Peel Hunt estimates the Numis Smaller Companies Index (NSCI) will grow at 3% and 13% over 2016 and 2017 respectively; the outer year forecast to us looks implausibly high, and is typically subject to downward revision.
While it is still early days, if our assessment of the economic outlook proves correct, and our earnings theses play out, then the valuation upside for the domestically exposed portion of the portfolio would be substantial. Meanwhile, we remain very optimistic about the outlook for our structural growth names, such as Fever Tree, Clinigen and Eco Animal Health, and our cash flow holdings, such as Ascential. Following the market correction, the NSCI is now valued on a twelve month forward PE of just 12x, a material discount to the FTSE100 on 15x. As such, we believe the portfolio has the potential to perform strongly from here.