As we articulated ahead of the referendum on the UK’s membership of the EU, we did not expect the vote to be to ‘Leave.’ However, as polls had been indicating a meaningful risk of such an outcome, we had taken some action to protect the fund in such an eventuality over the course of the last six months. Hence our longstanding overweight exposure to UK domestic cyclicals had been tempered and a modest holding in precious metals stocks introduced. Despite this, we remained modestly overweight consumer discretionary areas going into the referendum. The fund was also fully invested, with limited short positions in an attempt not to underperform the inevitable market bounce should the expected ‘Remain’ outcome transpire.
CHANGES TO THE PORTFOLIO
Immediately following the result, our initial aim was to reduce the net exposure of the fund, particularly in domestic areas most likely to suffer from the resultant economic uncertainty. Mainly on Friday, 24 June (the day the result was known), we selectively reduced exposure to a range of names, including Barrett Developments, Crest Nicholson, JD Sports, Workspace and Wizz Air. At the same time we introduced short positions in the FTSE 250 Index, Clydesbank, British Land, Foxtons and Countrywide. This reduced the net exposure of the fund by about 10%. Following further significant falls on Monday, 27 June (resulting in a 15% fall in the FTSE 250 index in two days) we have halted any selling in order to appraise current valuations in the light of likely scenarios for UK GDP growth.
Exposure to UK domestic cyclicals has been reduced such that overweight positions in retail and housebuilders are more than offset by underweight positions in real estate, travel & leisure and financials. The fund’s pre-existing underweights to the resources complex, capital goods, chemicals, food producers and IT hardware remain in place, as do overweights to media, support services and software.
From a thematic standpoint, the focus on structural growth and high cash yield remains valid, given that we expect the world to remain in low-growth, low-return mode. This core positioning remains intact.
We will continue to work over the coming days and weeks to establish how our sector views should change, given sterling’s depreciation and a potentially weaker environment for UK consumer and business spending. Close analysis of both economic and political newsflow will shape this thinking. The initial mark down in the most obviously affected areas (such as banks, real estate, retailers and housebuilders) has been particularly severe. In many cases we believe a recession is currently priced in. This is by no means a certain outcome at this stage and we would, therefore, expect significant ongoing volatility.
Our central case is that prospects for near-term UK GDP growth are diminished by the outcome of the referendum. We struggle to calibrate this with any certainty at this stage, given the current political vacuum. The timing and substance of proposals for the UK’s exit from the EU will help us to form more definitive views. Pro tem, our working assumption is that UK GDP growth in 2017 will be between 0% and 1%. Ultimately, we expect any deal with the EU by a future UK government to focus on ensuring access to the single market and to offer compromise on free movement of labour as a result. Net-net, therefore, by the end of this process (whenever that may be), the terms on which the UK trades with the EU may not have changed materially.
In the near term, we expect volatility to continue. We are conscious that we need to continue to maintain a global perspective too. Logically, Brexit per se should not impact materially on the global economy, provided that a framework for the UK’s relationship with the EU becomes apparent without significant delay.
Mid- and small-cap valuations were arguably already attractive relative to large-cap going into the referendum. Mid-cap was then trading at parity with the FTSE All Share index, while the Numis Smaller Companies index was trading at a 1.5 price-earnings point discount. Given the underperformance of both mid- and small-caps since the referendum, mid-caps are now trading on a 12-month forward price earnings ratio of 14 and the Numis Smaller Companies Index on 12, compared to nearly 15 for the FTSE All Share.
As the dust settles, we are feeling increasingly sanguine about the outlook and prospects for our investee companies, particularly as share prices for some of the consumer-cyclical parts of the small-cap market are now arguably already pricing in recessionary conditions. Meanwhile, the structural- and self-help drivers underpinning many of our portfolio companies should enable them to progress in spite of the near-term uncertainty.
As ever, the breadth of the small-cap universe should enable us to identify opportunities, whatever the ultimate economic backdrop.