Vista - How a polarised market can provide profits for the brave investor

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01/05/2019
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Many investors will be aware and perhaps bemused or sceptical that the UK equity market, as measured by the FTSE-100, has not been particularly impacted by the Brexit shenanigans over the last two years.  One explanation is commonly quoted as being the fact that over 75% of the earnings from FTSE-100 constituents such as BP, Shell, Rio Tinto and HSBC are from overseas, principally US dollars. This means that when the value of Sterling dropped after the referendum on 23 June 2016, the value of these overseas earnings rose when translated back into a now weakened sterling.

This means that as the chaos has intensified within parliament, weakening sterling. The FTSE-100 has often appreciated in response, presenting a natural hedge to the worrying economic implications that would normally emanate from such an uncertain environment.

Weakening domestic sectors

However, outside of this, representing the true Brexit effect, there has been significant weakness in domestic sectors which are dependent on consumer confidence and have little or no overseas earnings.  Such examples are anything linked to property whether that be residential or commercial. Others are retail which has had the double whammy of hesitant consumer confidence coupled with the impact of internet shopping on the high street. So, any business offering commercial property outlets to general retailers is probably operating in just about the worst affected environment possible.

It’s not all doom and gloom 

Yet, despite all the doom and gloom and predictions of disaster of two years ago, (the so-called Project Fear as often quoted by hard-line Brexiteers) overall, the UK economy is holding up well, relative to other countries such as Italy, Germany and Japan which are all either in recession or very nearly.

 
Nevertheless, there are areas where the share prices are pricing in future earnings uncertainty as they would potentially be severely affected in the event of a no-deal Brexit. Market capitalisation has come into play where unusually, large capitalisation stocks have been outperforming mid-caps and small-caps. Firstly, large caps are where the largest overseas earners are found, secondly, this is because a lot more of the mid-caps and small-caps are domestically exposed and thirdly, as investors have become cautious they tend to focus on the largest businesses as these should be more able to weather any storms that lie ahead whatever the outcome of Brexit.

This may present opportunity for the savvy investor who is willing to bet that the worst-case scenario is being priced into these currently unloved sectors and stocks. In many cases, the share prices are so depressed that there are eye-watering dividend yields on offer.  However, this is classic value investing and fundamental analysis and deep understanding of the underlying business is vital, otherwise the unwary investor may simply buy the chart which shows a depressed share price, get drawn into an 8% dividend yield, only for the business to founder, pass the dividend and collapse into a distressed situation with all shareholder value wiped out. Debenhams would be a case in point.

The alternative is to buy the growth sectors which appear immune from Brexit, perhaps those with significant overseas earnings which are currently doing very well. However, the valuations in terms of price/earnings ratios, will be considerably higher than the value sectors as referred to above.  The risk here is that either sterling strengthens on a Brexit deal, reversing the currency benefit previously enjoyed, or some other negative appears – either company-specific or sector-specific – which bursts the valuation premium bubble and investors run for the hills as the share price craters.

Keep a foot in both camps

So, we have a rather polarised UK equity market. One half, expensive with beneficial currency support, influenced by politics, the other potentially oversold and cheap, but vulnerable to a no-deal Brexit. When faced with such a dilemma, it is sensible to have a foot in both camps so that, as an investor, you are hedged to either scenario, and as many of the other scenarios currently being debated in parliament. However, when investing in a very uncertain environment; one certainty which you can focus on is the provision of income or more specifically, the payment of dividends, their growth in real terms and the sustainability and security of that dividend.

One quick and easy measure which all professional investors will look at when faced with a share yielding 8% or more is dividend cover. This is the ratio of earnings per share to dividend per share or in plain English, the ability of a company to cover its committed dividend payment by the profits from the company. Clearly, if the latter is deficient in this respect, then the company must pay the dividend from reserves which can only go on for so long before it must cut the dividend.

One definition of a share price, and a valuation measure, is intrinsic value. This is defined as the discounted present value of future cashflows i.e. dividends. Therefore, a company will only cut its dividend as a last resort because the effect on the intrinsic value is significant and especially if the company is viewed as an income share where the earnings are not growing much above inflation. This means that when a company has a high dividend yield and most likely, a depressed share price, if the dividend cover is low and not covered by earnings, the market is expecting that dividend to be cut. This means that the advertised 8% historic dividend yield is an illusion and more likely translates into a 4% yield going forward, coupled with a significant fall in the share price, if and when that occurs. If the price/earnings ratio also looks low, then this is probably a value trap for the unwary investor as the earnings (and the dividend) have not yet officially adjusted down to reflect the anticipated negative outlook.

A window of opportunity

At this point, it is probably useful to look at some of the sub-sectors of the UK equity market and how they have performed since the Brexit vote. Mining & Basic Materials is the top sector, more than doubling over the period, followed by Beverages and Electronic & Electrical Equipment. Conversely, Telecommunications, Industrial Transportation and Tobacco populate the weakest areas.  

This is the first step to focusing on where there may be some rich pickings but also some dangerous value traps. Clearly, this is where the skills of equity analysis come in and that is not the purpose of this commentary but perhaps it gives a flavour of why, at times like this, with a polarised market, for the brave investor, there could be some highly profitable opportunities.