Compelling valuations in domestic cyclicals

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Mitchell Fraser-Jones 29 June 2017 Est. reading: 5 min read

This post is part of a series explaining why we are more positive on the UK economy.
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Our investment approach sometimes appears contrarian, although we don’t go out of our way to do the opposite to the market. Often, however, we find ourselves drawn to areas of the stock market that have fallen out of favour – investor antipathy towards certain stocks or sectors becomes embedded in valuations and it is that undervaluation which sparks our interest.

Recently, we have seen value emerging in parts of the market that have fallen out of favour, in part, as a result of last year’s surprise outcome to the EU referendum. The market consensus has become far too cautious about the outlook for the UK economy since the vote and, although the initial savage share price reaction to the prospect of Brexit did not last long, in valuation terms the opportunity has persisted in a number of domestically-focused businesses.

Broadly speaking, there has been a significant divergence in the fortunes of UK economy-focused company share prices which is well illustrated by splitting the market into separate parts – one of businesses which are primarily global-facing, exporting businesses, and the other of businesses which are much more focused on the domestic economy. Helpfully, this is something Morgan Stanley has already done by creating two ‘baskets’ of stocks: UK domestics and UK exporters. The chart below highlights the extent of the change in valuation that we have seen post-Brexit.

UK domestic stocks now trade at a rare valuation discount to UK exporters

Source: Morgan Stanley, Woodford

Here we can see the relative valuation, in terms of price / earnings ratio, of the UK domestic basket versus that of the UK exporter basket, since 2009. Over that period, domestic stocks have consistently traded at a premium to exporters (in other words, they have been more expensively valued), with an average PE valuation premium of 15.1%.

In the aftermath of the EU referendum, this premium evaporated almost immediately, and in recent months, for the first time in several years, UK domestic stocks have been trading at a valuation discount to UK exporters.

Now, part of this move is perhaps rational – the weakness in UK sterling that we have seen since the Brexit vote is clearly beneficial for exporting business, which immediately saw an increase in the value of their export earnings and, in many instances, have benefited from a meaningful competitive improvement.

Exporters have therefore been seen as the ‘winners’ of Brexit and the perceived ‘losers’ by contrast have been the domestic stocks. Practically any business that has a domestic bias saw its share price hit dramatically after the vote and, although many share prices have recovered, there is still an evident sense of gloom about future prospects which is reflected in the chart above.

This represents some ‘broad-brush’ thinking from the market consensus in response to the Brexit vote. The Pavlovian reaction of “buy exporters, sell domestics” lies at the heart of the opportunity that we have been keen to seize upon in recent months.

In our view, the share prices of many UK domestic businesses now imply an imminent collapse in UK economic growth rates. We simply do not see that outcome as likely – indeed, we believe the outlook for the UK economy is improving, not deteriorating. With that backdrop in mind, we have looked for and identified some very high-quality businesses, trading on eye-catchingly low valuations where future growth expectations are far too modest.

As is always the case, these are long-term judgements, but we believe this valuation gap deserves to narrow and are confident that, over time, it will.

Read more from this series

Banks back in business

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For the first time in many years, after a prolonged period of rebuilding capital and recognising losses, UK retail banks are an attractive investment proposition.

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Contrasting expectations

Mitchell Fraser-Jones 29 June 2017 5 min read

While we have a positive view on the domestic economy, we remain considerably more cautious about the prospects for the global economy.

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Fixing the broken housing market

Mitchell Fraser-Jones 29 June 2017 7 min read

One part of the UK economy that looks well placed to benefit from this benign outlook is the construction sector. Here we see an industry with positive fundamental dynamics and a long-term opportunity, underpinned by the public sector.

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