Why UK equities seem unfazed about leaving the European Union
The UK’s multinational companies got a big bang out of Brexit, but it was over quickly. Since then there’s been no meaningful difference in performance with their smaller and more UK-focused peers, despite the stream of negative press around Brexit negotiations.
Since the referendum, a basket of stocks made up of companies listed on the FTSE 350 that earn less than 10% of their revenues in the UK (with equal weight given to each constituent) has risen by 43%. A basket of stocks comprising companies that earn more than 90% of their revenues in the UK has risen by just 4%. An equally weighted basket of all the stocks listed on the FTSE 350 has risen by 19%.
The referendum has had a significant impact on returns. What’s interesting is that the impact was so swift and, moreover, so definitive. Investors adjusted to the outcome of the referendum within two weeks: since 7 July 2016 the basket least exposed to the UK has only outperformed the basket most exposed to the UK by two percentage points (34% versus 32%).
This short and sharp adjustment mirrors the exchange rate. Sterling’s effective (trade-weighted) value initially fell by 11%, but has been stable since the fortnight after the referendum, appreciating by just 0.5%.
In the wake of the news that the UK and EU have reached agreement on the terms of divorce, sterling was unmoved. But that is unsurprising given the complexity of trade talks and uncertainty surrounding a final Brexit deal.
It is tempting to attribute the adjustment in stock prices to the exchange rate and the ‘translation effect’ on earnings — if a company makes most of its sales in foreign currencies, a large domestic depreciation immediately lifts earnings as they are translated on to sterling-denominated income statements. Indeed, the relative performance of our two baskets has correlated closely with the value of the pound since before the referendum (figure 6).
However, we believe the adjustment was about more than just currency. Such translation effects are a one-off. They should not affect the rate at which investors expect companies to grow their earnings sustainably over the medium to long term. Yet we can observe a similarly swift and similarly definitive adjustment in analysts’ estimates of these sustainable growth rates. Consensus forecasts are that the average sustainable earnings growth of the companies in our basket least exposed to the UK will be 9.5% compared with just 6.6% for the basket most exposed. Before the referendum, the former were expected to grow at a lower rate than the latter.
Figure 6: The impact of Sterling
The performance of stocks least and most exposed to UK sales has been closely correlated to the value of sterling over the past few years
Source: Datastream and Rathbones.
It may be that some factor entirely unconnected to Brexit is driving the divergence. Looking at the composition of our baskets by industry sector, the basket least exposed to the UK is biased towards companies that mine or refine basic materials and commodities, while the basket most exposed is biased towards financial companies. Yet when we exclude these sectors and adjust for biases, the picture is similar to that described above.
Over the past 10 years the average valuation multiple in both baskets has been around 13.5 times future earnings. Today, the basket least exposed to the UK has an average multiple of 16 times compared with 13.9 times for the basket most exposed. There is a clear penalty. Similarly, the dividend yield of the two baskets has been the same historically, but has now risen in the basket most exposed to the UK. But we caution those investors hunting for yield in UK exposed names: dividend cover is materially worse. Over half of cash flows are being used to pay dividends, compared with just a third for companies least exposed to the UK, giving the latter a much bigger buffer and scope to grow the dividend.
Although the media talks as though the probability of a poor outcome for the UK after Brexit changes weekly, markets do not seem to see it this way. The reaction was swift and decisive. Until there is more clarity on the environment in which the UK will operate after the referendum — enough to move both the exchange rate and the medium- to long-term outlook for growth — we do not expect those companies most exposed to the UK to outperform again. But it does not look as though they are likely to underperform by as much as we might have previously anticipated either.