The UK is a hidden gem for stock picking as it faces the Brexit, says portfolio manager and London resident Josh Jones.
Britons stunned the world last year by voting to leave the European Union, in a process likely to take two years or more once ‘Article 50’ of the Lisbon Treaty is triggered to begin the withdrawal. The British pound has lost almost one-fifth of its value since the June referendum on fears of economic chaos outside the Single Market.
“We think the Brexit and the weakness of the pound has created some pretty good opportunities in the UK, and so we’ve started to increase our exposure there,” says Jones, co-portfolio manager of the Robeco Boston Partners European Premium Equities fund.
“Basically on a bottom-up basis there are some really cheap stocks in the UK. Most of them are in the mid-cap space, as a lot of investors are just buying the multinationals that have currency exposure, such as the big healthcare or personal product companies that sell their products globally but report in pounds.”
“If 70-80% of your revenues are outside the UK, as the pound weakens, you’re just translating that back into more pounds and getting positive earnings revisions. So people are paying up for that, and larger multinationals outperformed in the UK last year.”
Jones says the fund has subsequently increased its exposure towards the UK, from 24% to 30% of the portfolio’s value over the past four months, while its mid cap exposure has increased from 30% to 33% over the same time period.
Boston Partners’ focus on bottom up stock-picking begins with valuation, looking for companies that are mispriced in comparison with their near-term growth and profitability. The portfolio exhibits a lower valuation level than the index at all times, with the portfolio currently trading at 15.5 times current earnings.
“We’re always trying to look for mis-pricings and anomalies in the market, where the market’s concerns about an issue is overdone relative to what’s going on economically with the business. The UK banks and insurers are a good example. We think that the situation facing UK banks is pretty close to being resolved; their balance sheets are now healthy.”
‘The market is still worried that Brexit will cause a recession’
“The prime example is Lloyds Bank, which is trading at 8 times earnings and 1 times book value. Their capital position looks fine, they’re paying special dividends, and they just bought MBNA, a US credit card business. The fact that they’re using their own internal capital to build a business is a pretty good indication that their finances are healthy.”
“By way of comparison, Bank of America was trading at 8x earnings or below a year ago when everyone was worried about it, and it’s trading at 14x earnings today. Lloyds today is doing well, with a respectable return on capital, but the market is still worried that Brexit will cause a recession, where credit risk will spike while interest rates will stay low. That could still be the case, but at 8x earnings it’s hard to discount it.”
Jones says the same can’t be said of banks in continental Europe, which are still struggling to recover from the financial crisis, with many dependent on support from the European Central Bank (ECB). “We’ve been pretty negative about a lot of the European banks for quite a long time; we just think they’re all still in a long period of capital retention rebuilding their balance sheets, and even when they’re done with that, they still have to deal with low interest rates and regulatory pressures,” he says.
“European bank shares went up last year, but a lot of that was following the US market, and the US banking market’s problems were resolved two or three years ago. With new US President Trump, regulations could be cut and interest rates could go up, so it’s game-on for US banks. We think Europe trying to follow that same game plan is a bad analogy – they’re just not in the same position.”
However, like the UK, Europe also has some hidden gems, Jones says. “One of our largest positions in Europe is Aurelius, a German private equity company. We love this business; it has one of the best management teams that we know,” he says.
“It’s basically an ex-McKinsey group that is doing turnarounds of distressed European businesses. We bought the company at around EUR 20 per share and it’s over EUR 60 today. We think that as long as management keeps doing what they’ve been doing, the share price will keep going up over time because they’re creating a lot of value. So this is a business we want to continue to own.”
“We still like some of the European industrial businesses such as Siemens, which has a pretty reasonable valuation today. We also like some of the European insurance market; insurance trends have been a bit tricky, but we think Swiss Re and Munich Re trading at or below their book values is still a reasonable deal, even though pricing trends are currently soft.”
Jones says a potential headwind for European companies is the tariffs threatened by Trump on imports, including one debated but unconfirmed proposal to slap a 35% tax on high-end cars such as BMWs.
“What you don’t want with an import tax in the way that it’s being proposed by Trump is to have low gross margins with a high imported portion of the cost of goods sold,” Jones says. “Ferrari is a perfect example. They make all their cars in Italy and their margins are good, but this is very different to a software company which has 70-75% gross margins, where if 20% of their effective sales base is the imported cost of goods sold, then a tariff causes a 4% hit to margins and you can absorb it.”
“If however you are an auto manufacturer with a 30% gross margin and the same thing happens, then you’re in big trouble unless you can move your manufacturing basis, or can raise prices. So it would be a big negative for those businesses if Trump imposes a tariff on cars. But don’t forget that a lot of the profitability of the big European auto makers comes out of China, not the US. If China really had a problem, it would further impact the likes of BMW.”
Jones says the massive quantitative easing program by the ECB bodes well for stocks. The central bank has been buying billions of euros’ worth of corporate bonds, which has a knock-on effect in being positive for the stock as well. The strong demand for the bonds lowers their yields and reduces the credits’ spread with benchmark German government bonds.
“Credit spreads are positively correlated with volatility, so by compressing credit spreads you are compressing equity risk premiums, which means multiples expansion for stocks,” Jones says. “Generally an investor wants to see a healthy level of credit spreads and a healthy level of inflation; you don’t want to see too much inflation or deflation; there’s a ‘Goldilocks spot’ in the middle.”
All in all, Jones is quite optimistic about the strategy as 2017 gets underway, stating “we believe the fund is well positioned to deliver in 2017, as it reflects the characteristics we seek on an everyday basis”.
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