The UK economy is likely to endure significant long-term headwinds if the Brexit goes ahead and investors are therefore better off remaining in defensive stocks rather hunting for bombed-out value stocks, according to Alan Custis (pictured below).
The manager, who has co-run the Lazard UK Omega and Lazard Multicap UK Income funds for more than a decade, says that it is currently difficult to know what the transactional impacts of the UK leaving the EU will be, based on the assumption that the sterling will weaken as a result.
Because of this, he warns against snapping up ‘bargains’ in the domestic-facing mid and small-cap UK markets, which are currently underperforming the blue-chip index for the first time in several years.
Performance of indices in 2016
Source: FE Analytics
In stark contrast, manager of the Henderson Cautious Managed fund Chris Burvill told FE Trustnet in an article this morning that under-performing value stocks could be the safer option at the moment given the high valuations of quality UK stocks. 
“Last year in particular growth names tended to fare better. There are, however, now signs that the tide is turning with ‘value’ investing potentially better suited to the environment ahead. Everything in markets is cyclical. The real question is when, and in my view we are already seeing conditions in place for a return,” he said.
While Burvill is currently buying into sold off areas of the market and seeking opportunities in areas such as the financial space, Custis warns that this sector could be in for a particularly turbulent time given the current macroeconomic situation.
He adds that domestic-facing areas of the market, including real estate companies, housebuilders and retailers, are likely to suffer because of the uncertainty surrounding the EU referendum, and points out that this could continue if the UK were to leave as overseas investors are less likely to buy into the UK market.
“I think that the whole [Brexit] campaign will be fought on the emotive topics of migrants, security, immigration, job security, which is fine and we should accept that those are the things that garner the front pages of all of the newspapers,” Custis said.
“However, the reality is that obviously Europe is by far and away our biggest trading partner – it counts for some 47 per cent of all our exports and services, and the relationship to a degree is imbalanced because we don’t account for that much of Europe’s. You could argue that we need Europe more than Europe needs us.”
Sentiment surrounding a potential Brexit appears to be mixed in the financial services sector, with the likes of ConBrio Sanford Deland UK Buffettology manager Keith Ashworth-Lord telling FE Trustnet last week that a departure from the EU could see the UK “soar from the ashes of the EU project”, while SWMC UK manager Brian Cullen warned that a Brexit could have a hugely detrimental impact on the market.
Custis argues that, if we do leave the EU, it will be what he has dubbed as a more extreme “Smexit”, which would involve exiting the European single market.
“Do we think that with a Brexit vote, Germany and France are going to welcome us with open arms? No. When global companies are thinking, ‘should we have the UK as a location or should we think about somewhere else?’ I think there will be huge inertia in terms of investor decision and therefore I don’t think, despite what people are saying, a Brexit would be a momentary blip,” he argued.
“Yes we’ll still trade with Europe because clearly we have to keep trading with them but I think it could come at quite a considerable cost, and therefore why would companies choose to locate themselves in the UK over the rest of Europe when they’ll have to pay a 10 per cent tariff?”
“You would like to think that ultimately the decision would be based on fundamentals and economics but obviously these kinds of things don’t tend to be based on that. From a personal standpoint, I hope that the facts are aired so that people can make an informed decision rather than go with an emotive decision-making process.”
Because of this looming fear hanging over the welfare of the UK market, the manager advocates buying into defensive, dividend-paying stocks that are trading at higher valuations than some areas of the market.
While some refer to these stalwart stocks as “bond proxies” and believe that they pose valuation risks, Custis says that investors must remember that the current macroeconomic situation is particularly unusual and needs to be dealt with differently compared to how they would invest in other market cycles.
“You’ve got negative interest rates around the world and you’ve got 10-year bond yields at 1 or 1.5 per cent and therefore I think you need to reflect on the valuation of some of these companies with that as a backdrop,” the manager pointed out.
“I think it’s arguably different at the moment and therefore if a stock is giving you 3 to 4 per cent organic top line growth, is managing its costs and growing its earnings at 6 to 7 per cent as well as growing its dividends at 5 per cent, it’s almost like a bond with a growing coupon. Why wouldn’t I pay 20x or 30x for that at the moment with no clear-cut economic growth on the whole?”
“The whole QE ‘free money’ experiment clearly isn’t working at the moment and you’ve got lingering concerns surrounding Chinese growth, US growth trajectory is more muted now than it would have been this time last year, so I can understand the sentiment around those names and why people would be owning those names.”
Examples of defensive stocks that Custis says could be seen as attractive at the moment include Unilever, Diageo, British American Tobacco and Reckitt Benckiser, all of which he says are appealing for slightly different reasons based on their bottom-up fundamentals as well as their defensive nature.
Performance of stocks vs index in 2016
Source: FE Analytics
For instance, Custis likes Unilever because of the rapid growth of the health and personal care space and he says Diageo could be promising because of its new chief financial officer and her implementation of cost-cutting and restructuring.
“It doesn’t mean to say that we as bottom-up investors necessarily subscribe to the stocks as representing good long-term value and I think that, subject to the outcome of the Brexit vote, there may be some great value to pick up in terms of those stocks that have been hit hard and will be hit hard over the next three months,” he pointed out.
“I think it’s a question to a degree of keeping one’s powder dry and seeing if there are some opportunities there.”
“Post Scottish referendum we saw the stocks that had been impacted bounce back and to a degree we saw that post the general election, so I think there will be some opportunities but in the meantime, we hold a number of those defensive names and we understand why and where the relative attractions fall for those stocks.”
Over the last year, Custis has slightly underperformed his peer group composite, although this could be attributed to his large weighting in oil stocks. However, the manager has doubled the performance of his peers over the last three months and over a longer five-year period, he has outperformed his composite by 121 basis points with a total return of 35.99 per cent.
Performance of manager vs composite over 5yrs
Source: FE Analytics
Lazard UK Omega has a clean ongoing charges figure (OCF) of 0.81 per cent while Lazard Multicap UK Income has a clean OCF of 0.8 per cent and yields 3.7 per cent.
