The UK equity market resembles “a coiled spring” that could see a disproportionate kickback if the UK’s departure from the EU is anything other than a complete disaster, according to JP Morgan Claverhouse IT manager William Meadon.
Despite a rebound that has seen the FTSE All Share rally by close to 7 per cent since the start of the year, it has made only about half the returns of the MSCI AC World index since the UK voted to leave the EU in June 2016.
Performance of indices since June 2016
Source: FE Analytics
In an article published on FE Trustnet last week, Laura Foll, co-manager of the Lowland Investment Company, pointed out the Bank of America Merrill Lynch (BofA ML) Fund Manager Survey has had to adjust the scale on its chart to show just how out of favour the UK is among international investors
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Fund flows data shows that investors are still pulling money out of the UK – but with the deadline approaching for the UK’s exit from the EU, Meadon (pictured) said we could be reaching an inflection point
“I always give the analogy of a coil,” he explained. “You know, you press a coil down so hard that you only need a slight marginal change – things don’t even need to get better, just as long as they are not as bad as was feared – and the kickback is disproportionate.
“We are at a very interesting stage clearly. You know the next week or two if we delay or we rule out a hard Brexit, we need to work out how much of that is in the coil which is pressed down and how much we should be going the other way, because clearly a lot of money has come out in fear of that and other things.”
Meadon admitted that while the UK is facing political and macroeconomic uncertainty, he said the key question is, what exactly is the market pricing in?
And, although the manager pointed out the UK looks cheap in terms of its current yield and P/E ratio, his favourite representation of value in the market is the yield gap, which shows the difference between the yields on gilts and UK equities.
“We ran this a few weeks ago and there were two points when equities had been cheaper,” he continued, “and that was the start of the First World War and the start of the Second World War.
“And actually someone came up to me last week and said ‘just run the chart again and update it’ and now it is cheaper than the start of the Second World War.
“The only time since the start of the 20th century that equities have been cheaper compared with risk-free bonds was the First World War. Are things really as bad as they were at the start of the First World War? That is really the question to ask.
“Is this the darkest hour before the dawn?”
Claverhouse invests in both growth and value stocks with the aim of delivering steady outperformance of the index and maintaining its record of dividend growth – it has increased its payout to investors in each of the past 46 years.
One of the stocks the managers are using to play the theme of value in the UK is housebuilder Barratt Developments. While co-manager Callum Abbot described it as “not the most glamourous stock”, he said the housing market in the UK benefits from some attractive tailwinds.
“We looked at some ONS [Office for National Statistics] data and the proportion of 20 to 34 year olds still living at home with their parents is as high as it has been since 1986,” he added.
“There is an undersupplied market and it has government support to build more houses, both parties want this. Now to us, that is an incredibly attractive market structure.”
Other fund managers are less convinced about the prospects for the sector.
Alex Wright of the Fidelity Special Situations fund is one of those steering clear, saying housebuilders’ all-time high profit margins give them significant operational leverage to any deterioration in demand for new homes.
However, while Abbot admitted that profit margins are high, he described this as a function of the high barriers to entry in the sector.
“Normally if your builder is making a return on capital of 30 per cent, you’d expect people to come into the industry, but it’s difficult when no one will lend to you,” he said.
“If you are a small housebuilder and want to develop a plot, it’s a lot of capital you need to put upfront for a payday in three or four years’ time and that is assuming you get planning permission, so there is a lot of risk for a small builder.
“Whereas if you have got hundreds of plots across the country you can manage that a lot better. And a lot of these guys were buying land at times when people thought the housing market in the UK was going to be under long-term pressure. While the house prices have recovered, the land market has actually stayed really benign, which again goes back to those barriers to entry. So while they are high, I think they are reasonably well protected.”
Even in the worst-case Brexit scenario, Abbot thinks the sector can hold up reasonably well. He said it has “a number of levers it can pull” such as refraining from buying more land, finishing up the projects it is working on and reining in capital expenditure, which should protect cash generation in future.
However, he said housebuilders still “regularly get beaten up on fear” with yields spiking up to about 10 per cent late last year and these figures still at about the 8 per cent mark.
“Going forwards I think they can continue to earn good returns on capital. Now they may have to give some of that back. But I still don’t think that makes them unattractive investment. Even if a housebuilder is on a lower return on capital, it’s still an attractive prospect – as long as it is not substantially lower.”
FE Analytics shows JP Morgan Claverhouse IT has made 245.07 per cent over the past decade, compared with 229.31 per cent from its IT UK Equity Income sector and 189.10 per cent from the FTSE All Share.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
The trust is on a premium of 1.78 per cent compared with discounts of 0.78 per cent and 5.68 per cent from its one- and three-year averages. It is yielding 3.87 per cent, has ongoing charges of 0.77 per cent and is 6.5 per cent geared.