UK housebuilders and domestic-facing stocks further down the cap spectrum are offering the best investment opportunities at the moment despite their lacklustre post-Brexit performances, according to Brian Cullen.
The manager, who runs the long/short SWMC UK fund, says that maintaining a long-term investment view given recent events is vital in order to drown out any short-term noise.
It won’t have escaped investors that last month’s vote to leave the EU has caused the divergence in performance between global-facing large-caps and domestic-facing smaller stocks to widen even further.
Performance of indices in 2016
Source: FE Analytics
In fact, just days after the vote to leave was announced, the FTSE 100 index hit its highest point in almost 12 months, which many attributed to the weakness sterling and the fact that the bulk of revenues from its largest members are in dollars.
“The fact remains that [the FTSE 100] is, to a fair degree, a measure of how companies are doing that dig lots of stuff out of the ground and sell it in dollars,” FxPro’s Simon Smith said in an article published last week.
“Oil companies make up three of the top six constituents and they have been flying because of the currency moves, up around 10 per cent since the vote.”
In contrast, smaller companies and property-related stocks have been hit particularly hard. Housebuilders have also suffered post-Brexit and have been consistently marked back over the last couple of weeks.
While many investors opted to sell out of housebuilders in the run-up to the referendum or have since gotten rid of their holdings, Cullen has more than doubled his exposure to the market area since 24 June.
In the run-up to the EU referendum the manager reduced his 15 per cent weighting to the sector to 6 per cent. Now the results have been announced though, he has boosted this position back up to his original weighting in the market area.
“We have been invested in the sector on-and-off for about four years now and have focused on a few names within it where we think the investment case has been the most interesting,” he explained.
“Taylor Wimpey is always one stock that is of particular interest. We’ve also been invested in Barratt and, at times, we’ve been on-and-off invested in Redrow. Since its IPO, we’ve been invested in McCarthy & Stone, which is a builder for retirement housing.”
“Going into Brexit, we saw there was still plenty of opportunity. We had this debate internally, I have colleagues who are much more cynical and believe they are cyclical companies that have had a very good run which isn’t sustainable. Whereas we were more confident going back three or four months was that the companies looked pretty cheap to us on either an asset basis or an earnings basis.”
In the run-up to Brexit, Cullen said that the land market remained benign while house price inflation was at a healthy level, which therefore offered housebuilders some margin relief.
“A few months ago, you could see very little out there aside from Brexit that was likely to suddenly change. For instance, build costs - which would be one way that margins could come under pressure - were subsiding this year, mortgage availability remained very good partly because of where interest rates were and are,” he pointed out.
“The actual cost of servicing a mortgage is very attractive and in most cases more attractive than renting.”
“All of this suggested that it was still an attractive sector. In May though everyone suddenly got much more relaxed about the prospect of us leaving the European Union. This coincided with Taylor Wimpey having an investor day which was a very positive event. We did use that as an opportunity to cut back our holdings ahead of Brexit. For instance, Taylor Wimpey went from being a 4 per cent position to a 2 per cent position.”
Cullen admits that, in hindsight, this was too much to hold at the time. He emphasises that there is a huge amount of uncertainty in markets at the moment and that nobody knows exactly what will happen over the short to medium term.
However, he says it is possible to seek areas of potential value through looking at company fundamentals and adopting a three to five-year time horizon.
“You have to make a lot of assumptions obviously but it’s about looking at what has potentially been priced into the sector in terms of house price falls, in terms of volume falls, in terms of cost, etcetera.” The manager explained.
“Our reckoning is that the prices today, which are pretty much where they were last Monday as well as after the initial two-day fall after the vote, are pricing in an approximate 15 per cent fall in house prices and around a 20 per cent fall in volumes, and that assumes they’re able to cut a little bit of cost in terms of build cost but not anywhere near as much as prices would fall.”
“This compares with the crisis when house prices fell around 20 per cent briefly and where volumes fell something like 40 per cent. It’s not as bad as then, but it’s still a pretty negative scenario and certainly one that suggests a large amount of stress for the UK economy and the UK property market.”
Cullen believes there is a very small probability that such falls will happen and bases this view on three factors: consumer confidence, mortgage availability and the willingness of banks to lend money.
While he admits the former is unclear at the moment, he says the latter two points appear supportive at the moment in a manner that completely contrasts with 2007, when interest rates were far higher and banks were far less willing to lend.
Another positive factor for UK property demand, according to the manager, is that the government has been offering greater support for first-time buyers through the introduction of the Help to Buy scheme.
“This [support] looks likely to continue and, speaking to the housebuilders we hold over the last couple of weeks, no one knows what will happen, but the view is there is a decent chance that there could be further stimulus in terms of policy,” Cullen said.
“The only unknown is then the consumer response – whether the consumer completely packs up and goes home or not. We think it looks overly negative so we’ve added quite substantially to the holdings that we have.”
“We’ve also added to names that we’ve looked at before and for whatever reason haven’t owned – we’ve now bought Crest Nicholson, we’ve added Berkeley Homes, Telford Homes and we topped up our holding again in Taylor Wimpey.”
The manager believes that market jitters within the housebuilding sector are simply muscle memory of what happened during 2008’s financial crisis and argues that, while selling out now is rational on a human level, it looks out-of-kilter with current market dynamics.
“For us it’s where the opportunity is over the next three-to-five years to make a lot of money. If that’s the domestic area which, at the moment we think it is although this could still change, that’s all that really matters,” he added.
Since Cullen launched the Dublin-domiciled SWMC UK fund in July 2014, it has returned 9.32 per cent compared to the FTSE All Share index’s return of 3.97 per cent.
Performance of fund vs index since launch
Source: FE Analytics
While the fund is down 16.34 per cent year-to-date, the manager says that this is down to him buying into attractively-valued areas of the market and remaining patient while they recover.
