Avoiding domestically-focused companies, overinflated large-caps and retailers impacted by falling consumer confidence is the key when attempting the navigate the markets following the UK’s vote to leave the European Union, according to Neptune’s Mark Martin. 
The FE Alpha Manager, who runs the Neptune UK Opportunities and Neptune UK Mid Cap funds, says investors should be wary of companies that can be hit by “a twin impact” of falling consumer confidence and rising costs of imports.
Since the EU referendum in June, many fund managers have considered the potential risks and while some have changed their portfolios accordingly, others have remained steadfast in their beliefs despite short-term underperformance.
The larger companies were the first to bounce back after the market’s initial falls, with investors flooding to large-cap defensive stocks in an effort to protect their capital and capitalise on a weaker sterling.
Performance of indices and pound weakness since the EU referendum
Source: FE Analytics
As the above graph shows, mid-caps have been hit particularly hard and have continued to underperform their larger counterparts since the vote.
This is due to the perception that many are domestic-focused stocks and have less exposure to global earnings, meaning they tend to be adversely impacted by the weakness in the pound.
This is shown by the rise of the dollar against the pound since the vote, which has strengthened by 13 per cent over the period, significantly impacting companies with a lack of overseas earnings.
But one area Martin (pictured) likes is the healthcare sector, which has been on a strong run since the start of 2014 and benefitted from a significant move higher following the EU referendum, as the below graph shows.
Performance of indices over 5yrs
Source: FE Analytics
As a result of the weaker pound healthcare companies, which traditionally sell a lot of their products to the US market, will benefit from lower costs and improving profitability.
“Healthcare is an obvious beneficiary at least from a very top down view of the post-Brexit world from the simple perspective of currency, because at a sector level healthcare is the biggest single beneficiary of a strong dollar in the UK market,” he said.
“A lot of these healthcare companies tend to have lots of production in the UK so if you are paying your staff in pounds and paying your rent in pounds but are able to get your revenues in dollars - as a lot of these healthcare companies do - then you’re onto a winner.”
A cursory glance at the top ten holdings of his funds backs this up, with the likes of Consort Medical, Genus and Chemring group high on the list.
Holly Cassell, assistant manager of the funds, sees other benefits: “It’s not just the improved profitability that you see short term for the healthcare companies. As a sector its highly dependent on significant R&D spending and that improved profitability allows them to reinvest into R&D and potentially gain market share away from overseas competitors.”
While there has been debate as to the extent of the funding the UK has got from the EU for research will be continued into the future, Martin does not see this as an issue in the medium to long term.
“I think overall the government has said it will be looking to support – at least in the medium term – strategic industries like healthcare so we certainly believe healthcare will be a long-term beneficiary [of Brexit],” he said.
Away from healthcare, Martin sees a lot of opportunities in the beaten-up mid-cap stocks. Indeed, despite Martin’s opportunities fund allowing him free reign to invest in any UK companies, he is significantly underweight the FTSE 100.
Cassell said: “We are very underweight the FTSE 100 in general. We’ve only got 10 per cent of the fund [in the index]; I think the benchmark is at 80 per cent.”
The £32m fund resembles his £600m mid-cap fund, with the likes of FTSE 250 firms Telecom Plus, Paypoint and Devro in its top ten holdings.
“We’re actually seeing a lot of opportunities within the mid-cap defensive companies and we have got a reasonable exposure to defence in the fund,” Cassell said.
One company the managers like is Ultra Electronics, which makes electrical and software products for industries including defence and aerospace.
“It has really similar end markets to BAE Systems and if you’re looking for dollar exposure given the foreign exchange dynamic we’re seeing at the minute – it actually has a larger exposure to the US than BAE does as a percentage of its total revenues,” she said.
Performance of stock vs BAE since the EU referendum
Source: FE Analytics
Post-Brexit, Ultra Electronics has fallen 5.3 per cent, while its much larger rival BAE Systems has risen 6.75 per cent. Martin said: “Ultra has been the victim of indiscriminate selling to some extent purely because it’s a 250 stock whereas BAE is a FTSE 100 company.”
“And that’s why we’re really excited by opportunities in the FTSE 250 right now, because there has been this - we think - an indiscriminate selling of stocks even where they are structurally advantaged and perhaps even better off post-Brexit than they were pre-Brexit.”
However, there are areas Martin is less keen on.
“Areas we’re avoiding would be domestic companies with significant imports. So companies that sell all or almost all of their products in the UK but which rely on imports into the UK in order to produce those products,” he said, pointing to his recent sale of soft drinks maker Britvic.
“One example that I can give you that we’ve sold in both funds since the Brexit vote is FTSE 250 company Britvic and that is because they sell a lot of their group products in the UK - and a lot of their revenues comes from the UK - yet they rely to a significant degree on imports.”
Performance of stock in 2016
Source: FE Analytics
The stock was hit particularly hard following the Brexit vote, losing more than 10 per cent in the first two days, and has fallen more than 10 per cent since the start of the year.
Martin says with the pound weakening, the cost of its goods will rise, while revenues will dip on a dollar-basis due to the foreign exchange changes.
Additionally, he is avoiding stocks linked to consumer spending in general as “mixed messages” suggest consumer spending is likely to drop off in the coming months.
“We have seen GSK consumer confidence survey indicate that consumer confidence post-Brexit had significantly weakened,” he said.
“So for us you’re losing on both sides of the coin with a company like Britvic as not only is consumer confidence falling, which could impact their sales, but also their margins are potentially being hit by increased costs of the goods sold.”
Within the FTSE 100, he highlights High Street retailers Next and Sports Direct as two firms that could also be hit by the dual impact of falling consumer confidence and rising costs.
Neptune UK Opportunities, which he has run since February last year, has underperformed the sector and benchmark since he took over, though this may have something to do with the outperformance of the FTSE 100 over that time.
Performance vs sector and benchmark under Martin
Source: FE Analytics
The fund has returned 2.1 per cent, six percentage points below its sector and benchmark.
Square Mile Research said: “Mark Martin has developed an approach that draws upon the resources of Neptune's investment team but also includes his own style. He is a naturally cautious investor who always looks at the potential loss of capital before making any investment.”
This means that, though the fund may underperform when the market is shooting the lights out, as has been the case over the last few months, it is likely to perform well over the longer term.
Indeed, a look at Martin’s UK Mid-Cap fund, which he has run since December 2008, shows it has significantly outperformed the sector and benchmark over the last five years, returning 144 per cent to investors over the period.
