For UK equities investors, much of the past year has been dominated by the UK referendum on EU membership. The unexpected vote to leave the trading bloc saw sterling slide and risk-averse investors pile out of smaller company holdings.
A flight to large-cap stocks with greater exposure to overseas earnings, coupled with more attractive valuations thanks to the fall of sterling benefited the blue chip FTSE 100 index.
Indeed, over 2016 the FTSE 100 rose by 17.35 per cent compared with a 4.67 per cent rise for the FTSE 250 index in the year through 21 December.
Performance of UK indices in 2016
Source: FE Analytics
The impact of the referendum outcome and uncertainty in the lead-up to the vote hit UK equities fund manager performance.
The average IA UK All Companies sector fund returned 9.52 per cent, while the average fund in the IA UK Smaller Companies sector rose by 6.55 per cent.
Performance of IA UK equities funds in 2016
Source: FE Analytics
As investors begin to prepare for 2017 and the commencement of UK negotiations to leave the EU, FE Trustnet looks at some of the forecasts made by managers for the year ahead.
Steve Davies, manager of the Jupiter UK Growth Fund and Jupiter UK Growth Investment Trust, says “the clear lesson for investors in 2016 was to expect the unexpected, particularly when it comes to politics”.
Davies says while Brexit has had a significant impact on how UK equities are viewed, there may be some positive signs for the sector.
“Investor sentiment towards the UK is at rock-bottom at present, for perfectly understandable reasons, but the same was true - albeit for different reasons - in emerging markets a year ago and we’ve seen what asset prices have done there since,” he noted.
“Anything that suggests we are heading for a softer Brexit and with an extended transitional period could trigger a bounce in sterling and a re-appraisal of the attractions of UK domestic companies whose valuations I believe now look very appealing.”
Alan Custis, manager of the Lazard UK Omega fund and head of UK equities, says the invocation of Article 50 of the Lisbon Treaty by the UK government during the first quarter of 2017, triggering its exit from the EU, could play out in markets in a number of ways.
“From a sector perspective, we think the rotation we have seen out of staples into more cyclical elements of the market will continue, as interest rates start to see some upward pressure and inflation also picks up,” he said.
“While UK GDP expectations have recently been crimped, we see global real GDP returning to levels close to their long term average.”
“In this scenario we would expect to see resource names more likely to maintain the performance they achieved during 2016. We are also constructive on the financial sector, as yield curve and LIBOR rate movements offer a more favourable backdrop than we have seen for some time.”
He added: “In conclusion, whilst factor investing has clearly paid off over the last few years, we expect the market to be more receptive to the underlying fundamentals in 2017, and we see insightful bottom-up stock picking as being an opportunity to be amply rewarded.”
Simon Brazier, co-head of quality at Investec Asset Management and manager of the Investec UK Alpha fund, says weaker sterling could fuel further M&A activity in 2017.
“Currency moves have helped exporters and UK companies with overseas revenue exposure, where we have seen profit upgrades as a result, while also contributing to M&A activity, such as Japanese company SoftBank’s recent deal to acquire technology firm ARM Holdings,” he said.
“A weaker sterling is undoubtedly beneficial to foreign acquisitions of UK companies, so we should expect more deals, and this is positive where it leads to increased synergies and efficiencies, economies of scale, better growth opportunities, and increased industry consolidation.”
“Future M&A activity will, however, also likely depend on the clarity, certainty and shape of the post-Brexit and post-US election political and economic environment.”
From an income perspective, there are several issues that investors should be aware of. Hugh Yarrow, manager of the Evenlode Income fund, has highlighted five key factors that he will be monitoring ahead of 2017.
Yarrow says that investors should be more long-term focused rather than being distracted by short-term factors.
“Ultimately, if a company can deliver long-run growth in per share cash flows and dividends, the share price will follow,” he said. “Patient, business-perspective investment is more relevant than ever in a world that sometimes feels overly obsessed with short-term noise, momentum trends and sector rotation.”
The firm also focuses on free cash flow and dividend growth, paying particular attention to asset-light companies with sustainable competitive advantages and long-run growth potential, which tend to produce sustainable dividend streams.
Companies able to manage balance sheet risk are also on its radar, particularly in an environment where debt has become cheap.
“We have been actively managing balance sheet risk in the portfolio over the last two years, and have a strong preference for management teams that take a conservative approach to a company’s capital structure,” he explained.
Other trends in the portfolio include “self-funders”: businesses that are able to invest in the long-term, pay a healthy dividend and grow cash in the bank.
“They are surprisingly few and far between at present, and are therefore worth cherishing and supporting,” said Yarrow. “Though long-term organic investment costs money today, these investments are the lifeblood of any business and will ultimately drive a company’s long-term competitive strength and cash flow growth.”
Finally, the manager says investors should be valuation aware, often finding best opportunities in “quality businesses facing short-term industry headwinds, but where cash generation remains strong and long-run growth prospects are good”.
“As the market inevitably gets buffeted around in 2017, we’ll keep an eye out for these opportunities. For the patient investor, unfashionable investments in fundamentally attractive businesses can be some of the most rewarding in the fullness of time,” he added.