A vast majority of UK retail stocks are likely to be hit by an “unhappy trinity” of headwinds as we head through 2017, according to EdenTree Investment Management’s Phil Harris.
The manager, who heads up the £163m EdenTree UK Equity Growth fund, is bullish on both the UK macroeconomic picture and the individual stock selection opportunities available at the moment.
However, given the recent rotation from quality growth into value stocks, he warns that investors could be susceptible to potential value traps lurking in the UK market.
Performance of indices over 1yr
Source: FE Analytics
“There is an abundance of opportunities in the UK, we are bullish for 2017. We think the economy will probably grow a bit more than most commentators think. 1.4 per cent headline growth seems conservative, I think it’s probably going to be closer to 2 [per cent],” Harris said.
“The UK is going to be relatively okay this year in terms of GDP numbers. The Brexit talks are a different issue. I expect it will become a little quiet after March as there are a lot of technicalities to work through.
“For next year overall, there is a relatively robust background. Having said that, there will be some specific sectors that get hit quite hard. The one we would like to avoid is retailers, not all retailers, but the big old-fashioned offline retailers, and some of the more basic pub and restaurant groups.”
The manager says any currency hedges that retailers have put in place are likely to run their course by April this year, which means import cost inflation will become a headwind for the sector.
Not only this, he says the National Living Wage – which will push the minimum hourly wage for employees over the age of 25 to £7.50 in April this year – will hit the market area particularly hard because of its dependence on lower price labour.
“You have an unhappy trinity of things that could go wrong for you, and obviously you have consumer underlying demand that may or may not weaken,” Harris continued.
“If you run the numbers for a basic pub group, you’re going to have to generate about 3 per cent like-for-like sales growth this year to stand still, given all of those cost pressures coming through. And it’s more for certain businesses than others – that’s a relatively optimistic figure.
“These guys tend to be lucky if they generate 1 or 2 per cent. So if you’re an average big pub company or retail figure, you will have to generate a lot of extra like-for-like real sales growth. These are the guys that are going to suffer this year.”
Not everybody staunchly shares this view, though. In an article published last week, FE Alpha Manager Henry Dixon told FE Trustnet that some retailers are pricing in a recession and are therefore trading on overly pessimistic valuations.
In fact, he believes that some retailers are set to benefit from the effects of inflation, citing manufacturer of own-brand supermarket products McBride as an example.
“Markets are definitely pricing something in close to a recession and that feels harsh in places. So where you can find the domestic portions of the UK market being priced in quite a depressed fashion, we’re looking to express a view against that,” he said.
While Harris is largely negative on the sector, he says there are still a very small number of opportunities in the space.
For example, he currently holds Supergroup, which owns the international clothing brand Superdry. Over the last year, the FTSE 250 constituent has returned 4.95 per cent compared to its index’s return of 18.08 per cent. It also has a maximum drawdown – which measures the most money lost if bought and sold at the worst possible times – of 17.13 per cent over this time frame.
Performance of stock vs index over 1yr
Source: FE Analytics
“Why do we like Supergroup? Firstly, it has an international spread and, secondly, it’s a great growth brand because it has been restructured,” the manager said.
“There is a big self-help agenda there. It has introduced a Chinese joint venture, it bought a US business in and it has double-run a lot of costs to try to reconfigure the distribution.
“It has the combination of a being a really good business with strong growth potential and also has a lot of self-help as well. It is a nice mix of things to look for, rather than the old-fashioned retailers.”
Generally speaking, Harris believes 2017 will present plenty of ‘buy’ opportunities. He says most of these will be further down the cap spectrum, given that many mega-caps are still trading on high valuations.
“It would be difficult to see sterling fall materially from here, it could fall on an intraday basis but a lot of research houses are nudging towards £1.30 to £1.35 against the dollar for the year-end,” he said.
“In that case, you could see your average mega-cap actually declining this year. At the moment everyone is pricing in the wonderful opportunities relating to the currency benefit, but that can quite easily reverse and so, when a company on a P/E ratio of 20x starts going down, that can look expensive.
“I expect that trend will run for the first few months still in terms of mega-cap but, for the whole year, mid-cap is now starting to look decent value again. It’s at a small discount to the FTSE for the first time in a while – it has been at a 20 per cent premium in the past.”
Performance of indices over 1yr
Source: FE Analytics
In terms of last year’s rotation out of growth into value, Harris says the key is not to place too much emphasis on valuation alone.
For instance, he believes no stock is necessarily expensive on a P/E ratio of 50x and that, equally, no stock is necessarily cheap on a 5x P/E ratio.
“You could quite easily buy a very low P/E stock that looks incredibly cheap on P/E and yield terms, but actually it’s a growth stock masquerading as a value stock,” he explained.
“I think [the value/growth debate] is an anomalous argument, because what you’re looking for is decent growth and good businesses at decent P/Es.
“I do shy away from the value idea, because some people’s idea of value is to find structurally challenged businesses. For investors looking for growth at a reasonable price, there are plenty of opportunities in the market today.”
Since Harris has managed EdenTree UK Equity Growth, which he now runs alongside co-manager Ketan Patel, it has returned 9.76 per cent compared to its average peer’s return of 15.86 per cent.
It has a clean ongoing charges figure of 0.79 per cent and yields 2.17 per cent.