If you’re avoiding the UK because of Brexit, you’ll probably miss out on some attractive valuations, according to Aviva Investors’ Chris Murphy, who says domestic names should see some uplift once investors start to focus on fundamentals again.
The resignation of prime minister Theresa May after failing to build a consensus over what a post-Brexit deal should look like has highlighted the considerable difficulties facing UK markets currently.
With a new prime minister to be chosen from the ranks of the ruling Conservative party – where there is considerable support for a ‘hard Brexit’ deal – it remains to be seen what outcome will arise.
Murphy, manager of the £984.7m Aviva Investors UK Equity Income fund, noted that the lack of clarity over Brexit talks, which are no closer to being resolved three years since the referendum, has had a significant impact on valuations in the UK market.
Since the referendum on EU membership in June 2016, the FTSE 100 has returned 29.28 per cent while the FTSE All Share has risen by 27.9 per cent. In comparison, the developed markets-focused MSCI World ex UK index has returned 55.06 per cent.
Performance of indices since EU referendum
Source: FE Analytics
Yet, with UK equities lagging their peers over the past three years, there could potentially be greater upside potential than other markets.
“When you look at the valuation of the UK market it is one of the cheapest – if not the cheapest – developed market in the world,” he said.
“That’s really a lot about Brexit and uncertainty. And yet, if you look at the make-up of the UK market, a large chunk of earnings is from overseas: they’re not actually predicated on the UK market.”
He added: “For investors with a long-term time horizon, when everybody is giving up on a market because of a particular event, once there’s some certainty you tend to get investors starting to look at pure fundamentals again.
“They will start to look at the UK and look at valuations and I think that will attract funds flows.”
The Brexit uncertainty and the recent sell-off in markets may also be causing boards to sit on their hands, said Murphy, who said any development on the political front could help spur corporate activity, particularly with sterling at its current levels.
“One of the things about the UK being an interesting market, if you compare it to the US, in terms of relative valuations today and also compared to long-run averages, nearly every sector in the UK is at a discount to the US in terms of valuation,” Murphy added.
“Now, is that because of the companies we’ve got? Are they low quality or anything like that? I think the answer is no.”
This focus on valuations is a key part of the Aviva Investors UK Equity Income stock selection process, the manager said, highlighting the dangers of getting caught up in a bubble.
“You always get bubbles and the dangers of bubbles is that people give up on valuation discipline,” he said.
Once the valuation discipline is lost, however, it can result in drawdowns if market momentum runs out of steam. As such, focusing on the business and assessing whether it is fairly valued or not is key.
“If you’re buying a business that you think is overvalued, in the end it’ll come back to bite you,” he said.
Murphy, who manages the fund alongside co-manager James Balfour, prefers companies with sustainable cashflows in industries with high barriers to entry – which is particularly important given the impact of technology and its disruptive effect on markets.
With a sector-agnostic approach, the Aviva manager prefers a broad spread of ideas within the portfolio which means there are “lots of different types of businesses performing and performing for different reasons”.
One such example is furniture retailer DFS, which while in a sector severely impacted by disruption has still retained its market-leading position.
Performance of stock over 5yrs
Source: FE Analytics
“If you want to buy a sofa, you can do it online,” he said. “But actually, most of us have probably all got a different view as to what a comfy sofa is: what fabric we like, what arms you like, whether you like to put your beer or wine or cup of coffee on it.
“You can’t do that on the web. With DFS it’s very hard to disintermediate through technology and it’s a business model that has survived through multiple decades of macroeconomic slowdowns, and incrementally wins market share.”
Indeed, the Aviva manager said the process is often about finding relatively mature businesses with strong brands and a big market share so that cashflows can’t be eroded through competition.
As such, Murphy said equity income investing is not about being “spicy or racy” and owning lots of tech stocks or small-caps; instead, it is about how consistency and low volatility can compound over the long term and generate high quality returns to investors.
“By choosing consistent businesses with good cash flows that generate yield, you get lower volatility of returns more consistent returns,” he explained.
To find these stocks, the manager looks up and down the market cap spectrum. He finds some of the best valuations among the FTSE 250’s mid-cap stocks, although it does own some small- and large-cap stocks.
“I think value doesn’t necessarily sit in the mega-caps in the long run, it’s more interesting below that. I think I’ve probably said that for most of my career.”
For Murphy it comes back to a building a portfolio using a bottom-up approach focused on valuations.
“We’re happy to have in big sectors no positions if that’s appropriate, as it’s built up on a stock price basis,” he concluded.
“We don’t want to create ‘a binary portfolio’. If you go back to post financial crisis when markets were at lows and things were recovering, we just didn’t take a big directional bet on beta in the markets to perform because if you’re wrong, you collect too much volatility. We want a broad spread of ideas.”
Performance of fund vs sector & benchmark under Murphy
Source: FE Analytics
Since Murphy took over the fund in April 2009, it has delivered a total return of 201.22 per cent against a 173.75 per cent rise in the FTSE All Share and a gain of 166.78 per cent for the average IA UK Equity Income peer.
Aviva Investors UK Equity Income has an ongoing charges figure (OCF) of 0.81 per cent and a yield of 4.39 per cent.