Investors concerned about the impact of Brexit on UK stocks should instead look for the valuation opportunities that have emerged following a broad de-rating of sectors, according to Invesco Perpetual’s James Goldstone.
Goldstone, manager of the Invesco Perpetual Select UK Equity and Keystone investment trusts, said valuation opportunities created by the Brexit referendum have helped him overhaul the two portfolios.
Having taken over both trusts from Invesco Perpetual’s head of UK equities Mark Barnett – with whom he still co-manages the £1.3bn Edinburgh Investment Trust – within the past two years, Goldstone has set about making changes to align the portfolio with his other mandates.
“I’ve made quite significant changes to the portfolios,” he said. “The overlap on day one was only about 35 per cent, so I’ve spent the period bringing in line with strategies I’m already managing.”
As such, Goldstone has been reducing the tobacco and healthcare allocations in both portfolios and reinvesting the proceeds into more cyclical areas of the market.
“My focus is around valuations and looking to find mis-valued opportunities and wait for the market to come around to my way of thinking,” Goldstone explained.
As a UK equity investor one of the biggest drivers of mis-valued investment opportunities in recent years has been the market reaction to the Brexit referendum.
UK equities sold off in the wake of the referendum but have since recovered, although the market has lagged its international peers as uncertainty continues to dominate.
Performance of FTSE All Share since UK referendum
Source: FE Analytics
“Brexit clearly is a risk but as always its question of understanding risk and assessing whether that is reflected in the price,” he said.
“My view is that the market is overstating the risks. Not to say that I have a blueprint of how Brexit will be resolved but I have invested on the basis that ultimately neither side will be served by driving the UK off a cliff and that there will be some reasonable settlement.”
However, not all market participants have taken such a view.
“The market made up its mind very quickly – literally day one after the referendum that this was dreadful news for any UK domestic exposure,” he said.
“On those first few days retail, leisure, domestic financials all really fell very sharply. These sectors all de-rated almost as one and – as often happens in these situations – the market didn’t differentiate really at all between some of the better quality businesses in those sectors and some of the weaker companies.”
One of his more contrarian positions – particularly with Brexit dominating investor thoughts – is the banking sector, where more encouraging signs have been emerging.
“Since Brexit, the market appeared to have made up its mind that because the UK economy is doomed, the banks lending to the UK economy must also be doomed,” Goldstone explained.
The fund manager – who holds both Barclays and Royal Bank of Scotland – said that much work has been done since the global financial crisis to rebuild balance sheets.
“From a starting point, pre-crisis, what now would be considered suicidally low capital ratios to now 13-14 per cent [represents] a very serious upgrade in capital strength of the banks,” he said.
Another factor has been the valuation of the sector, which has also been hit by negative sentiment towards the UK economy.
“The fact is, to date, there has been a very modest increase in impairments but it does look like the credit quality of these books are sound,” said Goldstone. “Earnings will be volatile in a recession but there’s certainly not an outcome that I can foresee that would call into question the strength of the capital base.”
Another area that was beaten up after the UK referendum was the retail sector, which has continued to face challenges from disruption and the move from high street to online.
However, Goldstone feels that, again, markets have tarred all retailers with the same brush and failed to take a closer look.
“In some cases [de-rating] would be appropriate but in last two years the sector moved almost as one, as the market hasn’t distinguished between those that are in a position to thrive in the new world and those that may ultimately disappear,” he said.
Clothing retailer Next is a “prime example”, said Goldstone, noting that the management team “really understands shareholder value” with buybacks and dividends.
The manager noted that its directory arm had been an “online business before the internet existed, yet it has been sold down and de-rated with retailers far less well-equipped for the online threat”.
“By being selective and choosing good businesses with shareholder-friendly management teams at points of panic, that contrarian approach is what I try to follow,” he added.
Performance of stock over 2yrs
Source: FE Analytics
Having cut holdings in tobacco and healthcare stocks, the Invesco manager has also taken underweight positions in the mining sector.
He said while valuations do look attractive following a couple of years of restructuring for the sector, miners remain extremely sensitive to commodity prices and Chinese demand, which he said accounts for around half of commodities demand.
However, Goldstone warned that debt levels in China now threatened to dampen growth in the world’s second largest economy and put mining stocks under pressure.
“No country has accumulated debt the way China has accumulated it without that ending in a bust: that’s an issue,” he explained.
However, the manager is not bearish about all miners with some exposure to gold miners which he said can act as hedge in some circumstances.
“[With] my concern around the credit bubble that has inflated in China, gold would be big beneficiary: it has worked historically as a hedge against some macro tail risks,” he said.
Indeed, the manager noted that the gold sector rose materially in the day after the EU referendum as investors sought safe havens for their cash.
The end of quantitative easing and raising of interest rates could place stress on some areas of the market, said Goldstone, particularly given that balance sheets for some companies remain unreformed since the crisis and debt as a proportion to GDP is higher than levels a decade ago.
However, there remain a number of opportunities for investors willing to take a bottom-up approach to investing.
“The market has been really bifurcated for quite some time and there is a group of loved shares that can do no wrong sitting at valuations that to my mind over time will struggle to deliver the sort of returns that are expected,” he said.
“Conversely, there are large parts of the market that people seem to have completely given up on where lower valuation anomalies and valuations are very attractive – providing companies deliver roughly to plan – and I think there is very significant upside.”
Since taking over the £66.1m Invesco Perpetual Select UK Equity Trust in October 2016 it has delivered a total return of 14.42 per cent compared with a 27.92 per cent gain for the average IT UK All Companies trust and a 17.54 per cent return for the FTSE All Share index.
Having taken over the £235.9m Keystone Investment Trust in April 2017 it has delivered a total return of 8.31 per cent compared with a 11.8 per cent gain for the index and a 16.58 per cent return for the average peer.
Performance of trusts vs sector & benchmark YTD
Source: FE Analytics
Invesco Perpetual Select UK Equity is trading at a discount of 1.7 per cent to net asset value (NAV), is 21 per cent geared, has a yield of 3.5 per cent and ongoing charges (including performance fee) of 1.38 per cent, according to the Association of Investment Companies (AIC).
Keystone, meanwhile, is trading at a discount to NAV of 11.8 per cent, is 14 per cent geared, has a yield of 3.1 per cent and ongoing charges of 0.62 per cent.