2016 was certainly a peculiar year for the UK stock market. Despite finishing with a fairly healthy overall return (in sterling terms at least), there were huge differences both across and within sectors. Take a look at the following chart.
The chart shows index and sub sector performance since the beginning of 2016, all rebased to 100. The thick dark red line shows the FTSE 350 index, which you can see has risen around 15% since the start of 2016. The other coloured lines show the performance of each of the FTSE 350 sub sectors, but with one important amendment: they only include UK domestic companies. To be more precise, I have excluded from the sub-sector indices any company that generates more than 25% of its revenue or profit from outside the UK. The companies left are actually a minority. Only 99 out of the 350 companies in the FTSE 350 are UK domestics by this definition – a useful reminder that the UK stock market is most definitely not the UK economy.
What is most striking about this chart is the almost universal underperformance of the UK domestics over this period. Indeed every sector apart from electric utilities has underperformed the broader index, in some cases significantly so. Two interrelated factors have driven this underperformance.
Firstly, following the vote the leave the EU on 23rd June, market sentiment towards the UK economy, and by extension the UK domestics, deteriorated markedly. You can see this clearly in the chart with the dramatic fall in share prices around late June and July. There has been some modest recovery since, but most have lagged the FTSE 350 and are still negative in absolute terms.
Secondly, sterling has fallen by 15% against the dollar over this period. Naturally this has boosted the value (in sterling terms) of those companies listed in the UK that earn their profits overseas – hence why the broader FTSE 350 index has performed so much better than the UK domestics. The two factors are interrelated because the fall in the currency has to some extent insulated the impact on the economy by favourably shifting the terms of trade between the UK and the rest of the world.
Interestingly, the underperformance of the UK domestics has not necessarily coincided with deteriorating financial performance. Indeed, for the most part, the UK domestics have simply de-rated both in absolute terms and relative to the wider market, while their financial performance has generally held up OK.
In the chart below, I have combined together the classic “consumer cyclical” sectors – housebuilding, home furnishings, retail, entertainment – in order to show the trend in valuation across these sectors. There are 31 companies in this sample. I have used p/e valuation multiples based on consensus earnings estimates. All have been rebased to 100 at the start of the period.
You can see that the group as a whole has de-rated approximately 10% in absolute terms over this period. The actual median p/e multiple today across the group is 11.8x, significantly below the wider market at 15.0x. This is somewhat depressed by the housebuilders, which are all under 8x p/e, but even excluding the housebuilders, the median p/e has still de-rated significantly and sits some way below the wider market. I find this is quite striking in the context of the broader global equity market that has re-rated upwards and is hitting all-time highs.
On the other hand, perhaps this de-rating isn’t that surprising. It is still early days for post Brexit Britain. As I wrote immediately after the referendum result, it is hard to see how Brexit won’t have some negative consequences for the UK economy, at least in the short term whilst the negotiations with the EU are ongoing. But looking further out, the picture remains much more balanced. Leaving aside social or political considerations, it is certainly possible to construct a positive case for the economy outside the EU. I remain open minded about the ultimate economic impact. Yet the absolute and relative valuations of the UK domestics suggest that the market is already discounting a pretty bad outcome.
This is why, having being cautious for a number of years, I now believe that the UK domestics are an interesting place to hunt for investment ideas again3. At this stage, the main risk is in being too early. It seems likely that 2017 will be a tough year for the UK economy, with inflation set to rise, putting pressure on consumer spending and corporate profits. Therefore, my main focus is on higher quality business models with strong balance sheets that can easily survive a period of cyclical weakness. In future posts, I will discuss some of these ideas in more detail.
1. The source data is Bloomberg. The data points are weekly since 01/01/2016. Companies with reported revenue or profit from outside the UK of more than 25% of the total are excluded from the subsector indices. The sub sector indices are calculated using the median.
2. The source data, frequency and calculation method is as above. The p/e multiples are calculated using Bloomberg BEST consensus estimates for one year forward earnings per share.
3. This is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.