Brexit update: impact of the UK-EU trade deal on the ES R&M UK Dynamic Equity Fund
So here we are (finally), three and a half years after the vote for Britain to leave the EU … a deal has been signed formalising their trading relationship. Currency and stock markets have already re-priced UK assets upwards, which has supported the short-term relative performance of the ES R&M UK Dynamic fund. It’s natural, given the significance of the headlines, to ask how this event might affect my view on the outlook for UK assets on a more intermediate-term view and whether I have altered the portfolio’s positioning at all in response.
Those who have met me over the last couple of years or listened in to various webinars during 2020 will have heard me speaking about the desire to set the fund up to be relatively balanced and diversified across multiple axes. So, I think about having an array of value creation drivers (or life-cycle categories of Potential within our team philosophy lingo), a balance of cyclical and less cyclical business franchises, and, of particular note on the impact of a Brexit deal, a combination of domestic-facing UK businesses and those who earn their profits overseas, but happen to be listed in London. Where I see particularly attractive risk / reward relating to one of these buckets I will tilt capital allocation, but the intention is to typically have balance and let portfolio returns be driven predominantly by idiosyncratic stock specific drivers.
For the last year or so, since the sharp repricing of domestic-facing equities in Q4 2019, I have not felt it particularly beneficial to tilt aggressively towards these UK domestic names. To some extent this is less a reflection that it is not possible to find attractive investment opportunities within this cohort, but more so that there are a broader set of UK-listed opportunities which I believed allowed me to diversify concentration risk away from the UK economy while maintaining upside potential. As such, the ES R&M UK Dynamic fund has broadly been operating within a band of c.20-30% exposure to UK domestics, which is not hugely different to the comparator benchmark (MSCI United Kingdom IMI). Today, we sit towards the top end of that range, in part due to some tactical allocation in Q4, but largely as a result of share price performance.
Figure 1. Asset allocation profile of ES R&M UK Dynamic Equity Fund, split by UK and overseas and defensives and cyclicals. January 2021
Source: River and Mercantile Asset Management LLP
Despite the deal, I’m not inclined to alter this materially today. What is clearly a ‘thin’ deal (it doesn’t include the Services sector, for example, which comprises ~70% of UK GDP) does take some of the more damaging short-term economic scenarios off the table but in reality its significance to the UK economy is swamped by the speed at which we can release lockdowns and recover from the effects of COVID-19 during 2021. In this sense, the UK has some recovery attraction given the depth of its recession and the fact it has secured a good supply of vaccine dosage, but beyond this there remain structural questions around productivity, amongst other things, which remain unanswered. Therefore, the opportunity to continue diversifying risk while accessing attractive upside via international-facing businesses continues to make sense at a strategic level. This deal should, however, in theory provide us with more confidence to ‘lean in’ to exposure to UK domestics should their relative attractiveness improve in future, given the reduced range of economic outcomes it implies.
 Author’s own definition of more than 50% of profits, sales from or fixed assets in the UK.
“We very much hope that the signing of the UK-EU trade deal encourages international and domestic investors to re-assess their weighting to UK equities, which fund flows since the Brexit vote in 2016 would suggest are currently low. ”
It’s worth pointing out some holdings which I think should be primary beneficiaries of a better near-term outlook for the UK economy, should this come to pass. Three spring to mind: NatWest has about as high a ‘beta’ to the UK economy as you will find, given its exclusively domestic revenue exposure and the weighting of retail and commercial banking within the group plus the natural equity leverage of a bank. I believe the mispricing today mostly relates to uncertainty around the outlook for loan losses and the Brexit deal therefore takes away some of the left-tail risk from more severe economic disruption. Whitbread, owner of the market-leading UK budget hotel brand Premier Inn, offers attractive operational gearing (i.e. the profit that will drop through from each incremental £ of sales) into a recovery in travel and leisure spend in 2021. Premier Inn’s revenues are broadly split 50/50 between business and leisure customers, so they benefit from greater visibility provided by both the Brexit deal and vaccine news (a meaningful proportion of leisure customers at weekends relate to weddings and sports events, for example). Increased interest in UK assets from international investors with greater clarity over politics and trade may also support valuations for its freehold property estate, which we also see potentially bringing Covent Garden landlord Capital & Counties into play as an acquisition target. Its prime West End footprint (increased by its 25% stake in neighbour Shaftesbury) of shops, restaurants and offices is both inimitable and will benefit both from tourists and workers returning and the likelihood that London retains its spot as one of the world’s leading cities, yet it trades at more than 30% discount to NAV.
Figure 2. The UK looks very cheap from an historical perspective and compared to other world markets
Left: The UK still looks very cheap even adjusting for industry group weights - Right: In USD terms UK equities are down to a 50-year low versus MSCI World.Source: MSCI, IBES, Morgan Stanley Research
We very much hope that the signing of the UK-EU trade deal encourages international and domestic investors to re-assess their weighting to UK equities, which fund flows since the Brexit vote in 2016 would suggest are currently low. When they cast their eyes on the opportunity set, they will find it is broad – with attractive valuations available on a complete cross-section of market cap, sector, and domestic or international exposure. Private equity and corporates have already demonstrated a willingness to shop in these sales, so I suggest acting fast to avoid disappointment!
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ES R&M UK Dynamic Equity Fund
This fund’s unconstrained approach enables investors to have targeted exposure to what we believe to be the strongest opportunities in the UK market.