Industry Voice: Brexit - business as usual

• The UK referendum on EU membership is undoubtedly a huge event for the UK equity market and has wider implications for smaller companies.

• Whether we vote for Remain or Leave, it will be business as usual for our funds. We are well positioned to weather any volatility.

• The underlying dynamics of the UK market are still attractive, whatever the outcome and, against the long term, valuations are cheap.Background
  The impending UK referendum on EU membership on 23 June has clearly been the main driver of volatility in the UK equity market in recent months. In the run-up to the vote this volatility has reflected an awareness that the polls are much closer than people initially thought and, as a result, the recent trend of selling domestic sectors has continued. In particular, we have seen increasing uncertainty from overseas investors, with few now seeing the UK as a potential investment environment ahead of the vote, and net withdrawals from overseas investors since last year.

Simply put, the referendum is a binary event: if we Leave, equity markets fall; if we Remain, they bounce. But post-referendum, global economic challenges remain and we have been positioning our portfolio with a view to domestic companies that are well-positioned to tackle global headwinds as much as any fall-out from the result of the vote. This is why, whatever happens on 23 June, it's business as usual for us.

Clearly, a Leave vote would have consequences for markets. These include sterling weakness, impacts on property prices, investment into the UK falling, rising inflation, falling stock markets, capital flight concerns and other short-term economic headwinds. Against this backdrop it is no surprise that as the vote has edged closer, investors have de-rated UK domestic stocks, effectively pricing in a Leave vote.

But as a result, the FTSE 250 is near the cheapest levels it has been relative to the FTSE 100 and domestic companies appear good value. In fact, the underlying dynamics of the UK market are now looking as attractive as they have for some time.

Figure 1: FTSE 250 relative to the FTSE 100

_{Source: Barclays Research, Datastream, MSCI. As at 31/5/2016}

Opportunities
We are currently positioning our portfolio to have exposure to businesses with strong market positions and companies that have displayed good earnings momentum and, crucially, will continue to show good earnings momentum post-referendum - no matter what happens.

Teasing out where companies can differentiate themselves amid an event that will send the market in different directions will be crucial. Uncertainty can lead to increased inefficiency, but that can drive opportunities on a medium-term view.

Figure 2: Relative performance of Domestic vs. International earners

_{Source: Liberum and Datastream, as at 2 June 2016. Note: Domestic earner = >85% of revenue is from the UK, International = < 40% of revenue is from the UK.}

One example of a company with a strong market position would be Greene King, which trades on a p/e of 10, and has the lowest gearing in the last 10 years. Like most other equities there is scope for the cost of its debt to fall even lower, which means corporate profitability will continue to grow. More importantly, it has published very strong recent trading updates, will benefit from Euro 2016 and is due to report at the end of June. Greene King continues to take market share and is very strongly-positioned, with a good consumer proposition. Clearly, the wider pub market and the trend for drinking out has been in decline, but if you are a winner in that market you will see substantial earnings growth. A company that is in control of its own destiny such as Greene King will be better equipped to endure through any post-referendum uncertainty.

Infrastructure spend as a percentage of GDP has been running below the long-term trend since 2004 (and has only recently caught up), while the government has pledged £400 billion expenditure by 2021. Whether we vote Remain or Leave, that expenditure is going to filter through. With that in mind, construction companies which focus on the infrastructure that is set to benefit from government expenditure (such as road, rail, and upgrades to the electricity network), are poised for upward earnings growth - finding companies where this is not reflected in the share price is key.

So from a bottom-up perspective, the housing market, the automotive market, and the consumer market look set to benefit from a Remain vote, continuing a growth trend that is already in motion. The state of our housing stock, the amount of RMI (repair, maintenance and improvement) that is taking place, and the age of the car pool are all drivers for growth, particularly with renewed confidence on employment (and the living wage to some extent).

Even though unsecured debt has been rising (which has been a good stimulus for the market), a large swathe of the country has not had the availability to buy essential items such as washing machines and sofas; SCS, the sofa retailer saw a 14.6% jump in sales growth showing there is pent-up demand. If people have enough confidence and there are reasonable levels of employment, we should continue to see spending growth. Indeed, there has been a substantial bounce in Barclaycard sales in the last few months, divergent from UK domestic stock valuations. A similar divergence took place around the time of the Scottish Referendum, when investors priced in significant disruption, but stock valuations rose once Scotland voted to remain in the UK. A similar trend could occur in the event of a Remain vote.

Business as usual
Investors tend to worry about holding risk assets but, over the long-term, they should not. London Business School data indicates that, since 1955, smaller companies have delivered annual total returns of 15.4%. This is during a period encompassing sky-high interest rates in the 1970s, the UK exiting the ERM, the three-day week, ongoing strikes in Britain and the Suez crisis in 1956. These are all periods during which, on paper, people shouldn't have held risk assets, and are arguably as disruptive as the referendum. The danger is if investors over-trade when the fundamentals point to risk assets being cheap value. Investors should remember that the point of greatest fear is when you make the greatest return, and those returns have been consistently delivered over the last 60 years.

Moreover, smaller companies have an inflexion point that can be rapid. This is because, fundamentally, smaller companies have better corporate profitability growth than their large-cap counterpart. Liquidity drives smaller companies down to low values, not fundamentals.

Figure 3: Relative sector re-ratings in 2016 - FTSE 350

_{Source: Liberum and Datastream, as at 2 June 2016. Note: For Real Estate, P/NAVs are used.}

Next steps
Valuations are clearly below average. While domestic earners outperformed in 2015, referendum polls this year have reversed that trend, while overseas earners have seen performance tick up marginally. Data indicates that the likes of leisure, construction, staffing, and housebuilding will bounce back if we vote Remain, and this is likely true. But there are opportunities all over.

From our perspective, we have broadened our portfolio somewhat, with a focus on sectors such as healthcare and engineering, that are less correlated and have less impact to a Remain or a Leave vote, as well as companies with international earnings. We are focusing on companies that are delivering, innovating and investing - and getting a return on that investment.

Companies that are merely seen as market participants have been hit by the broader sell-off in 2016. Our opportunity is to find companies that we think are not but have been treated like it, which includes companies that have greater exposure to overseas earnings. For example, Tyman, which derives the majority of its earnings from the US, has been sold off in the same way that domestic companies have. This offers an opportunity for a re-rating post-23 June.

We have also taken part in IPOs in recent weeks. Hotel Chocolat has appreciated by some 45% since float, while Joules is up 25% since float. They fit into our idea of companies that have a global opportunity but are well-established UK domestic brands, taking market share within their own market. They also have high-quality capital management (they are owner-founded and run businesses) and whether we Remain or Leave we wouldn't worry about either of them being able to deliver their own growth (of course, in the short-term share price performance could be volatile).
 
We are also mindful of the global challenges that remain, not least the China equation, as it seeks to rebalance its economy while avoiding a hard landing and a fresh credit bubble. Our portfolio is focused on these future challenges as much as it is on the referendum on EU membership. After all, once the referendum has passed, it is the macro-economic headwinds that we have been navigating around for some time, that will determine future performance.

As active managers, we are able to make active decisions that give us a broader base than the underlying index, while passives must track the domestic turnover.

For more on our UK Equity Funds visit columbiathreadneedle.co.uk/UKEQUITIES

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