Investment Strategy @ Point Brexit

The valuations of London Stock Exchange listed stocks have become very attractive lately, just as United Kingdom and European Union are about to part ways. With LSE being on a three-year rally, it represents an unprecedented buying opportunity for investors who are interested to pick value stocks. Experts however, caution that this could very well be a value trap having resulted from the weakening of British Pound among a host of other factors investors should be wary about before making any investment decisions.

The poor state of a country’s currency does not aid a value investor’s prospects in any way. While stocks can become attractive due to a fall in the value of currency, they do not become undervalued in comparison to their peers as currency effects all of them equally. The British currency has fallen sharply against the euro in the past six months, with fears of further downside in the run-up to Brexit. Impact of Brexit on the British Pound Sterling, with or without a deal, will put the British economy in an adverse balance of payments situation as it shells out nearly £32.8 billion as part of this divorce (UK Office for Budget Responsibility's estimate).

While the British exporters are taking advantage of the situation, domestic demand for goods and services are depressed on account of consumers postponing their purchase decisions. The industries which are witnessing the maximum negative impact of this currency weakness are import- driven industries, like apparel, agriculture products and engineering component importing businesses. However, the impact of this weakened balance of payment situation on the British economy will be short lived. With the business fundamentals of the British businesses remaining the same, in the short run exports will grow as it will be cheaper than before for outsiders to consume British goods, but imports will suffer as the English will find it dearer to consume imported goods. In the long run however the earnings of the British people will improve, and their consumption levels will be back to where it was originally. The heightened business activities will over time compensate for the losses on account of payments for Brexit made to the European Union. So, in effect, the currency and business activity cycle will become a little bit elongated.

Opportunities for Growth investing

Growth investors are drawn towards companies that are experiencing or are forecast to have a high growth rate (fundamental performance based on revenue growth, profits, EPS) than others. As these companies face high growth opportunities often due to them being a part of a sunrise industry, they tend to reinvest their earnings in themselves in order to expand while the opportunity lasts and they would hire new employees, purchase equipment, and acquire other companies.

These stocks don’t pay dividends and offer high risk, high return characteristics to potential investors. These stocks generally have high P/E ratios, EV/EBITDA ratios and would appear very expensive but suitably justified by their high growth rates. These stocks experience large price swings and have a higher stock beta and are best suited for investors who are risk-tolerant and have a longer time horizon.

Such opportunities existing at the London Stock Exchange are metal, mining and oil & gas exploration stocks that are either nearing production or whose prospects are very near to crossing or have crossed the high-risk stage.

Opportunities for Value investing

Value investing is about finding stocks whose market value is depressed due to transient economic factors and will perform well once these issues are mitigated. Market value of these stocks do not necessarily reflect their fundamental worth and these are valued significantly lower on account of adverse information flow from these stocks. Value investors seek stocks at a price that is a bargain compared to the stock’s intrinsic value. As time passes, other investors will eventually recognize these undervalued shares and their prices will start rising.

Additionally, value-oriented funds do not emphasize on growth factors and so even when the stock prices don’t rise, investors would benefit from good dividend payments. Value stocks, though having limited upside potential, are safer investments than growth stocks.

Given the current situation affecting the markets and almost all major scrips looking attractive, it is very tricky to pick a value stock solely based on their wreaked P/E ratios or EV/ EBITDA ratios.

The scenario on the London Stock Exchange looks very captivating lately. While the exchange is following the global trends in its rally over the past three years, the valuations of the London Stock Exchange listed stocks remain low. The indices at the Exchange are trading lower compared to their European counterparts and the forward earnings multiples of most companies are at a 13-year lows. The reason it seems for the above is a gradual slowdown in the flow of funds entering British capital markets from outside. While domestically the United Kingdom economy may not be in a recession, but its external situation looks weak with further chances of deterioration.

The Low valuations of  UK-based stocks have been caused by a weak British Pound and a slowdown in the flow of funds entering British capital markets from outside among other factors; as and when the currency situation improves or there is a fresh flow of funds from outside, it will affect all stocks equally, and there will be no scope for security underpricing or overpricing within the market.

With the burden on the British exchequer to honor its dues of £32.8 billion to the European Union on account of the divorce settlement, the pressure on the pound will increase further. With the general forecast of the impending business conditions also looking bleak, not much support will be coming from corporate income statements either. This certainly is not the time or opportunity for value picking.

The market landscape for real goods and services across continental Europe will also be impacted due to Brexit. Continental European countries have traditionally been the largest consumers of British goods as well as its largest vendors from where it sources its raw materials and other inputs. During the pre-Brexit referendum period, when Great Britain  was a part of the European Union, both blocks enjoyed mutually beneficial trading environment which ensured that goods and services flowed in to each other’s territories with ease and cost efficiency and a very wide market had developed owing to such mutually beneficial trading environment and relaxed tariff conditions. However, now with this beneficial trading environment about to go into the history books, there is every risk that this market that had developed between these two economic blocks could shrink and goods and services flow could be hindered and could become more expensive. Hence, despite a weakening of the British Pound, UK’s exports could come down and input costs could rise more than proportionately because of the above- mentioned real factors.

Given these above-mentioned conditions, the investors certainly risk being caught in a value trap. The factors affecting the stocks are market wide and not stock specific. Unless the investor is able to distinguish between factors that are affecting the stocks individually from the factors that are affecting the market as a whole, there is every chance that he will be investing in an overvalued stock. Over and above that the general economic conditions in United Kingdom do not foretell a good business environment for the foreseeable period.

A value trap is defined as a position where a stock or a group of stocks appear to be cheaply priced and an impending value creator, when looked at from the viewpoint of valuation multiples like, earnings multiple, cash flow multiple or book value multiples. However, when looked at from the angle of their business fundamentals they turn out to be of mediocre value. It is highly recommended that investments decisions are based on thorough evaluation of business fundamentals of a company and not based only on valuation multiples to avoid such pitfalls.

So, the strategy that an investor should follow while finding value in such markets, is to look for stocks that will be least affected by any prevalent market wide condition. While trying to pick value stocks the emphasis should be to look for stocks which are undervalued relative to their peers and not whose prices have fallen because of market wide conditions. The fundamental factors affecting the stocks should also figure prominently in the investors’ analysis if they do not want to be caught in a value trap.