The UK’s decision to leave the EU has pushed valuations to extreme levels but Artemis Fund Managers’ Ed Legget thinks that passively taking exposure to the whole of the market is far from the best way of exploiting the opportunity this has created. 
Between the Brexit referendum on 23 June 2016 and the end of February 2019, the FTSE All Share posted a total return of 23.40 per cent and underperformed the MSCI AC World’s 44.63 per cent gain (in sterling) by a significant margin.
Legget, who runs the £631.6m Artemis UK Select fund, noted that “UK equities are as unpopular among asset allocators as they have ever been” and cited data from the closely watched Bank of America Merrill Lynch Global Fund Manager Survey.
Investor positioning vs history
Source: Bank of America Merrill Lynch Global Fund Manager Survey, as at Dec 2018
“It is rare for investor positioning to differ from its historical average by more than one standard deviation,” he said, pointing out the findings of the above chart.
“Today, the average positioning in UK equities is almost two standard deviations below its long-term average – a similar level of revulsion to that seen in the immediate aftermath of the referendum in 2016.
However, while the manager conceded that this extreme underweighting is “understandable”, he argued that it also creates an attractive opportunity to buy UK companies with reasonable growth prospects that are trading on very low multiples.
Legget also pointed out that UK companies have been delivering strong earnings growth in recent years, despite the fact that the market is so out of favour with global asset allocators.
The combination of falling markets and progression in UK profits has been a “significant” de-rating. The forward price-to-earnings (P/E) multiple of the FTSE All Share has moved from 15x at the start of 2018 to just under 12x today.
The Artemis UK Select manager argued that profits and P/E cannot continue to move in opposite directions for the long term: either earnings will have to fall or the multiple will start to rise. And the early results of the current reporting season suggest UK earnings and dividends will continue growing in 2019.
UK stock dispersion remains wide
Source: Datastream, Exane BNP Paribas estimates, as at 31 Dec 2018
“On aggregate, then, there is value in the UK market. In our view, however, the wide dispersion of valuations at a stock level would make buying the index a poor way to take advantage of that valuation opportunity,” Legget said.
“Although the UK market as a whole trades on a low multiple, there are pockets of expensive stocks within it. Such is the desire for certainty that a relatively high number of stocks trade on P/E multiples of 20x or more – more than in 2001.”
At the same time, between 80 and 90 stocks are trading on P/E multiples below 10x, which is a similar number to 2009 and 2011. While some of these companies are structurally challenged and deserve to be rated this lowly, the manager said that there are some among them have the chance to grow “quite strongly” and this is where he is focusing his attention.
Within the Artemis UK Select portfolio, Legget is reluctant to hold too many stocks that would suffer if a positive outlook to Brexit meant that sterling rallied sharply.
An example would be GlaxoSmithKline, which has more sterling costs than sterling revenues; a 10 per cent rise in the value of the pound would see the company’s earnings from an estimated 113p per share to just 99p.
“In the event that a Brexit deal is agreed, a company like GlaxoSmithKline, which is generally regarded as a ‘safe haven’ – non-cyclical and without too much exposure to the UK economy – could suddenly appear very expensive. We are zero-weighted here,” the manager said.
While the fund does own overseas earners, such as BP and Ashtead, it also has exposure to companies that derive much of their revenues from home shores such as housebuilders (Redrow, Galliford Try), UK-focused banks (Barclays, Lloyds) and airlines (IAG, Ryanair).
Legget said there is “clearly” a strong case for companies such as this to re-rate in the even of a soft Brexit or no Brexit at all. But he added that there are reasons to expect to perform better than the consensus even if there is a ‘no deal’ exit; for example, the UK and EU have already fleshed out the outline of a future relationship for banks, which offers a degree of certainty for the sector.
The manager concluded: “The portfolio as a whole is trading on a multiple of just under 9x forward earnings and a forward dividend yield of close to 5 per cent. We feel these valuations fail to reflect the strength of business models and balance sheets of the companies that we own: we expect our holdings to deliver growth in both earnings and dividends in 2019.
“But we expect the bigger driver of returns to be a re-rating of our holdings back to more typical long-term valuation multiples once current uncertainties start to lift. The unusually low starting valuations of both the UK market and the portfolio, combined with underweight positioning towards the UK market, means we regard Brexit as an opportunity rather than a threat.”
Performance of fund vs sector and index under Legget
Source: FE Analytics
Since Legget took over Artemis UK Select in December 2015, the fund has posted a 13.02 per cent total return. This puts it in the fourth quartile of the IA UK All Companies sector.
However, the manager had a strong long-term track record when running the Standard Life Investments UK Equity Unconstrained fund. The manager’s approach, which is a high octane and high conviction strategy that can see his portfolios positioned very differently to the market, can underperform in the short term.
Artemis UK Select has an ongoing charges figure (OCF) of 0.86 per cent.