International earners and overpriced defensive stocks could be in line for a correction, according to FE Alpha Manager Mark Barnett who has been adding significant domestic exposure to his portfolios.
The manager of the £10.5bn Invesco Perpetual High Income and £5.1bn Invesco Perpetual Income funds said the market has performed extremely well since the global financial crisis partly due to very low interest rates and bond yields.
Yields have remained low throughout the period, meaning that the real yields of company dividends have been particularly supportive, he noted.
Performance of index over 10yrs
Source: FE Analytics
The other key factor in recent years has been the devaluation of sterling in reaction to the UK’s decision to leave the EU last year.
“Looking at the stock market in the UK – stating the obvious – what you can see quite clearly is [that] we have had a quite a decent re-rating since the lows of 2009,” Barnett said.
“We have gone sideways in terms of market multiples in part because of the weakness in sterling – [but] don’t forget that 70 per cent of the revenue in the UK stock market comes from non-sterling countries – so you are benefiting in earnings terms from that which has kept the P/E [price-to-earnings ratio] down.”
The other reason the market has remained buoyant in recent years is the return of commodities, which struggled in 2014-15 but have since rebounded.
This, along with an improved backdrop for a number of companies conducting most of their business outside the UK has meant that earnings growth has been a bit better this year and that has helped to keep the market multiple down.
However, the manager said the recent interest rate hike and rhetoric from the Bank of England that there may be a further one or two cuts over the next three years has made it a more interesting backdrop.
He said: “Clearly they are worried to a certain extent about some inflation coming through. They have adjusted interest rate policy recently to reverse what looks like now in hindsight an incorrect cut in August last year but the Bank of England are clearly signalling they may do one or two more increases.
“In part that reflects what I think they think is a slightly stronger picture in certain areas of the UK.”
Bank of England inflation expectations
Source: BofE
This should benefit domestic stocks, he explained, which have been largely unloved by the market for some time partly through the sterling depreciation but also over concerns for the UK economy post-Brexit.
Barnett noted: “The market is trying to say that Brexit is an accident waiting to happen and, although I accept that the UK economy has slowed this year from where it was last year, I think we can all agree on the fact that actually the economy has performed an awful lot better than many people would have expected at the point of the referendum result.”
Meanwhile, overseas markets have maintained strong performance this year thanks to the improvement in Europe, as well as stronger data from China and the US, where the economy has maintained a good trajectory, he added.
“There has been one notable exception and that is the Brexit risk that is perceived around the UK economy,” the manager said.
Looking at a basket of domestic companies including retail, leisure, real estate, banks, housebuilders and insurers, Barnett said these stocks have underperformed a basket of exporters since the Brexit vote.
He said: “Investors were not only scared at the point of the referendum as a result of the sterling devaluation and [the idea that] the UK economy is going down fast but they’ve continued to reinforce that view in the markets.
“The belief amongst many investors continues to be you want avoid UK domestic companies because these are the companies that are going to be hit hardest by the aftereffects of the Brexit referendum.
“If you look at this on a rating basis, the same basket of sectors has traded roughly in a 5 to 10 per cent discount to the market but that has widened out over the last year and a half. 
But the Invesco manager said he believes the Brexit negotiations will go well, despite the uncertainty surrounding the situation currently.
“It is highly unlikely that it is going to end in a stalemate. Everything I am reading about the behaviour – particularly of the Germans after their elections – suggests to me that they want to get a deal done and while they’re not going to do us any favours, that much is clear, at this point in time a deal is better than no deal in my opinion,” he noted.
Yet, Barnett (pictured) said the market is pricing in a pessimistic outlook for the UK economy, and is therefore mispricing the domestic stocks despite their earnings outlook relative to the overseas companies remaining constant.
“In other words: although the stock market has taken the position that things are getting worse, it doesn’t bear out when looking at the earnings outlook for these companies,” he said.
This is because the market is currently working on momentum, he said, rewarding consistency of revenues and earnings and rejecting the intrinsic value of a business whose near-term earnings are under pressure.
“All that investors seem to be concerned with at the moment is worrying about where near term earnings are going and forgetting about what might be the longer term value,” Barnett said.
“Overall the market pays very little regard for value or undervaluation and momentum keeps people paying up higher prices for a company that has done well in the hope that it can continue.”
However, at some point this will change, with the FE Alpha Manager offering three scenarios in which investors might begin to re-look at fundamentals and valuations.
The first is an acceleration in the US monetary tightening cycle as the US Federal Reserve is further down the road.
“I will be surprised if they don’t tighten in December and there will probably be two or three more next year. That might start to affect some of the ratings of these highly valued companies relative to the rest,” he said.
“It might be a sterling movement and the resolution of some of this uncertainty around Brexit that encourages international investors to look at the UK again and that actually that prompts people to reconsider what are clearly a set of undervalued assets.
“Or it might just be the fact that valuations in some areas have got too stretched relative to the prospects of these businesses.”
As such, he added that he has taken advantage of the weakness of the domestically focused sectors following the Brexit referendum to increase his funds’ exposure in this area.
“The revenue of the holdings in the Invesco Perpetual High Income fund is over 45 per cent from the UK, while that of the constituents of the FTSE All-Share is circa 30 per cent,” he noted.
Performance of fund since manager start
Source: FE Analytics
One area he has added to is real estate – particularly in London – with real estate investment trust Shaftesbury and property firm Derwent London both new positions in the portfolio.
“The market has taken a much gloomier view on the prospects of the sector as a whole and in particular Derwent,” he said.
“Shaftesbury has held up a lot better in part because there have been some significant overseas buying interest in that company but the point that is important to me is that these companies are now trading on 25 per cent discounts to their book value.
“I think the stock market is getting very nervous about the outlook for the real estate sector when the reality it is much more benign.”
As such, these companies are selling assets in the market at least at book value or in some cases at as much as a 10 per cent premium and using the capital to buy back shares at a 25 per cent discount.