Pharmaceuticals giant GlaxoSmithKline, luxury brand Burberry and cigarette maker Imperial Brands are three large-cap stocks that could insulate a portfolio from Brexit regardless of the outcome, according to JP Morgan Asset Management fund managers James Illsley and Callum Abbot.
Currently there is much uncertainty surrounding the UK economy and stock market, with investors concerned that a ‘no deal’ scenario could be particularly detrimental to domestic stocks.
However, Illsley – co-manager of the JPM UK Equity Core and JPM UK Equity Plus portfolios – said that outside of the noise the economic picture is broadly okay, albeit not spectacular.
“For every piece of bad news there is at least one piece of good news that you can offset it with. So, contrary to a lot of the bear stories that you hear and the negativities you would expect to hear, actually what you see on the ground at the company level is generally better than I would suspect the consensus lay-persons view is of what’s happening,” he explained.
Illsley pointed to unemployment – which is at a more than 40-year low – as well as economic growth of around 1.5 per cent, as positive for investors.
However, the elephant in the room is obviously Brexit and the expectations surrounding that. Indeed, with numerous swings in sentiment since the referendum, investors will likely have 29 March 2019 (when the UK will exit the EU) circled in the calendar.
Following the vote, the FTSE All Share fell by 7 per cent, as the below chart shows. However domestic mid-caps suffered far worse than the internationally-focused large-caps, with the FTSE 250 hitting a trough at 13.65 per cent compared. This compares with a 5.62 per cent fall for the FTSE 100 as overseas earners saw a tailwind from the devaluation of sterling against foreign currencies.
Performance of indices from 23 June 2016 to month-end
Source: FE Analytics
“Really there was very little operational impact from Brexit other than the fact that these overseas earnings were worth 10 or 15 per cent more,” Illsley said.
Since then, there has been quite a big catch-up trade from a lot of the domestic stocks that were probably too-heavily discounted and in the last 18 months the question of whether to be invested in international or domestic earners has become much less of a topic of conversation.
However, co-manager Abbot noted that “increasingly as we approach the end of March next year and people get a bit more nervous again they will start thinking – depending on what the newsflow from Brexit – do we need to start pricing in a bit more risk”.
Illsley added that currently it is impossible to know how much the market pricing in and therefore what the reaction of the stock market will be to any possible outcome.
“If you looked at where sterling got in the immediate aftermath of Brexit when people were selling domestics and the Bank of England scenario of a recession was front and centre then I think personally a reasonable amount is priced-in actually – certainly on the FX front,” he said.
Additionally, equity investors have been reducing their exposure to UK with outflows from the UK by international investors occurring both pre- and post-Brexit.
It could be argued, therefore, that the UK is cheap, as Illsley has previously argued. Indeed, despite 70 per cent of revenues coming from overseas there seems to be a lack of expectation for the UK equity market currently.
So, what can investors do with all this information in the lead up to the UK’s impending exit from the EU?
“On the day if we had a hard Brexit announced you would still expect domestics to fall significantly and the market to come off,” Abbot said.
“Equally, if we had a soft Brexit you would think the UK market should do well because of that lack of expectation and pretty much constant flow of negative cash.”
He added: “If that starts to reverse, it won’t take much to close that valuation gap and you could have a really positive story for the UK equity market as it plays catch-up and the economy catches up with the rest of Europe.”
Performance of stock vs index over 3yrs
Source: FE Analytics
However, betting on one outcome or the other might not be the most prudent investment decision out there, and as such the fund managers are insulating the domestic parts of their portfolio with some attractive international earners.
Starting with pharma giant GlaxoSmithKline, in which the pair retain a high conviction despite strong performance of the stock over the past three years, having outperformed the FTSE All Share by 4.94 percentage points.
“It is a pharmaceutical company that is defensive in that it has earnings coming from outside of the UK – not just the US but genuinely international earnings,” Abbot said.
However, he noted that it is not just a pharma company but also has a consumer staples business making it more diversified than others.
Additionally, with a high dividend, investors can take some security knowing that there is a steady yield on offer.
“So, it is a diversified, defensive stock that we think would do well in either scenario but if we left the EU you would certainly see people looking to add a stock like Glaxo for sure,” Abbot said.
Next up is luxury retailer Burberry, which has been on a very strong run over the past three years, beating the FTSE All Share index by 30.64 percentage points.
Performance of stock vs index over 3yrs
Source: FE Analytics
“You compare that to a domestic UK-focused high street retailer and the drivers are completely different – the high street retailers are going to struggle on the Brexit vote whereas Burberry gets a lot of its earnings from overseas,” the co-manager said.
“It has got growth drivers from the increased consumption of luxury in the emerging markets – and more globally.
“But it is also trying to re-orientate its business model from the top-end of secondary luxury such as Ralph Loren or Calvin Klein to more high-end luxury such as Gucci and if it is successful you will definitely see a margin uplift.”
As such, it has structural growth drivers regardless of the outcome of Brexit, although in a ‘hard’ Brexit scenario its international earnings and generally defensive nature should insulate it.
Finally, tobacco company Imperial Brands is an attractive option, despite losing investors 9.74 per cent over the past three years.
While there has been a “wobble” the stock remains “generally defensive” despite the rise in popularity of heat-not-burn, next-generation vaping products in the US, according to Abbot.
“Questions are arising from the FDA [Food and Drug Administration] investigations into tobacco so you have seen that come under pressure but that has hit British American Tobacco harder than it has Imperial,” he said.
“Imperial has got still good dividend growth and has a broad international exposure and is much cheaper than BAT [British American Tobacco]. It is a cheap defensive and there are not too many of those around so we still like that.”
However, the manager stressed that buying overseas earners for the sake of being international or defensive will not work.
“We are wary that we want companies that are operationally performing well still, that are genuinely what we think of as quality and have momentum in terms of their earnings,” he said.
Illsley and Abbot are co-managers on the JPM UK Equity Core alongside Christopher Llewelyn and Anthony Lynch and JPM UK Equity Plus with Nicholas Horne and Anthony Lynch.
The funds have yields of 3.07 and 1.91 per cent clean ongoing charges figures (OCFs) of 0.4 and 0.9 per cent respectively.