Election shock completes year of the totally unpredictable


Current Overview

I think it an opportune time to recollect on the remarkable (astonishing even), largely unexpected events of the past year.  I have also a one year FTSE 100 chart in front of me that slants firmly upwards from left to right.  First came the Brexit vote which even the bookies had as largely unanimous (that we would Remain) and the country voted to leave.  The market was expected to tank, it did for 2 days only before commencing a steady 25% climb higher.  Next came the Trump presidential election win; the markets were forecast to dive, the dollar to collapse.  Neither materialised and we have seen steady appreciation in both since.  And now we have a hung parliament in the UK and heightened anxieties about stalling government at the critical juncture of Brexit negotiations.  Where will the market head next?

The outcomes of the above events were clearly close to impossible to predict in themselves. More importantly, what the market would do (in addition) in reaction to these events, equally as difficult to predict.  The Brexit vote gave rise to a weakening pound in simple terms; perhaps as it was so unexpected, nobody thought of what the net effect on the market would logically be.  The result, companies with overseas earnings (most of the FTSE 100) have benefited as a result of positive FX translation effects – the market has risen.  Granted challenges have presented for UK centric companies where a weak pound brings headaches.  With reference to Trump, despite his total lack of political experience, promises of tax cuts, significant infrastructure spending and financial sector de-regulation has lured investors into shares – the market has risen.  The market has also taken the now inconclusive UK election result largely in its stride as renewed pound weakness is a positive for many companies as above.

It has been an amazing time to be at the coalface talking to clients about markets which are rising when many have dared to turn on their computers to look.  If one didn’t fully comprehend the massive effect FX has on a company’s fortunes, one does now.  I have been taking profits in sectors which pre Brexit I was languishing in.  I have fully understood the negative effects of a weak pound for any business importing product from overseas.  I have been reminded of the genuine importance of having funds spread across different sectors with differing geographical exposures.

The election result will of course have most impact at home: UK government policy (though not in isolation) shapes UK GDP and UK centric companies have naturally been relatively weak over the past two trading sessions.  Business confidence has been understandably knocked and consumer spending is now at its lowest since 2013. Rising prices (due to a weak pound) relative to sluggish wage growth will be (re)confirmed later this week.  I think any talk of a base rate increase will likely be kicked well down the road now.  Election uncertainty has been removed but a renewed and deeper uncertainty has been created.  Perhaps the spectre of a softer Brexit (whatever one’s interpretation of that is) could be taken as a positive.

Conversely a third increase in US interest rates is forecast near term.  US stocks look fully valued on many metrics but this does not mean, shares can’t rise further, at least short term.

Stock specific comment

Babcock International’s current price (888p) is a clear recent example of the now heightened anxiety relating to how and when the government will be able to award contracts.  Serco (115p) and Capita (540p) are in similar support services sector predicament. Babcock’s focus on essential infrastructure should provide support as decisions here cannot be delayed indefinitely.  In addition, the reduced threat of another independence referendum in Scotland should protect their interests there. The profitability profile and low valuation in the context of high forward sales visibility supports the investment case even in the UK business faces short term challenges.  A Price to Earnings ratio of 10.4 for 2018 and a forward dividend yield of 3.4% (3 times covered by profits) rates attractive if contrarian. With the shares back near 3 year lows with chart support, I remain a firm holder and buyer of the stock.

I have turned my attentions back onto mid cap UK transport player Go Ahead Group (1750p). As a 65% shareholder in Southern Rail, the valuation is depressed (PE ratio is 8, dividend yield a growing 6%) but in my view is overly discounting the value of the other elements to the business which includes the London Midland and South Eastern rail franchises.  It runs 25% of London buses and regional bus services in North East England, Oxford, Brighton, Poole, Gatwick Airport & Crawley. Infact the profits of the bus division alone would pay the company dividend with the rail side of the business seemingly in the valuation for free.  The trading statement at the end of April was in line with the company maintaining guidance for the full year, citing a strong balance sheet.  There are international operations in Singapore and Germany.  Buying against the trend is of course a risk but the shares are fast moving and I hope for a robust pre-close update on June 22nd and an improvement in the price.  A takeover cannot be ruled out going forward.

This report was written by Philip Scott, Director at SI Capital on 12/6/17 when the FTSE 100 was trading at 7511.