So, the dust has settled after the election, and perhaps unsurprisingly the UK equity market has taken the unexpected Conservative victory as a sign to push valuations on a bit further. This has been particularly noticeable at the mid and smaller end of the market, where the impact of domestic economic policy is at its greatest. For choice, we are probably comfortable that the re-rating is merited – whether you agree with the policy specifics or not, the majority government will give a clarity to the policy agenda that will let businesses plan accordingly. It does, however, bring with it the certainty of an In/Out referendum on EU membership. We are comfortable that the prospects of a “Brexit” are remote, but we do recognise that (as we have seen with the General Election, and the Scottish Independence referendum before it) errant opinion polling can engender an environment of uncertainty and speculation that is unhelpful for equity markets. If there is an upside to the recent turn of events, it is that the Conservative Party recognises that waiting until 2017 to hold the plebiscite – when the government might be in the middle of a mid-term funk – might not be the best point to argue that the UK’s interests are best served by remaining part of the European project.
The impact of the last month’s events on the performance profile of many UK equity funds has been dramatic; particularly those with a significant domestic bias to their earnings. Up to the point of writing this piece, so far this month our UK Dynamic Fund has risen by 7.0% – meaningfully ahead of its benchmark index. These are significant moves that demand critical appraisal of the current position. In a way, these share price moves are simply allowing a catch up of domestic equity performance that has lagged over the last nine months – despite the fact that UK focused businesses were a rare source of earnings upgrade momentum over that same period. Equally, because the recent share price gains have been focused on companies in the portfolio that were most lowly rated, the overall portfolio valuation dynamics have not worsened materially. Yes, the cheapest stocks are no longer quite so cheap; but the median company is not materially more expensive than it was a month ago, and the most expensive stocks are largely unchanged.
We said at the start of the year that a sustained “Bull Phase” of the equity market associated with continued growth in the Anglo-Saxon economies and monetary stimulus in Europe would be prefaced by a rise in equity valuations. Equity markets run ahead of analysts and companies upgrading expectations. If global economic growth is about to hit an upward trajectory, then getting bounced out of markets now because valuations have jumped is likely to hurt in the long term.
In absolute terms, the current UK Dynamic portfolio is not particularly expensive. On a pro forma, “as earned” basis, the December 2015 PE on the portfolio is 13.7x – which for underlying earnings growth of 13% gives a PEG ratio of just over 1. That number is slightly skewed by two very cheap PE stocks, whose enterprise value is considerably larger than their equity value (hence the low PE), but the median stock in the portfolio has a PE of a little over 14 times. The most expensive stock in the portfolio (Sage) is trading on 22.7x pro forma Dec 15 earnings – albeit that this is after a near 20% rise in its share price since the start of the month.
All of this matters, because Dr Yellen at the US Federal Reserve has reminded us again this month that US interest rates are almost certainly going to rise this year – and we know from previous experience that rising interest rates puts most pressure on the highest equity valuations. Running with a gung ho portfolio whose valuation justification lies on profit to be earned a long time into the future, or one dominated by stocks that are deemed to be effective bond proxies in the era of quantitative easing will come under pressure as monetary conditions normalise in the US and then the UK. However, portfolios based on businesses that are appropriately valued and can exploit the economic growth that causes interest rates to go up in the first place will continue to deliver attractive returns.
We have no doubt that politicians will conspire to give us a few more sleepless nights over the rest of the year. A Greek default on its debts will come at some point. Looking further out a failure of the right wing Eurosceptic elements in the Conservative Party to secure a Brexit could threaten the party’s very existence in its current form. To go all Donald Rumsfeld, there are still the unknown unknowns that have yet to be imagined. But taking the current situation at face value, there is upside yet in this market.