Where Next?

A recent edition of The Economist noted a marked increase in European democracies using referendums to solve particularly tricky political quandaries. The editorial suggested that this was a symptom of the political establishment’s failure to cope with the rise of populist parties by offering a meaningful vision of future success for the masses rather than the few. It also noted that, despite appearing to be uber-democratic, actually they frequently fail to resolve the issue at hand. The Scottish Independence referendum has hardly put the issue to bed. Worse, the people of Greece resoundingly voted against its bail out terms last year – only for the government to accept even more stringent proposals over the heads of the people. Finally, it noted that a craze for referendums ends up leading to bad politics. One cannot lose sight of the fact that the current Brexit referendum exists as a vainglorious monument to a Tory party rift. Like Scottish Independence, the losing camp in the Conservative Party are unlikely to meekly accept that the people have made their choice.

All of which makes the economic turbulence which has accompanied the referendum process in the UK all the more disappointing. The UK was not the only major developed economy to have a slow first quarter economically, but recent signs from the US suggest that its softer patch at the start of the year was just that – a soft patch. Recent indicators have pointed to a pick up in activity again. In the UK, the housing market remains robust; but other areas appear to be still marking time ahead of 23rd June.

Against that backdrop, equity market movements are still being driven primarily by what is happening in fixed income markets – particularly in the US. The US Federal Reserve offers a dovish view of future rates policy and miners and industrials soar at the same time as beleaguered banks swoon. Suggest that the process of rate normalisation might restart after a six month hiatus, and that trade goes into a sharp reverse. This is quite a direct, and relatively predictable, causation. However, we would also argue that bond markets are having a more tangential – but no less significant – impact on equity valuations. Particularly at the individual stock level.

The sustained bull market in bond markets – especially in developed world, government bonds – over the last decade has created a desire in equity markets to find equivalent “bond-proxies”, which offer the prospect of higher income yields, but bond-like delivery of earnings and dividends. In particular, the global consumer defensive businesses have seen their ratings bid up to demanding levels, but any business with a history of sustained growth and dividend delivery is likely to have some element of “bond-proxy premium” built into its valuation. Which makes the consequences of failing to deliver ever increasing profits and dividends all the more dramatic to share prices.

Perhaps the most telling example of this in the last six months has been Next plc. (To be clear, we have no axe to grind on this particular stock one way or another. We don’t own it, and it is not under review as we write this.) For the best part of 20 years, Next has been viewed by the majority as the benchmark by which all other quoted retailers in the UK should be judged. It saved itself from bankruptcy in the early 1990s, kept its fashions relevant for its core market over an extended period of time, pioneered the concept of “Clicks and Mortar” retailing, and across all that time managed its capital base efficiently through regular share buy-backs and special dividends. In December last year, its share price topped out at £80 per share. In 1991 you could by those same shares for 12p.

Yet, in the short term at least, £80 was the apogee for the share price. Within six months the share price was down to £50 – a near 40% decline. The difference, one softer quarter of trading, with a reining back of short term expectations. Fundamentally, the business has not changed in any meaningful terms. It has the same store portfolio, designers, management team etc. It cannot be worth 40% less than it was just six months earlier. This does not mean it is cheap today – the £80 may have been wildly too optimistic – but this volatility in response to short term trading conditions is symptomatic of a market that more than ever prioritises near term delivery and momentum over long term value. To square the circle, it is entirely possible that the caution leading up to the EU referendum was the crucial factor behind that slower trading environment. Other key factors (employment, real wage growth) remain as robust as they were before the start of this year.

Next is an example of a trend that is manifesting itself across the UK equity market. Ostensibly predictable growth continues to be bid up. Those that slip up find their valuations savaged. Yet, one bad quarter’s trading does not make a bad business. Investors who believe that equities can deliver bond like cash flows over a sustained period of time are kidding themselves. It is one of the key skills of the successful equity investor to determine whether slower periods are part of the normal variability of a trading cycle, or a symptom of more deep rooted problems.

All of which helps to explain a slightly paradoxical situation: that we find ourselves more bullish today when one does not have to look far to find challenges to equity investment, compared to last summer when apparently everything in the garden was a lot rosier. The difference is valuation. Not of the market as a whole – the 12 month forward PE has barely changed over that period. But of individual equities themselves. Great businesses with minor short term challenges are in many cases being devalued to very attractive levels for anyone with a medium term investment horizon.

Are we claiming that it is that hoary old chestnut, the “stock pickers’ market”? Yes and no. Big picture events like the US interest rate cycle and Chinese financial stability – alongside the outcome of the EU referendum – will continue to drag markets one way and another. But real value is definitely appearing in pockets of companies.