The UK hasn’t left the EU yet, but Brexit is already wielding its influence over the financial markets. For the past three years, investors and traders have had to tread a minefield of uncertainty as politicians continue to debate the country’s departure from the bloc.
The impact of Brexit is still open to ambiguity but, with as little as eight weeks to go before the current 31 October deadline, investors need to take precautionary steps to protect their portfolios and traders must put their thinking caps on to find the hidden trading opportunities.
Geographical and industry diversification helps spread risk
The UK stock market has continued to grow since Brexit – the FTSE 100 is up nearly 19% since the referendum in 2016 – but the uncertainty means the country has been held back. Traders keen on indices should consider branching out overseas where growth has been more than twice as strong, with the Dow Jones Industrial Average (DJIA) up 54% while the Nikkei has risen by 42%. Considering the French CAC 40 has risen 36% and the German DAX is up 28% since the referendum, it seems the risks surrounding Brexit are considered higher for the UK than the EU.
The FTSE 100 is made up of the 100 largest-publicly listed stocks in the UK, most of which are international firms. The fall in the pound since the Brexit referendum has been regarded as a win for those businesses that sell overseas as they receive a windfall when translating their earnings from abroad, like the dollar. On the other hand, the weaker pound and the threat of Brexit on supply chains is considered a negative for many members of the FTSE 250 because their businesses depend more on the UK and EU markets, and the relationship between the two. Having said that, the FTSE 250 has so far outperformed the FTSE 100, up over 22% since the vote.
Geographical diversification is the one of the best ways to spread the risk attached to Brexit. Although Brexit could have far-reaching consequences beyond the borders of the UK or the EU, the rest of the world continues to get on with things, demonstrated by the strong performance in the US and Japan. The MSCI World Index tracks large and mid-cap stocks in 23 countries and about 5.7% of the portfolio is made up of UK stocks, with another 14.4% tracking other European shares. While that has increased 29% since mid-2016, the World Index ex-UK, which holds a similar portfolio but with no UK assets, has reported a stronger increase.
ETFs and ETCs
There are many exchange traded funds (ETFs) that not only offer the benefit of geographical diversification but also have exposure to a wide variety of industries and sectors, putting them in a position to tackle the threats of Brexit. For example, the Vanguard FTSE All-World UCITS ETF tracks the FTSE All-World index, providing exposure to over 90% of the global stock market. Those that made an investment in this ETF in June 2016 have seen the value rise by almost 36%. There are ETFs that have a narrower focus. The iShares Core MSCI Japan IMI UCITS ETFS tracks the MSCI Japan Index, providing broad exposure to over 2,700 of Japan’s largest stocks. It has grown by 24% since the referendum.
For those that don’t feel confident deploying their money behind stocks, there are also options to trade exchange traded commodities (ETCs), which act like ETFs and track the value of one or a group of commodities. Commodities are needed everywhere in the world and are therefore shielded from the political turmoil isolated to the UK and the EU. Usually, gaining exposure directly to commodities can only be done through trading, but you can invest in an ETC much like you would any other stock and try to benefit if the basket of commodities it tracks appreciates in price. For those wanting diversification, consider the ETFS All-Commodities ETC, which follows a varied basket of commodity futures by tracking the Bloomberg Commodity IndexSM. For those that want more direct exposure to a particular commodity, such as the safe haven of gold, they can invest in the likes of the ETFS Physical Gold ETC.
Another way of easily diversifying your holdings amid Brexit is by deploying some funds in investment trusts that focus on stocks outside of the UK and the EU. These also come with the benefit of dividends.
Alliance Trust is one of the largest investment trusts in the UK but its investments are spread around the world, putting in a better position to weather the threat of Brexit. Its largest holdings include Alphabet, Microsoft, Facebook and Philip Morris International – all of which will remain relatively unphased by Brexit. It has delivered a total shareholder return of over 56% during the three years to the end of July 2019, outperforming the 45% delivered by its benchmark.
Polar Capital Technology Trust is another UK-listed trust that has a portfolio that should be well-shielded from Brexit. UK investments make up just 1.4% of its portfolio with the rest of Europe accounting for another 4%. Its investments are geared toward technology and over 70% of its investments are in the US and Canada.
JPMorgan American Investment Trust invests in North American businesses and aims to outperform the S&P 500. Not only does this provide exposure to the US and Canada, both relatively unaffected by Brexit, but a diverse range of industries. Its four biggest areas of investment are IT (20% of the fund), financials (18%), healthcare (10%) and consumer discretionary (10%).
The North American Income Trust aims to provide above average dividend income and long-term capital growth to investors by investing in stocks within the S&P 500, which it has outperformed over the past three years. Over one-quarter of its fund is made up of financials, 14% healthcare and 11% energy. Its three largest holdings are Chevron, Philip Morris and Citigroup.
The Baillie Gifford Japan Trust invests in small- and medium-sized businesses in Japan and focuses more on delivering long-term capital growth rather than income. The four biggest components of the fund are commerce and services, electronics, manufacturing, and IT, communications and utilities. The top 20 investments make up only 30% of the fund, meaning it is not overly invested in any one company. Its four biggest investments are in SoftBank Group, Rakuten, SBI Holdings and Kubota.
The last investment trust to consider is Tetragon Financial, which invests not only in stocks but everything else too – from bank loans to real estate to infrastructure. This flexible approach to investment gives it the ability to react to any sudden changes in the market by pulling out its money from one area and deploying it another when needed.
Real Estate Investment Trusts (REITs)
Real estate can be a safe place to store money during times of troubles, but many worry about the effect on house prices during times of uncertainty or if there are fears of a recession (like there is now). However, some areas of real estate have proven to be resilient – such as healthcare, logistical outlets and storage facilities. For example, Tritax Big Box REIT, which invests in logistics facilities in the UK, generally leases out large warehouses to big-name clients on leases that tend to last over a decade, providing some certainty and transparency over future income.
If investors want the added comfort of geographical diversification then they can opt for ones operating in the likes of the US. Health Care REIT and Ventas both invests in buildings like hospitals and retirement homes in the US, which will remain vital regardless of the economic environment.
Invest and trade Brexit-proof stocks in the UK
Some may have the temptation to neglect UK stocks whilst the Brexit uncertainty rumbles on but there is still plenty of opportunity in UK equities. Many stocks have had a ‘Brexit discount’ slapped on them since the vote and the weaker pound has made them attractive to overseas investors looking to grab a bargain. There are plenty of UK-listed stocks to consider in the face of Brexit, whether you’re looking to protect your portfolio and batten down the hatches or capitalise.
Geographically diverse and scale
For now, London’s largest stocks are generally benefiting from the Brexit-induced fall in the pound because of their international presence but the threat to their UK-EU supply chains remain. This is why investors need to consider those that do a lot of business elsewhere as well as those that have the ability to manufacture and source from other regions to mitigate the risks of Brexit.
The puzzle now is putting the right pieces together. Investors need to find stocks that are geographically diverse, have the scale needed to absorb inflation or tighter spending, generating cash with manageable debt piles, and, ideally, still growing and paying dividends.
Take the banking sector as an example. Lloyds’s business is focused on the UK market and has seen its share price tumble over 12% since the referendum. Meanwhile, banks that derive most of their profits outside of the UK and Europe, like Standard Chartered and HSBC, have seen their share prices increase 15% and 34%, respectively.
Lloyds share price: what would a no-deal Brexit mean?
Or look at the travel and leisure sector and identify those chasing growth outside of the UK or EU. In hotels, for example, Dalata Hotel Group operates in the UK and Ireland while InterContinental Hotel Group’s revenue primarily comes from the Americas and is growing in areas like China. Both have seen their share prices rise since the referendum, but Dalata’s 25% increase is overshadowed by IHG’s 69% rise.
Investors should also look for firms that are not only geographically diverse but provide vital services. Take Craneware, which has seen its shares almost double since the 2016 referendum. It provides technology and services to allow the healthcare industry to become more efficient and profitable. Not only does it help vital industries save money, but it has minimal exposure to the UK. It predominantly operates in the US and reports in dollars. Sticking to the resilience of healthcare, investors may also want to have a look at NMC Health, the largest private healthcare company in the UAE.
Similarly, Ferguson is another London-listed stock primarily operating in the US. The company distributes plumbing and heating products and makes just 11% of its revenue from the UK, with the rest coming from the US and Canada. AVEVA provides software to the largest industries around the world, including oil and gas, chemicals, utilities and food and beverage firms. It doesn’t class Brexit as a principal risk and over two-thirds of its revenue comes from outside of Europe, with a fraction coming from the UK.
Fashion brand Burberry caters to affluent individuals that won’t see their financial position take too much of a hit as a result of Brexit. Growth is firmly geared toward Asia and it has benefited from increased tourism into the UK thanks to the lower pound, encouraging them to splash out on expensive luxury items.
Investors should also consider stocks that thrive when consumers must tighten their belts and inflation rises, both of which could intensify after Brexit. ‘Discounters’ like B&M, which is rapidly opening new stores as other retailers shut up shop, are likely to benefit from any economic hardship inflicted on UK consumers. The Big Four supermarkets – Tesco, Sainsbury’s, Asda (owned by Walmart) and Morrisons – will see competition with Aldi and Lidl intensify.
Then there are companies that help consumers save money on non-discretionary services like insurance and energy bills. People will need these types of services regardless of the outcome of Brexit, but any economic downturn that happens as a result will encourage them to save money. This could present opportunities for companies such as Moneysupermarket.com.
Then there are the companies that provide vital services to consumers. This spans a wide variety of services. Insurance is a must, so firms like underwriter Beazley or Admiral Group should remain robust whatever Brexit throws at them. Energy providers, while far from immune from disruption from Brexit, will still have to keep the lights on and people will still need to pay for water from utility companies.
Then there are the likes of mobile carriers and broadband providers. The services are discretionary but one of the last costs to be but by consumers. Again, this should mean firms like Vodafone and BT Group should be shielded from the threats of Brexit in terms of consumer spending, even if it does force them to become more competitive on pricing.
Lastly, there are those selling addictive products that hold up well regardless of the economic climate, particularly cigarettes. Their traditional tobacco businesses may be in long-term decline but their sales will barely see a dent from Brexit, meaning firms like Philip Morris International or British American Tobacco can be regarded as safe bets over the short term – and they pay dividends.
Many of the companies that have been mentioned have the added benefit of structural growth, which in layman’s terms means they have growth underpinned by the nature of their business or sector. This includes firms that hold leading positions in industries that suffer from chronic undersupply – like construction or waste recycling. For example, whatever the outcome of Brexit, the UK will still have to address the shortage in housing and improve its plastics recycling to meet climate change goals. That underpins future growth for housebuilders and building materials suppliers such as Breedon, as well as waste management firm Biffa.
How will Brexit impact housebuilder shares?
Then there are fast-growing players in the alcohol and drinks industry, which shows no signs of slowing down even if there is drastic change occurring. Alcohol sales tend to hold up well during recessions or downturns. Fevertree Drinks is the market-leading mixer provider in the UK but is delivering faster growth in countries like the US, Canada and Australia. Diageo, which makes many of the alcoholic drinks they are mixed with, is also well protected from the impact of Brexit thanks to its internationally diverse business.
A final example is the cyber security sector, which is becoming increasingly important for businesses of all sizes as the number of cyber attacks (and the penalties of being subject to one) increase. GB Group, which specialises in software that helps identify and locate customers, offers the added bonus of being geographically diverse with customers in 72 countries.
London is home to some of the world’s largest commodity giants such as BHP, Rio Tinto and Glencore, all of which mostly operate outside of the UK and EU. Some have suggested Brexit does pose a threat, but the international nature of their businesses means they will be among the least-affected. BHP, for example, makes a fraction of its revenue from Europe and is predominantly operating in the Americas and Australia. Outside of the largest miners, investors may want to look at smaller gold miners as a way of deploying some money in the safe haven of gold through a stock (or ETC as mentioned earlier). Centamin, which has the flagship Sukari gold mine in Egypt, or Fresnillo, which operates in Mexico, could be attractive. However, investors should be aware that you are investing in a stock and not the commodity it makes, which brings added risk compared to trading directly in gold or another metal.
Lastly, investors may want to seek out companies that could capitalise on discounts being applied to valuations, mainly those looking to consolidate or bulk up through acquisitions. A slew of London-listed companies have attracted takeover bids from overseas investors looking to grab a bargain due to the weaker pound.
One company to watch could be Melrose, which buys businesses, improves them, and then sells them on for a profit. The turnaround specialist says only a small amount of sales rely on smooth UK-EU trade and that it has hedged against potential fluctuations in the pound over the next year. It has not explicitly said it could look to grab a bargain amid Brexit, but it could be one of the first to pounce if the right opportunity comes along.
How to protect your portfolio in a recession
Be proactive, not reactive
Predicting the course of Brexit has become increasingly difficult amid the political turmoil in recent weeks, as both sides of the debate step up their efforts ahead of the 31 October deadline. This highlights the need for investors to be proactive, rather than reactive, to avoid any sudden movements in the market.
For investors, consider the following points when analysing your investment portfolio:
- How do movements in the pound impact the stock? What currency do they report in?
- Where is the supply chain and how dependent is it on UK-EU relations? How exposed is the stock to potential tariffs and border checks?
- How geographically diverse is the stock? How dependent are sales in the UK and the EU?
- How vital is the product or service being provided? Will consumers and businesses cut spending in the event of a downturn or if prices rise?
- Look for stocks that have actively prepared for the worst-case Brexit scenario, such as those that have relocated workers or sourced new EU licenses. Some stocks have been publicly upbeat about the prospects of Brexit, such as Wetherspoons.
- What are the stock’s growth prospects pinned on? Is it pursuing structural growth, or will its prospects be harmed because of Brexit?
- Spread risk by considering deploying cash in ETFs, ETCs, investment trusts or REITs, which can all offer some much-needed diversity to a portfolio.
IG Group is a UK-based company which helps clients trade financial markets on leverage via trading in financial derivatives such as contracts for difference and financial spread betting.
The Financial Analyst is always on the lookout for interesting opinion and commentary from those working at the coalface of the financial sector. We offer a platform for a variety of views and promote hard-hitting takes on markets. Get in touch to contribute to The Financial Analyst