Investors are slowly returning to UK equities after the EU referendum shock and are right to do so, says Katen Patel of JP Morgan Asset Management.
Patel, co-manager of JPMorgan Mid Cap (JMF), describes how the investment trust was quickly repositioned after the Brexit vote last year. Performance has bounced back and with the shares up nearly 30% over 12 months, he looks forward to another year of picking stocks in the FTSE 250 index.
While the UK's divorce talks with the EU will continue to hang over the prospects for 'mid-cap' stocks in 2018, he believes the long-term trends for growth in this part of the stock market will eventually reassert themselves.
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Gavin Lumsden: Hello, with me today is Katen Patel, co-manager of JPMorgan Mid Cap, an nvestment trust that had to respond very quickly to the shock Brexit vote last year . Katen, very good to see you. Could you remind us what you and your co-manager Georgina Brittain had to do when we got the Leave vote in the summer of last year?
Katen Patel: Absolutely. It was a very volatile period as you can imagine for most UK fund managers. And really the work had been done in the prior six to nine months, once we were aware there was going to be a referendum on our EU membership in the UK. We spent a good amount of time meeting with our companies, within the portfolio and within the universe, meeting with research analysts, meeting with industry experts to try and ascertain the impact on our companies within the portfolio. To see how they would react to a big sterling depreciation and more pressure on the UK consumer.
GL: So what did you do that Friday? We wake up, we know what the result is, it’s not what we expected or not what a lot of people expected. What did you do?
KP: Well I didn’t sleep much because I was monitoring through the night and it became clear at 3-4 in the morning that it was going to be a Leave vote. Therefore I came into the office very early, we already had our plans in terms of stocks we wanted to sell out of.
GL: What were you selling?
KP: We were really selling consumer-facing stocks. A lot of domestic retailers for example. And looking to recycle that into internationally exposed names who would benefit from currency depreciation. And that currency depreciation was obviously going to bring through inflation and therefore that was going to have an impact on some of those retailers. But obviously the work we had done prior to that meant we had strict price limits on everything we put on.
GL: I was going to ask you because the market slumped, particularly the mid-cap index around which you’re investing. It was immediately sold off very heavily because of you and other investors like you were selling the shares.
GL: But you sell immediately nonetheless because it’s better to get out quickly than hang around and see the share prices continue to decline?
KP: Yes. So you need to fund the other side of that as well. We had a fair value on most of the domestic stocks and therefore put price limits based on that value assumption, based on the work we’d done prior to the referendum.
GL: The repositioning obviously benefited the trust, you’re up about 30% over one year, so that’s very good. And that’s ahead of the market and the market recovery as well. Have you bought back any of the stocks that you sold?
KP: We did have a very significant overweight to UK housebuilders and we did decide to pare that back, which I think was sensible given the uncertainty with the outlook. One stock that we have added back to was Bellway [BWY], the national housebuilder and we added to that at the beginning of 2017. And the whole sector has rebounded in terms of government support they’ve had, underlying demand and also land prices remain very benign which is allowing housebuilders to build and generate still healthy returns on capital. Bellway has actually outperformed operationally in terms of their delivery on site and management have upgraded their guidance for the year, so adding back to that position has benefited and the shares are up over 40% year to date.
GL: Very good. Do you think investors are returning to the UK stock market having panicked and exited so quickly after the referendum?
KP: To some extent yes certainly and that’s reflected in the discount to NAV [net asset value] of the investment trust which has moved in from north of double digit to 6% currently.
GL: It was about 12% in the summer. It’s halved basically.
KP: Yeh but that 6% still does indicate some caution around UK equities at the moment. Clearly investors are waiting to see how negotiations pan out over the next few years. And indeed prior to the referendum date being set it was trading at or near NAV so I think that 6% does indicate some uncertainty.
GL: Do investors have to ignore the Brexit cloud, the Brexit negotiations which twist and turn obviously day by day, week by week? The market doesn’t necessarily reflect the economy.
KP: That’s right and particularly in the mid-cap space. UK equities don’t necessarily translate into the UK economy. You do have a significant amount of UK exposure. In the mid cap space, for example, revenue exposure is about 50% domestic and 50% international so particularly for active managers like ourselves where the portfolio is currently positioned 45% weighting to domestic exposure and 55% to international exposure.
GL: I see, so you are still quite exposed to the UK economy?
KP: Absolutely, and we’ve been very selective. Things like the challenger banks, things like the housebuilders, certain technology companies where we feel very comfortable because they are in structural growth areas of the market.
GL: And are valuations in the mid cap and the FTSE 250 index, are they good value in light of growth forecasts?
KP: I would say reasonable value. So the 12-month forward price-earnings ratio of the FTSE 250 is around 14.5 times and expected earnings growth is around 10% for the next 12 months. It actually looks relatively good value against the FTSE 100 which is trading on a similar forward 12-month price-earnings ratio and earnings growth forecast is about 8%, so two percentage points lower than the FTSE 250.
GL: What would you say to investors who say the FTSE 250 mid-cap stocks have done very well, the index is up 161% over 10 years. So that’s a good long run. Why should it continue?
KP: I guess that’s really just a continuation of the trends that we’ve seen over the last 40 to 50 years. Mid caps have outperformed large caps in two out of every three years since the 1950s. And I think there are a number of reasons why that will continue. Not least, mid cap companies tend to grow faster than large cap companies, it’s clearly easier to grow from a smaller base. They tend to be less mature in their life cycle as well. And as I say often growing in structural growth areas of the market. They also tend to be more nimble and I think there are a number of examples of large cap incumbents being challenged by disrupters from the mid-cap space. And I mentioned challenger banks earlier. That’s a key area where we’ve seen the likes of One Savings Bank, Aldermore and Shawbrook – the latter two of which have been acquired now – challenging the likes of Lloyds bank, RBS and HSBC through very lean operating models, operating almost purely online and generating very high returns on equity. And I think that’s attracted buyers to come in and pick two of those assets up. I guess a third reason is M&A [mergers and acquisition]. That has been a key feature of the mid-cap space. It’s averaged about 6% of index market cap being acquired per annum over the past 15 years or so and that really provides support for valuations and given the appreciation we’ve had in sterling, we’ve certainly seen a pick-up in the last year or two and I do expect that to continue.
GL: And looking forward to next year , what are the challenges that you see?
KP: I think there will certainly be oscillations in sentiment between periods of worry and periods of euphoria depending on Brexit negotiations. We’ve repositioned the portfolio, very swiftly obviously last year, to face a more uncertain environment and therefore I will be looking to take advantage of any volatility in the market as the detail of the negotiation comes through.
GL: OK Katen thanks very much for telling us about it.
KP: Thank you.