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26 September 2016

Beyond Brexit: Remaining focused on valuations

By Nick Kirrage, co-fund manager of the Elite Rated Schroder Recovery

Investors could be forgiven for being a bit confused following the Brexit vote. The UK's economic outlook has been downgraded, but the stock market soared after a sharp initial fall. Uncertainty is likely to prevail in the coming months. So what's the best investment approach? Keep calm and carry on!

Brexit is an important event that is already having an impact on the UK's wider economy, but it doesn’t affect the way we run the Schroder Recovery fund. Our focus is on ‘value investing’, which means finding companies whose shares have taken a hit due to a temporary setback.

This could be a poor annual profit report or a balance sheet crisis, or it could be a macroeconomic event like Brexit, which may temporarily cause certain sectors or companies to fall out of favour. The important thing is that we believe these companies have a bright future. We aim to buy shares at a vastly reduced price while others are jumping ship, and then hopefully enjoy a decent profit when the companies eventually pick themselves up.

The next few months or even years may be difficult ones in the UK. We will undoubtedly see volatility as Brexit negotiations get underway. However, it is our job to take advantage of that volatility and exploit the emotional reactions of the market by remaining focused on valuations.

Which companies do we like right now?

We greatly favour banks at the moment (including the Royal Bank of Scotland, Barclays and HSBC), because even though they have struggled in recent years, we believe they have great potential. Since the Brexit vote, we have topped up our investment in RBS. In the short term, the bank faces multiple headwinds from litigation to regulatory uncertainty, while low interest rates continue to hamper profitability. Despite these factors, we think it has been oversold considering other improvements in the business. It currently trades at just 0.6x its tangible book value – which in layman’s terms means it is cheap.

RBS has undergone a dramatic de-risking over the past eight years, meaning it is now almost solely a UK and Ireland retail business. Government pressure will diminish as the taxpayers' stake is sold down. We believe the potential for long-term capital and dividend growth is significant for RBS.

Anglo American is another example of a stock that has underperformed, but that we have invested in over the past year, believing it to have been significantly undervalued. The market sees Anglo’s balance sheet as an issue, but on further analysis we think it is in a reasonable position to see the company through these tough times. Despite a rebound in recent months, the potential share price upside is still significant. As always, investors should keep in mind we mention these examples for illustrative purposes; they are not a recommendation to buy or sell.

Long-term benefits of value investing

Value investing’s major strength is its disciplined focus on buying attractively-valued, out-of-favour companies at all stages of the investment cycle. Put simply, the theory goes that if you buy something that's cheap, you've got a better chance of making money over the long term.

Of course, you will often hear about 'value traps', meaning stocks that are cheap for a reason and may never recover their value! Over ten years of running this fund, my co-manager Kevin Murphy and I have honed our in-depth analytical approach to identifying companies we believe truly have the best recovery potential.

We judge this by looking for a combination of triggers, including a robust strategy in place for turning around the business and a strong management team.

Value investing requires patience, as it takes time for a business to turn things around. It’s not something that happens overnight, so it may suit investors with a similarly long-term horizon. The idea is that it could very much be worth the wait.


Where to next?

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Nick's views are his own and do not constitute financial advice.