Fears of Brexit - provides opportunity

Monday, 18th April 2016 14:35 - by David Harbage

Investors hate uncertainty, even more than bad news. This oft-quoted truism is certainly being borne out in, certain segments of the financial markets, ahead of the 23 June referendum on the UK’s continued membership of the EU.

Although campaigning only officially began this week, the prospect of the public voting for Britain to leave the European Union (colloquially termed Brexit) has already resulted in widespread disruption to the valuation of financial assets. Much of the controversy and fears – via claim and counter claim, from the respective ‘remain’ and ‘leave’ camps – has already been rehearsed, but the issue will undoubtedly remain a media headline for at least the next two months.

In terms of the likely short term impact of a Brexit on UK company shares, consideration of currency and interest rates – as much as trading prospects – come to the fore. Sterling has been weak against the US dollar since August of last year, falling from 1.58 to 1.38 at the end of February (before recovering a little to 1.42 today) and has retreated 10% against the Euro since the beginning of December 2015. Whether a firm is an exporter or an importer, where its product or service originates (by reference to costs) and is sold will determine the extent of it being classed a beneficiary or a loser, by reference to the foreign exchange issue. The effect of translating such dollar or euro earnings into a weaker sterling can produce a positive surprise, although nowadays the accounts of many of the FTSE100’s biggest multinational businesses are reported in dollars. Of greater consequence might be the prospect, in the event of a Brexit, of domestic interest rates having to rise to support the value of sterling. Besides that, prospective investors will have to consider if the British pound’s recent weakness is set to continue, post the referendum result, or reverse - both in the short and over the longer term.

The stock market has focused on domestic businesses which are most likely to suffer as a consequence of a Brexit but, rather than focus on those that might have difficulty selling product into Europe (uncertainty over trade relationships) or importers facing difficulty in passing on higher costs (induced by sterling’s relative weakness), have marked down the equity value of property and house building companies. Real estate companies often carry significant levels of debt and the prospect of higher servicing costs (prompted by rate hikes) is a concern, but the balance sheets of the major REITs have been transformed over the past decade to typically feature lower overall gearing and a lock-in to the prevailing lower rates. FTSE100 giants British Land and Land Securities, which saw their share prices fall by 25% in the three month period between November 2015 and February 2016, have subsequently begun to recover their poise over the past couple of months.

By contrast, the equity worth of that other interest rate sensitive sector - house builders – is languishing close to its six month lows. The prospect of overseas investment buyers of residential property (whose appetite is almost solely confined to London) becoming less enamoured in the face of a weaker pound is undoubtedly a risk, but one which only impacts Berkeley Group and, to a lesser extent, Telford Homes within the listed universe. A shortage of skilled labour has been another concern surrounding the industry, especially in the south east of England, and any disruption to the cross-border flow of such plumbers, bricklayers, electricians etc would be a negative. Some economists worry that Brexit could lead to an economic slowdown, pushing up unemployment, repossession of homes and a subsequent significant (downward) correction in house prices. The new home builders have significantly outperformed the wider UK stock market over the past five years and, given their ‘boom-bust’ history, it is not surprising that investors have looked for opportunities to call the peak in the current cycle and book profits.

Beyond the London-oriented companies, stock prices of the national, volume house builders have also been marked down despite ongoing evidence (notably in Persimmon’s trading update on Thursday last) of strong demand. While the wider market has recently advanced – the FTSE All-Share index has recovered 13% from its 11 February 2016 low point – every listed house builder has retreated, with the exception of Telford Homes who last week announced that its profits for the year ended 31 March 2016 were expected to be slightly ahead of market expectations. Over the past ten weeks, shares of Barratt Developments have fallen 14%, Bellway by 11%, Bovis by 13%, Crest Nicholson by 16%, Inland Homes by 5%, Persimmon by 14%, Redrow by 16% and Taylor Wimpey by 7%.

This comes despite the consensus of broker opinion moving more positive (across 11 house building stocks, the writer could only find 10 instances of an analyst calling a Sell, amongst a total of 116 recommendations). The ‘sell side’ of investment banks continue to upgrade profit forecasts for the current year (and the following year), accompanied by higher price targets, on almost every listed industry constituent. As a consequence of the share price weakness, traditional valuation metrics – such as PE, PEG, Yield, price to NAV – suggest this Brexit-induced weakness could represent a buying opportunity for investors who consider that the environment for domestic home builders remains benign.

Persimmon‘s intimation that, in the period from 1 January to 14 April 2016, visitors to their sites increased 12% as compared to the same period of 2015 suggests demand for new homes is not going to reverse in the immediate future. Bearish commentators point to concerns about affordability (by reference to the historic relationship between average salaries and house prices, which takes no account of the cost of servicing a mortgage) and worry that the UK housing market has reached ‘bubble about to burst’ proportions. Recent demand for buy-to-let property, ahead of this month’s introduction of a 3% surcharge on stamp duty, has undoubtedly pushed overall prices higher and some retracement can be expected in the next month or so as demand eases.     

Last week also marked the launch of the government’s London Help to Buy scheme, which extends the boundaries of the original model (interest free loan on up to 20% of value for 5 years, 1.75% thereafter) to encompass new build properties (worth up to £600,000), higher HMG loan (up to 40% of home value) to more applicants (earning up to £90,000).

While opinion polls indicate that the EU referendum is too close to call, financial futures houses are calling the outcome as a clear ‘remain’ (a binary bet on UK to Vote Is currently priced at 68-71, via IG index). If that turns out to be the case, a sigh of relief rally could prompt a 100+ point rally on the FTSE100 index. But sectors or stocks which were marked down lower on Brexit fears – such as Berkeley Group, amongst house builders - are likely to benefit most from a bounce back. By contrast with the unloved, upmarket London builder, MJ Gleeson is a relatively small builder of low cost homes in the north of England (average sale price £125,000 in 2015) and develops strategic, green field sites in the south of England to sell onto larger house builders. However, in equity valuation terms, MJ Gleeson stock appears ‘up with events’ and appear expensive compared to their peers; for instance, sharing a 30 June year end, the equity of FTSE250 index constituent Redrow is currently valued on price/earnings ratio of 6.2 times June 2017 estimated profits whereas, for the same year, the shares of MJ Gleeson are priced on a heady multiple of 12.4 forecast earnings.

Beyond such shorter term or intra-sector trades, investors should always look to the longer term prospects and, insofar as this industry is concerned, take a view on whether current house prices are sustainable (consider interest rates, employment prospects, population) and whether builders can continue to replenish their land banks with plots that can be developed profitably. As the reader might already anticipate, the writer is in the bullish camp and expects the share prices of house builders to rally if – in the EU referendum vote – the British electorate decide to retain the status quo with our European neighbours.

Written by David Harbage for lse.co.uk on the 17th April 2016