Steven Romick’s, co-portfolio manager of FPA Crescent Fund, special commentary titled, “Will Brexit Spark A Much-needed Market Revaluation?”
Markets globally have reacted negatively to the British having voted to leave the European Union (EU) after more than four decades. The night before the vote, UK betting markets reflected that the “remain” camp was heavily favored to win. In a 2015 speech titled, “Don’t be Surprised,” I wrote that “investing, like life, is imminently unpredictable. There are surprises – some good, some bad.” That speech seems all the more relevant today given global market volatility.
“Brexit” falls into the bad surprise category as investors clearly had not priced such an event into the market and so it caused stocks around the world to decline. Those companies more exposed to the UK, such as those in the financial sector and more cyclical businesses, have been hit the hardest while safe havens, such as gold, have rallied. The UK market decline in dollar terms was actually far worse than in pounds thanks to the British currency having wilted 10% versus the dollar.
We didn’t have a compelling opinion in advance of the vote but what happens next is also unknown. Importantly, the referendum is not legally binding. In other words, the population voted for a divorce but it’s up to the government to submit the papers. The UK government now needs to exercise Article 50 of the Treaty of Lisbon in order to secede from the bloc. With Prime Minister Cameron’s resignation effective this October, that leaves the submission to his successor, who may not file in 2016. There is even a small chance that Brexit may not even happen. But assuming the likelihood that the UK does leave the EU, the biggest question becomes what will a new agreement look like? It may not be too bad. What will the economic impact be on the UK and the EU and how might it spill over to the rest of the world? It certainly is a near-term economic suppressant but is it the beginning of deglobalization? Will other countries suffer populist revolts and seek to exit as well? We, like everyone else, simply can’t say for sure.
We do expect that there could be continued market weakness and volatility as the future begins to unfold, particularly given the lack of precedent for dissolution of such scale. Uncertainty breeds larger risk premia for stocks and other risk assets. UK voters have opted for the unknown and brought the rest of us along with them on a ride whose final destination, at least for now, is just a big question mark. If global stock markets were trading at 8x earnings, Brexit would have less of an impact. Unfortunately, that is not the case. When markets are priced for perfection (as they were), negative shocks have the greatest potential to create market disruption. Brexit might be the first step back to more appropriate valuations.
Some investors are nervous holders looking for an excuse to sell so we may see further downside. What’s more, it’s not like the global economy is bolstering corporate profits, so a possibly overdue recession may hasten a decline. And, interest rates will not remain this low forever and certainly can’t decline much more, eliminating another key underpinning of stock performance. As we’ve recited all too many times of late, equities are not cheap. We discussed all of this at our recent Investor’s Day. The transcript can be found at http://fpafunds.com/docs/adwfpa/2016_06_fpa-crescent-fund_id_transcript.pdf?sfvrsn=2.
Even when investing in pockets of value, it doesn’t mean the rest of the world will immediately agree with you. That was evident recently with regards to our position in financials. As good of a value as we perceive them to be, the market sold them off in the wake of Brexit and that has contributed to our equity portfolio declining more than the market in this recent downturn. The financials we own have largely U.S. exposure and what business they conduct overseas is broad-based without disproportionate exposure to the UK. Nevertheless, their stock prices are volatile, causing our portfolio to do better than the market some days but worse on others. What happens on any given day doesn’t matter; what does matter is the businesses’ operating results while we own them and where these stocks are trading the day we sell them. We don’t know how they will ultimately perform along the way or in the end, but low valuations – combined with historically strong balance sheets – give us a margin of safety that will hopefully protect our capital and then provide a return on it. The Federal Reserve published its annual stress tests the day before the Brexit vote and all of the companies we own, which were subject to the exam, fared favorably and were deemed strong enough to weather a severe economic meltdown without help from the U.S. government.
The Crescent Fund’s (the “Fund”) portfolio of value investments (both equities and debt) should provide downside protection in a severe market downturn. The relatively small market price decline since the Brexit vote is more market noise than anything else. The Fund’s 36% cash position provides additional protection in the portfolio and will be used when the inevitable opportunities arise to purchase good companies at cheap prices. Price declines have allowed us to put some capital to work but we are waiting and hoping for even better bargains. In the scheme of things, the market hasn’t really declined all that much. As we’ve argued for the past couple of years, we believe the market has borrowed from future returns. Brexit may have sparked this recent market decline but it happened against a backdrop of historically high valuations. Should stocks really decline (unlike what’s happened thus far) and/or high-yield bonds once again offer returns in the teens, we anticipate deploying our cash to buy up compelling bargains.
Despite the fact that the Fund doesn’t have any direct exposure to UK-centric businesses, Brexit has had an impact on our portfolio but to date it’s nothing more than should otherwise be expected and well within the range of what has transpired in similarly contentious periods in the past.
It’s our job to structure a portfolio that will do well over time but that seeks to avoid a permanent impairment of capital. Watching investments be marked down does not feel great in the moment but thankfully it’s not the moment that counts. What matters is what happens over time when emotions carry no weight and facts prevail and those with staying power generally triumph.
Steven Romick
Co-Portfolio Manager, FPA Crescent Fund
June 28, 2016
Brexit
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