Ahead of the referendum vote in the UK we naturally assessed our direct exposure to UK companies in our funds. The Seilern flagship fund, Stryx World Growth fund, had only one UK holding which was Reckitt Benkiser.
Reckitt Benckiser is a true multinational company with less than 10 per cent of sales coming from the UK. This will clearly benefit the company as their non-UK sales are converted back into a substantially weakened GBP. Regarding their costs base, Reckitt Benckiser runs a very lean operation. A large proportion of the products the company sells are quite voluminous, especially in relation to the cost at which they are ultimately being sold. If you want to sell shampoo at a competitive rate, you need to ensure that it is produced as closely as possible to the point of sales, as the transport costs become an important factor. As a result, Reckitt produces very locally in their Home and Hygiene products, giving the company’s gross margin a natural hedge. The exception to the rule is the Health division. These tend to be more complex products which are much smaller, lighter and cheaper to transport. Their production is therefore disproportionately located in the UK. Overall, the fall in GBP would benefit Reckitt’s gross margin, but the company does hedge some of its transactional cost counteracting this benefit.
The potential negative would come from a weaker UK consumer, or Brexit leading to an outright recession. It is very hard to predict what the macroeconomic effects will be at this stage though. There are also some uncertainties surrounding the regulatory environment, especially surrounding the export of consumer health products and the future approval process for these. The impacts of this will take some time to materialize and should not be existential, as the company exports these products to many non-EU countries.
It is not only the UK companies that are affected by the results of the referendum. The consequences of the vote go beyond. For example, the strength of the USD will undoubtedly have negative consequences for globalised American companies. However, while the full impact of Brexit has yet to be seen, we know that these sorts of markets also bring opportunities. In a market which is increasingly driven by ETF investment, the weight of some of the stocks in these funds may be unfairly penalised. An example of this is Inditex, which is a very large constituent of the Spanish index and range of local ETFs. As the country may experience equity outflows and the Spanish sovereign debt spread widens versus its German counterpart, Inditex’ share price could be affected disproportionately despite the fact that it is not a cyclical business and its exposure to the UK market is limited.
The actual consequences for the stocks will obviously depend on the scenario which ultimately materializes. In a mild outcome where the United Kingdom leaves the European Union in a swift and amicable way, earnings revisions for our companies, which are mostly global businesses, should be modest. Similarly, if there is a recession in the UK, the implications for Europe and the US should also be manageable. On the other hand, if the uncertainties persist and political tensions inside the United Kingdom and the European Union trigger a crisis of confidence, earnings expectations would have to be revised down more severely. The extent of the drop in share prices would ultimately depend on the multiple that investors would apply to these reduced earnings. This, in turn, depends partly on the cost of money and the decisions made by central banks, and partly on how severe investors ultimately think the situation is going to be. Central banks have already stated their willingness to intervene. What remains to be seen is how expectations will develop.
In this volatile context, the only thing that we can guarantee is that we will remain as disciplined as ever in the execution of our more than two-decade long strategy. We remain confident in the prospects of the companies in our portfolio and that by remaining disciplined the Seilern Stryx World Growth fund will continue to behave as expected.
First, the companies we invest in are not dependent on the debt market for their financing requirements. Their balance sheets are not burdened by significant pension fund liabilities which, with falling yields, could become a sizeable concern for many companies. Second, we are not exposed to banks or insurance companies which will considerably help us avoid the worst part of the turmoil, as these sectors have been amongst the most punished since the vote. Third, we are invested in liquid stocks. At the very start of an episode of stress, the most liquid companies may be penalised as funds sell them first when searching for a fast source of liquidity. However, these tend to be expected and are temporary dips from which the companies recover relatively swiftly. Lastly, in this context of reduced visibility and low growth, market participants should pay an increasing premium to stable growth stocks. With money flowing from central banks and volatility remaining at a high level, the so-called high multiple enjoyed by quality growth stocks and considered an anomaly by certain investors could swiftly become the new normal.
Raphael Pitoun is CIO at Seilern Investment Management. This comment was originally published on 2 July.