Beyond Brexit: Navigating opportunities and risks, September 2016

We hear from the four managers on the Franklin UK Managers' Focus fund, which is on the Chelsea Selection, about where they are investing since the Brexit vote.

Co-fund managers: Colin Morton, Paul Spencer, Richard Bullas, Ben Russon

Britain’s largest companies have powered ahead since the Brexit vote, supported by their significant overseas
earnings. Yet the domestic economy is also getting a boost from the Bank of England, which may be good news for medium and smaller businesses. So which part of the market looks the most compelling? The Franklin UK Managers’ Focus, on the Chelsea Selection, is a best ideas fund that invests across the UK equity market-cap spectrum.

Although the result of the European Union referendum came as a surprise to markets, the initial volatility quickly gave way to a more considered approach. We think there’s good reason to believe that, given time, markets will get through this period of uncertainty.

That’s not to say there won’t be upheavals, shocks to the economy and a potential economic slowdown. But taking a long-term view, this may be a good buying opportunity in some of the hardest hit areas, if you’re willing to be patient and take that risk on board.

Lower for longer

In the lead up to the vote, the bookies’ money was on a ‘BRemain’ scenario and more than a few economists were discussing the possibility of an interest rate rise. The situation has obviously since reversed and the Bank of England has now cut rates instead. Our longer-term predictions suggest a deflationary scenario is more likely, which could extend the low-rate environment further.

Recycling profit from large caps

Since the UK's vote to leave the EU, defensive stocks are looking fully valued by historical standards. Given the interest rate cut, this could continue for some time. But there are a whole host of companies that are now looking undervalued too.

With the outperformance of large caps relative to mid and small caps, we have been recycling capital out of the larger, international stocks and reinvesting into mid-sized and smaller companies with more domestic exposure.

For example, we reduced our holdings in AstraZeneca and British American Tobacco and reinvested the proceeds in more domestically-focused stocks such as Bovis Homes, Dixons Carphone and Bodycote.

A pick up in mergers and acquisitions?

In the near term, one area we think will pick up is merger and acquisition activity. International buyers may now be looking for opportunities to acquire quality UK businesses at ‘bargain prices’ due to the fall in the pound. The most probable targets for such activity are likely to be small and medium-sized companies.

The largest deal since the vote has been SoftBank Group's takeover of UK chip designer ARM Holdings. There have also been a number of smaller deals, such as the takeovers of Odeon and Poundland, and we expect more to come.

The importance of diversification

The wide range of possible outcomes makes portfolio positioning difficult in the short term, but does underline the importance of diversification. Franklin UK Managers’ Focus brings together the experience of our entire UK equity team, meaning the fund gets the expertise of large-, mid- and small-cap specialists.

Each manager is responsible for roughly a quarter of the portfolio, with each of us contributing our top stock ideas. The result is a high-conviction portfolio invested across the full depth and breadth of the UK market. We work as a close-knit unit, based at Franklin Templeton’s office in Leeds. Each manager employs a pragmatic long-term investment approach with no deliberate bias to growth or value stocks. We invest in high quality companies with strong balance sheets, shareholder-friendly management and sustainable business models.

Investment decisions are based on rigorous in-house valuation and risk modelling, with careful analysis of the downside risk for each stock. Once we have chosen our stocks, the proposed portfolio is assessed to protect against any unintended biases or concentrations.

Published on 04/10/2016