Which sectors to watch?

‘In the view that “a bad stock in a good sector will tend to outperform a good stock in a bad sector”, looking at sector trends may be one way to cut down on the research needed to identify suitable individual picks or funds,’ suggests Mould.

A weak pound, in theory, favours exporters most of all, as they are also benefiting from low sterling trading costs – examples include sectors such as industrial engineering, forestry and pharmaceuticals.

Companies with a lot of exposure to international revenues or assets also benefit, although they also have higher overseas costs which will be boosted in sterling terms. Such sectors include mining, oil and gas, beverages and tobacco.

Domestic plays such as estate agents and house builders are little affected by sterling weakness, while importers such as general and food retailers are hard hit by a sliding pound.

That theory is largely borne out if we look at the top 10 sectors of the 39 groupings that form the FTSE All-Share index.

	Sector	1-yr returns (%)
1	Personal Goods	16.7
2	Forestry & Paper	14.6
3	Autos & Parts	11.7
4	Industrial Engineering	9.8
5	Tobacco	9.3
6	Electronics	9.3
7	Household Goods	9.3
8	Mining	8.3
9	General Industrials	8.1
10	Pharma/Biotech	7.6
	FTSE All Share	3.2

Source: Thomson Reuters Datastream. *Data to 7 March 2017.

 

Overseas and dollar earners have done well out of the weaker pound, as have overseas asset plays including industrial metals and exporters such industrial engineering, which should also benefit from any uptick in UK and global economic activity.

As another example, British tobacco companies are global players with a lot of non-UK earnings, so they would benefit if the pound weakened further. The sector is also very defensive: demand is pretty stable, regardless of changing economic conditions, because giving up cigarettes is such a challenge.

Pharmaceuticals, another defensive play, also benefits from overseas and non-sterling exposure, as well as from broader trends such as ageing western populations. Additionally, with continuing robust dividends it remains attractive to income investors. ‘The pharma sector looks attractive beyond the Brexit issue, after a weak 2016,’ says Adrian Lowcock of wealth manager Architas.

In general, more risk-averse investors should look for stable, resilient sectors with reliable cash flows, such as food producers, utilities and consumer staples.

On the downside, higher import prices are being fed through to consumers in a number of sectors, and there’s a danger that people simply hold off purchases, particularly in the light of wider job uncertainty.

Sectors at risk include retailers, restaurants and pub groups. Phil Harris of EdenTree Investment Management warns that ‘cost inflation will be joined by rises in the Living Wage and business rate increases to create a potentially lethal cocktail for profitability’ in many cases.

 

Large/mid caps

In the aftermath of last June’s vote to leave the EU, large companies, which have on average 70% overseas earnings, benefited from the currency boost to those earnings, outperforming more domestically focused mid-cap stocks for the first time since the financial crisis of 2008.

The FTSE 100 index was up 20% over the year to 18 March, compared with 13% for the FTSE 250 of mid-cap stocks.

But Harris points out that ‘earnings growth forecasts for this year and next, showing continuing strong growth for mega caps, are almost wholly dependent on continued weak levels of sterling’.

In contrast, he says, mid-cap company growth is rooted in broader growth trends ‘and is therefore far higher quality than that as a result of one-off currency effects’. He believes mid caps will re-establish their performance lead if sterling stabilises or rallies. However, that’s where a decent crystal ball would come in very handy.

Investment/trading ideas

Investors looking for the security of large multinationals with strong brands and good dividends could consider pharmaceutical research giant GlaxoSmithKline, power and gas distribution group National Grid and international tobacco producer Imperial Brand, says Ian Forrest of the Share Centre.

Lowcock suggests Unilever and Reckitts Benckiser as global players in the consumer staples sector. ‘The businesses are very well managed and the companies are defensively positioned.  They have been popular amongst investors in recent years as they offer a dividend and growth,’ he says.

Growth stocks in more vulnerable sectors such as retailers – for instance Hotel Chocolat and Patisserie Valerie – are likely to be much better placed to be able to negotiate with suppliers and manage these increases. ‘The clear message is to buy growth in these sectors and avoid “legacy” assets,’ Harris says.

If you are reluctant to pay over the odds for quality defensives and more interested in recent signs that ‘value’ strategies are returning to favour, Mould likes Jupiter UK Special Situations.

The manager, Ben Whitmore, ‘has forged a fantastic long-term reputation of finding well-run and financially sound businesses that other investors have shunned. With a patient approach and a comfort in investing away from the crowd, this strategy could do very well in 2017 as investors look away from the “expensive defensives”.’

For shorter-term traders, meanwhile, the tensions of the Brexit negotiations are likely to produce plenty of opportunities to exploit valuation anomalies among individual stocks across the board over the coming couple of years.

 

Small caps

UK smaller companies were hard hit by the vote for Brexit. Not only did most have far less overseas exposure to provide a currency boost, but the fear was that their domestic focus left them more open to any Brexit-induced economic slowdown. So far, that hasn’t been a problem; but difficult negotiations could see UK growth weakening.

Even smaller and medium-sized companies that depend on international exports and imports are potentially more vulnerable in the face of protracted Brexit trading negotiations than bigger companies with more strings to their bows.

As a result, the sector has fallen out of favour with investors. The Investment Association’s figures, for example, show net outflows from UK Smaller Companies funds in seven of the past eight months from June 2016 to January 2017. In contrast, the UK Equity Income sector saw net outflows in only four of the eight months.

However, there is a sense that for long-term investors there are now real bargains to be had. That’s borne out by the fact that the investment trust UK smaller caps sector discount has widened from just 6.1% at the start of 2016 to 13% as at mid March.

‘Even though Brexit uncertainty is still rife, we believe that long-term investors are being offered an attractive entry point into UK small caps today, though only if they are able to stomach potentially high volatility,’ says Alex Paget of Kepler Partners.

There’s an additional potential benefit as far as investors in small companies are concerned, which is that weak sterling has boosted interest in mergers and acquisitions, as overseas buyers go bargain-hunting. Phil Harris is among those commentators who expect much broader M&A activity in mid and small-cap stocks as 2017 progresses.

Investment/trading ideas

In the current climate, Jason Hollands of Tilney Bestinvest likes small companies that operate internationally but have much of their cost base in the UK. He picks out tonic water producer Fevertree Drinks, Abcam, which makes protein testing kits for life scientists, and defence technology company Ultra Electronics.

Patient investors prepared to accept the shorter-term risks could do well out of a smaller companies investment trust, particularly if they are able to buy it on a wider than usual discount.

One evident bargain is Henderson Opportunities Trust, run by the well-regarded specialist Neil Hermon and currently on a discount of more than 14%. Herman aims to find companies producing self-generated growth regardless of the wider economic backdrop, and has a high weighting to healthcare.

 

Foreign exposure

Given that the world is rife with uncertainty, it makes eminent sense to spread your interests wide. This may seem counter-intuitive as the FTSE 100 shows no sign of faltering at present, but if the pound drops in the coming months, it will increase the value of assets held in overseas currencies, assuming their price stays the same.

To put that into perspective, consider the impact of currency movements last year on UK investors’ returns. Data from JPMorgan shows that the US stock market returned 12 per cent last year, but UK investors gained more than 33 per cent because of sterling’s decline.

UK investors’ returns from European investments were boosted from 3 per cent to almost 20 per cent, while returns from Japanese equities were lifted from near zero to 23 per cent.

Additionally, regional diversification helps protect your overall portfolio from any UK-centric market slump, and can also mean you have exposure to parts of the world with more dynamic economies.

Investment/trading ideas

For UK investors, exposure to US assets would make sense from a currency point of view, but US equities are expensive relative to their history. Russ Mould of AJBell suggests a better option might be Japan.

‘After a 28-year bear market which leaves the Nikkei 225 at barely half of its 1989 peak, Japanese stocks are cheap, relative to the western markets, its own history and possibly in absolute terms too,’ he says.

He likes Legg Mason Japan Equity. ‘Managed by the highly experienced Hideo Shiozumi, this fund is not for the faint-hearted and can be highly volatile, but the manager has proved time and again that when Japanese equities are in favour, he has the ability to significantly outperform.’

Alternatively, despite the political noise, there are clear signs that the Eurozone economic outlook is improving as leading indicators continue to provide positive surprises. PMI surveys have illustrated the highest level of confidence since 2011, and a move towards a reflationary environment was highlighted by consumer prices rising sharply to 1.8% year on year.

Alternatively, European markets continue to represent relatively good value, and Hargreaves Lansdown recommends FP Crux European Special Situations, run by the highly regarded Richard Pease. He looks for businesses in niche areas with high barriers to entry that are set to prosper regardless of wider economic conditions.

Again, attractive international opportunities also continue to be thrown up for short-term traders with a canny eye on market and currency reactions to political posturing and tough Brexit talk. Europe and the US, as well as the UK, are likely to be prime hunting grounds.

The bottom line, according to Gavin Haynes, is that the continuing unpredictability of political events is ‘a sideshow, and not a reason not to invest’. He points out that anyone who had retreated to cash in the face of the events of 2016 would have lost out on double-digit gains across most markets. For the equity investor these will be difficult waters to navigate.