Fri, 24 Jun 2016
An indiscriminate sell-off could put some quality companies on sale, but investors must be patient, given the near-term uncertainty surrounding the Brexit vote, says Morningstar's Alex Morozov.
Jason Stipp: I'm Jason Stipp for Morningstar. Global markets tanked after the U.K. populace voted to leave the European Union overnight. I'm checking in today with European director of equity research Alex Morozov to get his take on the Brexit vote and what it means for valuations.
Alex, thanks for calling in today.
Alex Morozov: Good morning.
Stipp: First of all, it seems like there are still a lot of things that we don't know about the situation. We do know that the vote happened, that the populace voted for the U.K. to leave the European Union, but a lot of things that happen next, we don't know.
So as an analyst looking at companies, looking at sectors, what are the things that you are considering as you're doing scenario analysis for such an unexpected event?
Morozov: Jason, actually the only thing that we know is that the vote happened, and everything else is pretty much an uncertainty at this point.
First of all, it's not even actually conclusive that the U.K. is now out of the EU. There are a number of obstacles they have to overcome. There's a two-year period during which they have to negotiate the withdrawal agreement, and there's even some speculation that ... U.K. politicians might not even follow the referendum decision. Although, I don't view that as a likely outcome. Ultimately, there's very little clarity in terms of what the Brexit actually entails.
For the mid- to long-term view on the economic impact of Brexit, we look at a number of experts out there, and they all seem to agree that the long-term effect is likely to be limited. Essentially, if Britain, and I know it is an if, but if Britain is able to negotiate free trade agreements with its partners, there's likely to be actually a marginal positive impact once the fears subside, and confidence returns. Right now, nobody knows what's happening, so the fear is at its peak levels, and the uncertainty is quite high.
If the trade agreements are stalled, yes, there could be some definitely negative impacts to the economy over the over long term, and that could actually creep into companies' financial statements. Ultimately that's what matters for us: If there are issues with tariffs, if there are additional costs that are going to be incurred by the companies that import from the U.K. or export to the U.K., or have manufacturing in the U.K., then that will be impactful.
Another factor, another element, in this right now is that sterling is down dramatically, which is not necessarily a bad thing. It's a bad thing for any multinational that has U.K. revenue--it will be taking that sterling revenue at a lower exchange rate. But if you have manufacturing in the U.K. right now, let's say you're a global company with a diversified revenue base, sterling is actually a plus. That's why we actually see a number of companies right now that are up today, which is somewhat surprising, but there are a number of companies that are trading up.
Stipp: At Morningstar, we really think about two things: What happens in the market, and what happens with the intrinsic long-term underlying values of companies. That comes out in our fair value estimates for those companies, which we can roll up to sectors, roll up to market fair valuations.
As you're looking at what the market is doing today and the sell-off that we're seeing, and you're thinking about the fair value estimates for companies, do we expect that the fair value estimates are going to change in any large wholesale way? Are we going to see big drops in our fair value estimates?
Morozov: I would say that with the exception of the financials sector--the financial sector is in a slightly different situation right now--but with the exception of the financial sector, I don't anticipate any kind of dramatic changes to our valuations because of the vote. Primarily, because we do not really incorporate anything that is so highly uncertain and so highly unclear into our discounted cash flow model.
One thing that we do see is the uncertainty going up, and I'm going to quote someone here. It's largely the fluctuations that drive bargains, and uncertainty due to fluctuations prevents other people from taking advantage of them, and that's actually exactly what we're saying you should do. We're not necessarily going to know when the floor is going to be reached. There's a lot of volatility right now--almost at a level we haven't seen since the global financial crisis--but when you look at the underlying fundamentals, nobody is very clear in terms of what's actually going to happen to the underlying financial statements, to the costs. And when there's that much uncertainty, obviously the sell-off happens. But it is clear to me that perhaps the impact is significantly overstated.
Stipp: Given that, do you think that for bargain-hunters who have a stomach of iron, they could go in and find some individual opportunities when we see such a big sell-off? Or would you say that the uncertainty right now would suggest you should stay on the sidelines?
Morozov: Every investor has their own tolerance for risk, so this isn't advice for anyone in particular. I would say that in general when you see dramatic, indiscriminate sell-offs like what we're seeing today, you're better off looking for companies with economic moats. It's the first thing that I would look at. Which companies have the ability to perhaps pass input costs on to its customers? Which companies are at an advantage? Which companies have global scale, global distribution abilities? Companies with economic moats typically are the ones that I would look at during moments of indiscriminate selling. Because, really, the market doesn't care whether the company has a moat or no moat. The sell-off is widespread; the sell-off is indiscriminate, so wide-moat companies would be the first place I would look.
For foreign investors who perhaps are looking to just avoid U.K. exposure entirely [will want to avoid] the companies that have a significant exposure to the U.K. market, so the U.K. homebuilders, U.K. banks, REITs, etc.
But multinationals with a limited U.K. revenue base are probably not going to see significant impact. And actually if you have a significant manufacturing footprint in the U.K., you would definitely benefit from weaker sterling. Diageo, for example, the Scotch whisky manufacturer, is up a few percentage points today. That's one company that perhaps sees the sterling weaknesses as an opportunity rather than an issue.
But as I said, general bargain-hunting for wide moats, with the full caveat that we're not forecasting when the floor will actually be reached, or how long the sell-off will happen. As I said, the uncertainty right now is quite high.
Stipp: So keep a long-term perspective, look for competitive advantages, be ready for the market to go even lower in the short term, potentially. A lot of unknowns. And essentially keep an eye on that long-term intrinsic value. Alex, thanks so much for calling in today and giving us your perspective from Amsterdam.
Morozov: It's my pleasure. Thanks.
Stipp: For Morningstar, Jason Stipp, thanks for watching.