Brexit Chaos: How Investors Can Stay Calm

Note: With Brexit concerns roiling the market this week, we're presenting a commentary from Morningstar Investment Management's Dan Kemp on the right way to think about political risk. A version of this article appeared on www.morningstar.co.uk.

People love to talk about Brexit, and investors can be tempted to trade based on expected outcomes. We believe the investment basis for this is weak and don't see a strong connection between political developments and investment fundamentals. Benjamin Graham--the father of value investing--considered investing in something you don't understand and can't analyse to be speculation. We agree. As long-term investors, politics doesn't play much of a role in how we view our portfolios. We want to know the range of possible outcomes and position accordingly, but we must resist speculating.

Writing About Political Events Much has already been said about the recent Brexit developments--before, during, and after each negotiation point. Even professional investors spilled a lot of ink or pixels exploring the possible outcomes and implications. We don't always write about these events as we don't want investors jumping at shadows. It's not that we ignore politics or don't want to share our thoughts; it's that we believe doing so may send the wrong message to investors.

We are long-term investors rooted in fundamental facts. Political events rarely fit into that equation, primarily for two reasons: their short-term nature and their unpredictability. For instance, whether Theresa May is successful in her vision for Brexit or it results in further Cabinet resignations still carries a lot of unknowns. It makes great news fodder, but the clearest effects on markets tend to be short-lived. Also, it's hard enough to predict political outcomes. But to be useful, an investor's prediction must not only accurately capture an outcome but all that follows, too--how the market responds, and how policies or other changes stemming from the event may one day affect investment fundamentals. Let's take each point in turn.

Predicting is a Hazardous Game It often seems that campaign promises are made to be broken. We might talk a long time about the imbalance between the ease with which a politician can talk about solutions and the reality that political deals can be hard to strike and are often loaded with compromise. This is democracy, and we believe we should embrace it, while maintaining a healthy skepticism about the execution of what is said.

Soapboxes aside, the point is that it's hard to connect pre-event analysis to post-event reality. And if the connection here is tenuous at best, then we might say we're operating in what statisticians call a "low validity environment." Plainly put, it's what Mike Tyson was referring to when he said something like, "Everybody has a plan until they get punched in the face."

So, it seems predictions for the Brexit deadline and beyond are bravely asserted, but once pundits--or investors--get hit in the face with the political change, they often need to reanalyze and reconstruct their theories. The effect is that political outcomes drive short-term, knee-jerk reactions in markets. Recall the predictions, even by at least one investment bank's researcher, that a Trump win in the 2016 U.S. election would cause calamity in markets--which it did globally overnight after the election, only to give way to considerable market gains since.

At Morningstar Investment Management, we don't make investment decisions based on political events because we don't see a connection to fundamentals. Our process rests on four pillars: understanding how a security's or market's price compares to its underlying cash flows, both in relation to its own history and to its peers; studying fundamental risk; and observing contrarian indicators, or evidence that an investment is unloved (or overly loved) by the market. Political outcomes like Brexit don't tend to affect any of these four pillars in any reliable, foreseeable way.

A Suggestion for Reframing Brexit As long-term investors, we encourage investors to reconsider how they view Brexit. The following points may help:

• Don't react immediately to news, however certain or material.
• Don't try to anticipate market reaction; markets move faster than any investor and price-in anything fundamental immediately.
• Wait out the noise and wait for real change with policies or earnings implications.
• Be prepared to act against the herd; what is assumed as consensus does not always become reality.

Volatility can be your friend by offering quality assets at cheaper prices than previously available.

At most times, we try to emulate great value investors, like Benjamin Graham or Warren Buffett, who would caution against investing in something you don't understand. Political events like Brexit can't be understood because of the indirect and tenuous connection it has on investment fundamentals. We therefore believe that when investors depart from long-term, fundamentally sound investment analysis, they can drift dangerously into speculation.