How value can help prepare for the 'Brexit test' – whatever it may be

05/02/2019

Andrew Williams Investment Specialist, Equity Value

With less than two months to go – at least at the time of writing – before the UK is set to leave the European Union, the one thing each of the country’s politicians seem able to agree upon is the only way to avoid financial disaster is by following their own specific view of how Brexit should or should not occur.

It is a pretty stark illustration of Elroy Dimson’s view that “risk means more things can happen than will happen”.

How we have been preparing our portfolios for whatever Brexit brings has, unsurprisingly, been a question we have fielded with increasing regularity in recent months and indeed years.

And of course that view goes back a lot further than 24 June 2016.

The relatively simple truth is, when we look at stocks, what we are doing today is not markedly different to what we were doing two and half years ago – or long before that.

No matter what may be going on in the political or economic worlds, we always rigorously stress-test the businesses our valuation screens flag up as cheap.

We have always stress tested the businesses that are flagged

That means we spend the great majority of our time poring over company reports and accounts with a view to answering one question: is this business’s balance sheet strong enough to give it a good chance of making it through whatever situation or downturn has hurt its share price – and thus of allowing the wider market to catch up and recognise the underlying value we have attributed to it?

To that end, we need to build up a deep understanding of a company’s debt.

When will it mature? Is it bond debt or bank debt? What are the covenants imposed by the lender?

Arrangements that appear sustainable today may become onerous in a different economic environment, which makes it is imperative we critically appraise the company’s balance sheet in a wide range of possible future environments.

Switching our focus from associated risks to potential rewards, knowing what a business’s profits are today as well as their long-term average is just as crucial – as is understanding the nuances of the economic cycle and their possible impacts on a balance sheet.

Brexit isn't a catalyst for our discipline - we've always been diligent

All of which may look like we are preparing our portfolios for Brexit but that is simply a happy by-product of a disciplined, long-term, value-based investment strategy.

Ultimately, all this detailed work is not a ‘Brexit test’ but a ‘severe financial stress test’ – envisaging, for example, the kind of conditions businesses endured through the 2008/09 global financial crisis.

It is work we do on every single potential investment, irrespective of the prevailing market environment or any preconceptions of what 29 March 2019 – or any other single day – may bring.