What were your general impressions about the Conservative victory from an investment perspective?
I think the Conservative Party’s resounding victory on 12th December had two impacts from an investment perspective: Brexit looks now certain to happen on 31st January 2020, and the country managed to avoid installing a hard-left Labour government, which to my eyes promised some profoundly business unfriendly economic policies. Of course, it will take a long time to see what the exact economic impact of Brexit will be on the U.K., but in the short term there appear to be a key positive and a potential risk.
The positive is a short-term boost to economic activity. Recent data suggests an economy in pause. In fact, From August through October, GDP growth in the U.K. was precisely 0.0%. This macro data is supported by company meetings we’ve been having with U.K. management teams. We’ve sensed for some time that Brexit-bred uncertainties have been delaying and curtailing investment decisions. Their removal may therefore lead to a spurt in economic activity.
There are also risks. It has to be remembered that the Withdrawal Agreement describes the terms under which the U.K. leaves the European Union. In February, while the country will no longer be part of the EU, little will have actually changed as the U.K. will then be in a transition period in which the long-term relationship between the U.K. and the EU will be negotiated. This transition period is scheduled to end in December 2020, and Prime Minister Boris Johnson has ruled out its extension. So the possibility exists that the U.K. could leave in 2021 without a trade deal. In that case, the U.K. would trade with the EU under World Trade Organization (WTO) rules. In the intermediate term, then, we are not yet out of the woods.
Do you anticipate that this will alter the strategy’s weighting in U.K-based holdings?
It’s possible, because the U.K. looks to us like a fundamentally attractive country in which to invest. Indeed, there are more U.K. stocks than any other country in our database of investable international small-cap companies, which we’ve been building for more than a decade.
However, although we are very much bottom-up stock-pickers, we were mindful going into the election not to expose the strategy to what we deemed was excessive U.K. political risk. So despite the U.K.’s weighting in the strategy being second only to that of Japan, it’s fair to say that we’ve been cautious and somewhat underweight when set against the potential to invest in U.K. companies based on the strong fundamental opportunity set. As the political risks have diminished, we’ve begun to reevaluate the opportunities for many U.K. companies both in and out of our database.
Are there any areas of the U.K. market that now look more interesting to you?
Our answer on this may seem counterintuitive, but it’s a good reminder of how stocks make their way into the portfolio. Logically, if U.K. stocks look somewhat less risky in the aftermath of the election, then companies with a high percentage of their profits generated within the U.K. would seem to deserve the most attention from investors. However, such a top down view is really not the way that we run the strategy. We have an uncompromising quality standard that’s required for a company to be eligible for this portfolio. The potentially positive ramifications of the recent election would not cause a medium-quality company to become a high-quality one. So rather than adding more U.K. stocks, it’s more likely that we’d increase the weighting of selected high-quality U.K. stocks that we already own.
Mr. Rayner’s thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.
