Description

Large swathes of the UK equity market have traded down significantly since the Brexit vote (23/24 June).  I recognize that VIC is not normally a standard venue for macro calls, but I will risk it and share one here anyway, as I believe the 'event' / opportunity is asymmetrical, timely and interesting (particularly with other geographies posting record prices for indices).  The opportunity relates to Brexit.  Specifically, I believe there is a sufficiently high probability that Brexit will not happen.  I recommend to go long the FTSE 250 index, or, alternatively, a basket of specific securities which I outline in a section, below.  I apologize in advance for brevity.

CRUX OF THESIS

• Whilst a slim majority of the UK population is advocating Brexit, a meaningful majority of UK members of Parliament (MPs) are against it, and UK is fundamentally a Parliamentary democracy

• The new UK PM (Theresa May) gave away her hand by appointing 3 Eurosceptic, pro-Brexit members (Davis, Fox and Johnson) in posts that are most closely tasked with delivering on Brexit promises, which are: access to the Single Market or a set of trade deals which are in aggregate no worse off than the current status quo, and significant curtailment of the European principle of free movement.  This cannot be delivered.  At the same time, Ms May is a pragmatist and advocated for Remain, not Leave; her pick for the post of Chancellor also advocated for Remain.  They will not rush Article 50.  Less advertised is also the fact that Ms May has a finance career background, and her husband is also an executive with Capital Group.  This further adds to the probability of her behaving in a rational, aggregate utility-optimizing manner for the country.  Having consolidated her resources, the new PM has room for political maneuvre.  The pro-EU opposition (the Labour party) is in total disarray and if it manages to right itself, the pressure on the new government to avoid Brexit will only increase

• By installing the 3 Eurosceptics in their specific posts, Ms May is in a win-win position: either the trio somehow wrangles a reasonable and attractive deal with Brussels that will take the UK out of the EU on acceptable terms, or the 3 Eurosceptics fail, at which point Ms May will have full support of her party to fully scrap Brexit or return to the public with a fresh referendum, one that will have far more specific wording, with explicit clarification of the economic trade-off that the public will be asked to make.  By that time (likely H2 2017 or later), the impairment in business confidence will translate into job losses, goods inflation, and destocking across the economy.  The first human principle - self-preservation - will take hold and play more meaningfully in the public's vote in a 2nd referendum, should one be held.  The narrow margin of victory for Leave in the first referendum would be overcome, in my opinion

• I thus assess that large swaths of the UK equity market are pricing in an adverse scenario that ultimately has a much lower probability of materializing.  Specific sectors that have suffered the most are banks (both big and small), real estate agencies, airlines, homebuilding/construction, REITs and select retailers.  The most time-efficient way to play on the recovery is to invest in the FTSE 100 or FTSE 250 index; the headline of this write-up is FTSE 250 not 100 because miners are over-represented in FTSE 100 and I did not want to dwell on them too much in my write-up (though I own gold & gold miners as a portfolio hedge).  Given the nature of the thesis, it's a start, but I believe a risk/reward profile-enhancing move is to be more granular and pick a manageable basket of securities, which I will explain later

• The markets seem to forget irreplaceable, intangible assets that the UK possesses and that will continue to make UK a relative economic 'winner' versus all of other Europe, such as a vibrant labor market, an abundance of workers with the 'right' skills (knowledge economy, IT, STEM), world-class universities, freedom of speech, competent / unbiased institutions and most of all - the lingua franca (English).  These factors appear to be underpriced, underdiscussed.  Finally, I do not see other Western European cities offering the combination of factors which made London the dominant financial centre for servicing its span of time-zones: access to human capital, infrastruture, sufficient depth of real-estate / living quarters, and of course - English, English, English.

THE BASKET

I have 8 names: ALD, MTRO, RBS, FOXT, CWD, SVS, WIZZ, EZJ; broken down in 3 groups

• Banks: I believe Aldermore (LSE:ALD, 1.38 GBP/sh), Metro Bank (LSE:MTRO, 18.47 GBP/sh) and Royal Bank of Scotland (LSE:RBS, 1.82 GBP/sh) are the most interesting.  They are down 33%, 12% and 28% since the day before the Brexit referendum, respectively.  Aldermore and Metro are challenger banks that I expect to continue secularly taking share of the UK banking market.  RBS is the only large-cap UK bank that I am willing to own, as it is most closely tied to the UK economy and has a low investment banking exposure / dependence on M&A & debt underwriting volumes.  In particular, I expect ALD and MTRO to have value as buyout targets in the future. I have opened accounts with both of them and was pleased by the efficiency and quality of service

• Real estate agencies: I believe Foxtons (LSE:FOXT, 1.25 GBP/sh) is the most interesting.  It is heavily-associated with London, and yes, I see significant likelihood of FCF for the next 12 months to be zero or even negative, but in the long-run, even if Brexit was to occur, the brand is strong and the strong financial position (net cash) would allow the business to take advantage of turbulence by consolidating the market; the business model is attractive (fundamentally recurring lettings and management revenue stream; flexible margins as staff can be let go).  The size of the business and its prior history of LBO mean a take-private is not out of the question.  I also have a proclivity for overweighting my location-specific investments to university/college towns, which naturally favors FOXT.  If FOXT is not your bag of tea, other reasonable names include Countrywide (LSE:CWD, 2.59 GBP/sh, materially below VIC write-up level) and Savills (LSE:SVS, 6.55 GBP/sh)

• Airlines: I am generally leery of the airline sector for the usual reasons, but - everything at price.  I favor the low-cost operators with net cash positions: Wizz (LSE:WIZZ; 16.30 GBP/sh, roughly at the same level as the initial VIC write-up) and EasyJet (LSE:EZJ; 11.47 GBP/sh).  WIZZ in particular has a compelling, well-documented bull thesis available on VIC, and EZJ has also been discussed.  The UK outbound traveler to Europe is an important profit driver for both businesses but a direct corollary of my fundamental Brexit thesis is that the British Pound is likely to strengthen again, and thus holiday expenditures will not decline as much as expected.  The overall sentiment in the sector is poor.  But, both WIZZ and EZJ are secular winners and I expect them to emerge stronger in the medium term.  WIZZ also has a ridiculously defensive capital structure

• I am not advocating homebuilders at this time. I believe the real estate agent play is a strictly-dominant opportunity vs homebuilders due to cost flexibility and lower range of downside risks or poor capital allocation decisions

• I am also not advocating REITs, as they are dominatead by real estate agents for similar reasons to homebuilders, and appear to contain fundamental illiquidity risks which I would rather avoid in this particular situation

• I am not advocating UK disposable-income retailers at this time, as I cannot get comfortable with the secular industry outlook and some specific issues, even at these prices. 

RISKS

The key risk is that I ended up misreading the political / socio-economic situation and the new UK cabinet takes the country out of the EU on poor terms. In this case, an international investor may take a meaningful FX loss on the investment, and the local currency return would also be reduced (even though I believe that the names I pick are likely to outperform the broader UK market over a full cycle). Selling GBPUSD short or buying puts on GBP can take out some of the FX risk.

Then there is the general worry that at any moment the public's faith in Central Banks' efficacy wavers too much, and the equity & bond prices show it.  Others are virtually certain to be more qualified than me to talk about this, but my own mitigants here are cash, gold / gold miners, and a short book to bring down my net exposure somewhat.

In any event, the world does not end all that easily. 

Catalyst

• Talks with Brussels and incoming economic data, earnings and anecdotal news items (businesses cutting jobs or relocating staff), and labor statistics all combine to crystallize the costs of Brexit in the minds of the public further and give the policymakers the ammunition to take steps to avert it

• In the event that talks with Brussels succeed in unearthing an attractive deal, the basket likely still pays off but in a less IRR-productive way than if Brexit is scrapped altogether.