Small Cap Value Report (24 Jun 2016) - Brexit Day!

Good afternoon!

There's nothing of interest in results or trading updates today, so I'll do a summary of the Brexit situation & points arising instead.

What an exciting, and chaotic 24 hours! I've only had 2 hours sleep, so am not sure how much I'll be able to write today before I flake out. Last night was undoubtedly the most exciting election I've ever experienced. Everyone seemed convinced that Remain would win, with 52:48, but it quickly became apparent that Leave were doing unexpectedly well.

Luckily, I spotted the opportunity to have a wager, and did some nifty trades which paid off very well. Good thing too, because today has been carnage - with small caps marked down 10-15% across the board pre-opening, and then further falls if anyone tried to sell.

I can still barely believe that the British people overall (principally non-London England, and Wales) have voted to leave the EU. It's simply staggering. Although I voted Remain (a last minute change of heart), I'm perfectly happy with the Leave outcome. In any case, we all have to accept the democratic outcome of the Referendum, and get on with it. I've got no time for people who whinge about the outcome. It's done, and let's all now come together and make the UK outside of the EU a great success.

A few further comments;

A 52:48 Leave win is not exactly a landslide. I wonder if Cameron & EU might try to cobble together a compromise - e.g. a new associate status for the UK, rather than full withdrawal?

Nothing much happens in the immediate future anyway - apart from the introduction of massive uncertainty into many areas of life. Plus a 2-year negotiated withdrawal process (which has not yet begun).

PM Cameron resigning, but not for 3 months. Osborne must go too.

Polls & betting odds were (once again) completely wrong, throughout the campaign. How can this be? Are polls any use at all?

FTSE 100 - I shorted this, but after a big initial drop, wondered why it was recovering strongly back up to over 6,000. The reason is of course that c.70% of FTSE 100 earnings are overseas. So with sterling having sold off considerably, that actually enhances the sterling value of earnings.

Sterling - amazingly, this apparently both a 6 month high, and a 6 month low, on the same day! The range today has been between £1 = $1.32 and £1 = $1.50. Mind-boggling! Short term movements probably don't matter that much, since most companies hedge their forex exposure, usually 6-12 months ahead.

The key question is at what level will sterling settle at? At the time of writing it is £1 = $1.37. That will give a big boost to UK companies which export. It will also give a big boost to UK tourism, as the UK will now be a cheaper destination for foreign tourists to visit. So hotels, and UK-based hospitality type companies are worth a look perhaps?

Outbound tourism becomes more expensive for us Brits. So that's probably why easyJet (LON:EZJ) and Flybe (LON:FLYB) are both down sharply today. (I hold long positions in both, and have bought more today). I think Brits will still want holidays abroad, but might trade down to a cheaper hotel. In any case, exchange rates fluctuate all over the place over time anyway. So will this drastically reduce outbound air travel? I very much doubt it.

Mind you, I do wonder what sort of reception Brits will get when we travel abroad, given that we've torpedoed the EU with our Brexit vote?!?

A weaker pound also means that imports become more expensive. So if sterling remains depressed, we're likely to see inflation increase somewhat. It's bad for clothing retailers too, as they largely import in US$, therefore have to either accept a lower gross margin, or raise selling prices (which reduces demand). Although retailers are used to managing forex & margins.

Overall economic impact - we're really in uncharted waters now. Nobody knows fully how things will pan out. There's bound to be some negative economic impact - because of job losses (esp. in financial sector), but more because I think companies are likely to defer investment decisions. That can create a vicious circle which could tip us into a recession.

Profit warnings - because of the above point, I think we need to change our mindset now from expecting growth in earnings to continue, to instead preparing ourselves for profit warnings. Particularly in companies that supply capital equipment, or software, or any other discretionary spending (e.g. marketing) which clients might decide to defer. Employment agencies might also have a hard time, if recruitment is reined in.

Small caps were marked down 10-15% across the board today, so it's interesting to monitor which companies are attracting buyers, and which aren't. The ones that aren't may have further to fall. Especially as small caps are usually illiquid, so there could now be overhangs of people who want to sell, but can't. Quite a few broker platforms fell over this morning as well, I hear. So the selling may not be over yet.

Possible small cap bargains? Everything's changed with Brexit, so in my view a 10-15% markdown is probably wise, to reflect changed circumstances, and the increased risk of profit warnings. So personally, I'm not buying indiscriminately. A small cap has to look stunning value for me to be prepared to buy it today. I did pick up some more Laura Ashley Holdings (LON:ALY) earlier, at about 21p. That's giving me a 10% dividend yield, in a company with a strong balance sheet, and an international brand & operations.

Possible large cap bargains? This has been a great hunting area today. There were some stunning bargains when the market opened, if you could get a trade executed.

I like the housebuilders, and have bought some Persimmon (LON:PSN) at a 27% reduced price today. Also, Richard Crow mentioned Galliford Try (LON:GFRD) as looking great value, so I've picked up some of them today too.

To my mind, new housing is more important than ever, and with low interest rates, I doubt Brexit will have much impact on demand.

Hedging - I should add, that I've shorted the FTSE Mid 250 Index, as a hedge, just in case the market does go into complete meltdown. Edit: since mostly closed, as the market is recovering nicely mid-afternoon.

Scotland - this is going to be a problem. They voted Remain, but got diluted away by more Brexit votes in England & Wales. So expect yet more wrangling there, ad nauseam, pretty much as we're used to, but worse.

European/global markets - we've really put a spanner in the works! Some European markets (e.g. German, and Italy) actually fell more than the FTSE 100 today. Even the Japanese market hit its circuit-breakers overnight. So Brexit is sending shockwaves around the world. Who knows what the implications will be? Obviously one hopes that everything settles down.

UK Banks - Mark Carney spoke this morning, saying that a £250bn credit line was available to UK banks. He pointed out that their balance sheets are very much stronger now than they were in the last crisis in 2008.

What happens next? Nobody knows. My feeling is that trade between the UK & EU will continue as normal for now. The EU is in real trouble, as other countries want their own referenda too - especially Holland, and Italy. I think we could be seeing the early stages of the EU disintegrating?

As regards my investments, good companies tend to do well, largely irrespective of macro factors like this. I think we need to spend the weekend thinking carefully about the business model of every investment we have. Some might need to be chucked out, if there are uncertainties, not reflected in the price.

When the market sells off to this extent, there will undoubtedly be some bargains lying around. Fortune favours the brave, so this is a great time to rummage around for good businesses that have been undeservedly sold off.

Liquidity - one final point, remember that liquidity is usually only there when you don't need it. In a bear market, liquidity in small caps can completely dry up. Remember what happened to me in 2008, when I foolishly went into the crisis holding huge, illiquid small cap positions, and was geared! That combination of gearing & illiquidity is catastrophic. So please don't ever gear up in illiquid stocks. "Gear today, gone tomorrow", as the saying goes.

I think this is a good time to hunt for bargins in mid to large caps. At least with those they are so liquid, you can ditch them at the drop of a hat, and thereby protect your capital, if the market as a whole really nosedives.

If you're not geared, and you've done your research properly, on fundamentally sound companies, then you can just switch off the computer, and ride out difficult patches such as we're seeing now.

Volatility - one more point too. Equities are inherently volatile. They go up & down all the time, for numerous reasons. Lots of people try to time the market, but very few consistently succeed. That's why I think that for most people, taking a long-term approach, it's usually best to just ignore the background noise of market fluctuations.

OK, the UK leaving the EU is a big deal, but as the CEO of Norcros (LON:NXR) said to me a week ago, "Is business going to stop? Of course not!" Business is all about finding solutions to problems. So I take the view that my best shareholdings will almost certainly be worth significantly more than they are now, in 5 years' time. Although there may be points in between when they are worth less, who knows?

Or, if in doubt, we can just sit on the sidelines in cash. There's no compulsion to be fully invested all the time. Whatever floats your boat!

Have a great weekend!

Regards, Paul.

(usual disclaimers apply)