DIY Investor Magazine
| August 2017
34
IS IT ALL DOOM AND GLOOM FOR UK DOMESTIC CYCLICALS?
The UK is leaving the EU, economic growth is slowing, household disposable income is being squeezed and interest
rates only have one way to go
David Smith
Henderson High Income Trust.
The case for UK domestic cyclicals – those businesses
whose earnings rise and fall in-line with the broader
economic cycle – could be considered as poor as a
Conservative election campaign. Indeed domestic
cyclicals have materially underperformed since Brexit,
but is it all doom and gloom or has it created a longer
term buying opportunity for some good quality albeit
cyclical businesses?
One of the key considerations in our investment process
is valuation; or in other words, what the current share
price implies about the quality of a business and its
future prospects. I agree that the outlook for the UK is
uncertain but I would also argue the risks are already
well known and hence valuations reflect this uncertainty.
The chart below shows the valuation of UK domestic
cyclicals compared to the UK market.
As you can see domestic cyclicals are the cheapest
they have been relative to the market since the last
recession. Remember that was the worst recession
for a number of decades. Are things really that bad?
Unemployment is low, consumer leverage remains
below previous peaks while there seems to be signs
of wage growth. In recent weeks we have seen results
and trading updates from domestic companies such as
Next and Pets at Home. Both delivered what can only
be described as remarkably in-line statements with no
change to analysts’ earnings forecasts.
Despite this, both share prices were up strongly on
the day of their results showing how far sentiment and
valuations had fallen for these companies.
Although the fears over the UK economy may play out,
I feel the share price under performance in certain
domestic companies has presented an attractive
buying opportunity for some good quality albeit cyclical
businesses.
Two examples are Whitbread and Lloyds. Whitbread,
owner of Premier Inns and Costa Coffee, has leading
market positions, strong brands, a robust balance sheet
and is underpinned by freehold property.
The company still has good opportunities to expand the
business through the roll-out of its key brands which
should drive higher profits over the longer term.
Although short term trading concerns have put pressure
on the share price this has created a compelling
