In the lead-up to the referendum on the U.K.’s continued membership in the European Union, certain British bookmakers were offering four-to-one odds on bets the U.K. would opt to exit, meaning they anticipated a mere 20% probability of a leave win. At the same time, both sides were running neck and neck in the polls, rationally implying around a 50% chance of a leave vote result. This opportunity to receive a profit equal to four times one’s initial investment on an outcome estimated to be 50% likely, while losing only one’s initial investment the other one time out of two was an obvious example of a mispriced bet. Similar to the U.K. bookmakers mispricing of the Brexit bet, the market occasionally misprices stocks, placing the odds either in favour of or against the investor.
Our role is to track and evaluate the various opportunities the market is offering and pass/sell when the probability of excess returns is not in our favour and to purchase when the expected return on investment is favourable. Consequently, this process leads to the sale of securities and an accumulation of cash at times when the vast majority of investment opportunities are trading at valuations in excess of their respective intrinsic values (the value necessary to deliver the investor a fair return). Conversely, when market conditions create ample opportunity to obtain high-quality businesses at material discounts to fair value, the process will lead to a deployment of cash or a reallocation from fair-valued to discounted securities.
What does all this mean as a portfolio manager in the context of Brexit? Consistent with this approach, we have been raising cash by reducing positions in fully valued securities in Trimark Europlus Fund and shifting assets from higher-priced European equities to more attractively priced emerging-market equities in Trimark International Companies Fund over the past year, as favourable opportunities in European equity markets faded following the launch of the ECB’s quantitative-easing program.
In contrast, last Friday after the vote, we were selectively buying high-quality U.K. and European businesses – those which, at Friday’s prices, we estimate represent favourable investment opportunities – during the panic-driven sell-off that ensued following an outcome that wasn’t priced into the odds determined by bookmakers or adequately factored into the prices of stocks.
I believe the long-term future of the U.K. outside of the EU is bright. The country has the opportunity to shed the burdensome regulation and bureaucracy of the EU, and solidify its status as a highly productive, rationally regulated and diplomatically governed economy, with low unemployment levels, similar to the position now enjoyed by Switzerland. In contrast, countries such as France, Italy, Portugal and Greece are now increasingly vulnerable in the aftermath of the Brexit, as the long-term stability of the union, and therefore the notion of a readily accessible financial backstop to such countries, becomes fraught with doubt.
Moreover, the U.K. citizens’ desire to leave the EU is not an isolated instance. A majority of people surveyed in Greece, France and Spain hold unfavourable opinions of the European Union, calling into question the long-term stability of the union in its current form.†
Akin to the bookmakers’ Brexit odds, the market may have once again mispriced the value of certain assets on Friday after the referendum results were announced. Perhaps the euro should have been declining materially relative to sterling, instead of what occurred following the vote, which was the opposite. After all, if the U.K. economy is to become much like Switzerland’s, one could conceivably look to the history of the Swiss franc to gauge the long-term trajectory of Britain’s currency.
It’s not surprising that through our research process of identifying and vetting well-managed companies that are protected by sustainable competitive advantages, earn high returns on capital, generate strong free cash flow and benefit from above-average organic growth prospects, we find a disproportionate number of such businesses in the U.K. and Switzerland. Both countries have market-oriented policies, reasonable taxation, limited bureaucracy, pragmatic regulation and fair legal systems; all of which garner talented and motivated citizens, foster innovation and entrepreneurship, and can result in high rates of growth, promoting investment. These attributes give us a high degree of confidence that the U.K. will enjoy long-term economic success outside of the European Union.
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