Britain's Stock Market Darlings Have It All to Lose in `Brexit'

Is Possible 'Brexit' a Gamble for the U.K.?
  • FTSE 250 gained as exposure to banks, commodities limited
  • Smaller companies could miss out on euro-area recovery

The risk of Britain’s isolation from the European Union is threatening what has been a winning trade for the country’s stocks since the financial crisis: buy small.

Buoyed by their limited exposure to slowing emerging-market growth, a rout in commodities and a banking crisis, the U.K.’s small and mid-cap shares outperformed their bigger peers in all but one of the years since 2008 and surged more than three times as much from a low that year through 2015. That trend has started to reverse.

Investors have punished the FTSE 250 Index more than the FTSE 100 Index this year on concerns about growth prospects for smaller companies if Britain decides to exit the EU. Given their reliance on both domestic and European demand, not only could a so-called “Brexit” cause them to miss out on any benefits of a European economic rebound, but they’d also take the hit from any upsets in the British recovery.

“The darlings of the U.K. stock market of the past few years will have a greater exposure to a Brexit,” said Justin Urquhart Stewart, co-founder of Seven Investment Management in London. His firm oversees about $13 billion. “It might be a good idea to prepare for that before everyone rushes out of the door. It’s definitely a risk you should be factoring into your portfolio.”

The FTSE 250 rose 0.1 percent in London on Monday, while slides in large banks dragged the FTSE 100 down 0.4 percent.

The debate over whether the U.K. should leave the EU has intensified amid speculation that the referendum could be called as soon as June. While Chancellor of the Exchequer George Osborne last week denied that the impending vote is hampering business, Credit Suisse Group AG said in a Jan. 18 note that the uncertainty will push British companies to postpone investments and hiring, further hurting already disappointing growth.

The U.K. economy probably expanded 2.2 percent last year and will maintain that pace in 2016, according to projections compiled by Bloomberg. That’s a decline from 2.9 percent in 2014. While euro-area growth is still slower than in the U.K., it’s forecast to accelerate every year through 2017.

In the event of a “Brexit,” Credit Suisse recommends watching 16 British companies with the biggest earnings exposure to Europe. Of those, only five belong to the FTSE 100, while the rest are either members of the FTSE 250 or too small to be included in either gauge. With more than 60 percent of their revenue coming from Europe, Thomas Cook Group Plc, Berendsen Plc and Shanks Group Plc depend most on the region, according to the bank. All three are in the FTSE 250.

When the FTSE 250 last underperformed the large-cap index in 2011, the euro area was struggling with an escalating sovereign-debt crisis. Tour operator Thomas Cook was the biggest loser that year, slumping 92 percent.

On the upside, the FTSE 250’s slide has trimmed its premium over the FTSE 100 to the lowest since May. Valuations for the small-cap index have tumbled 18 percent since a decade-high at the end of last month, to 15.8 times projected earnings compared with 14.8 for the FTSE 100. Still, cutting ties with Europe may keep multiples lower in the long-term, analysts at Liberum Capital Ltd. wrote in a Jan. 14 note.

QuickTake Will Britain Leave the EU?

Although lower valuations provide a good entry point for investors, smaller-cap shares will be especially vulnerable to increased volatility as the vote approaches, according to Hassium Asset Management’s Yogi Dewan. A measure tracking U.K. stock swings has jumped 35 percent this year, more than a gauge tracking volatility in euro-area equities.

“Brexit leads to a lot of uncertainty and markets hate that,” said Dewan, Hassium’s chief executive officer. “Even if the U.K. doesn’t leave Europe, all this noise and politics will not be helpful at all for companies on the brink of reaping the benefits from a pick up in European demand.”

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