By David Goldman, co-manager of the BlackRock UK Income Fund
History shows that it often makes sense to buy during times of pessimism. In our view, this is the case with UK retailers right now – despite a challenging start to the year.
Last year was an exceptional year for the UK consumer, supported by strong employment and wage growth. Fortunately, we were net beneficiaries through the BlackRock UK Income fund’s exposure to a number of UK retail stocks. But as the year drew to a close, we decided to reduce the fund’s allocation to the sector because valuations looked quite high.
Since the beginning of this year, UK retailers have come under pressure as a result of poor weather and uncertainties facing the market.
A number of retailers have missed earnings estimates, causing share prices to fall by 30-40% in some cases. In our opinion, the market has over-reacted and this has presented us with attractive buying opportunities.
Why are we bullish? In comparison to other countries, the UK consumer remains in pretty good shape, supported by benign and improving credit conditions. We expect to see 2-3% consumption growth this year. Although this isn’t as strong as 2014 or 2015, it is not to be sneered at. We don’t think the UK is heading towards recession.
Selectivity is crucial when it comes to picking stocks. We look for companies that are in a strong position, where there may also be an element of self-help. This could be via a recent merger or acquisition that presents cost and revenue synergies. Most of all, we like businesses that are in control of their own destiny with management teams who deploy their resources and capital well such that they consistently stay ahead of the competition. We focus on businesses that generate plenty of cash and then use it wisely.
The shift from offline to online consumption has been a gradual process in the UK, but certainly one that stands to gain momentum from here. We estimate that Amazon currently claims 25% of UK retail sales online, which is perhaps no surprise. The online retailer has continued to gain market share over time.
Amazon poses a threat to many businesses and so when investing in retailers we need to see that they either have a differentiated product or pricing power. For example, we like clothing retailers that have developed a strong presence online and are ahead of the curve when it comes to the speed at which they can despatch goods or complete returns. We want the consumer to view them as a distributor of choice, supported by a strong online platform.
For retailers with a presence offline, we like those that are not locked into long leases and therefore have flexibility with their presence on the high street.
The rise of discounters has been exponential in recent years, but this is not an area the fund has sought exposure to. We don’t like businesses where the only point of differentiation is price. Instead, we prefer to back those with a differentiated offering that have pricing power and who are dictating the terms of trade.
Capacity has increased in the restaurant and food retail sectors over the past few years. As a result, retailers in this space have experienced reduced footfall and pricing pressure. For this reason, we look closely at sub-sectors where the opposite is true because capacity has been taken out and become constrained. Consumer electronics and cinemas are good examples.
Earnings across UK retail stocks have come under pressure in recent times, but this was from a strong base in 2015. However the sector now trades at a discount to other parts of the market, even though free cashflow yields are very good, a lot of capex has already been spent and online now offers less capital intensive growth for the best businesses.
We look for those UK retailers that have strong balance sheets and that are sustainably generating a lot of cash. Cash which allows for investment in the business and shareholder distributions. We continue to focus on a selective approach to picking stocks for the BlackRock UK Income fund.
Although the market is unwilling to give UK consumer-facing stocks the benefit of the doubt, we are. It’s definitely time to shop around.
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