If the last year has taught me one thing, it’s that assumptions should never be made when it comes to politics or the economy. For example, the EU referendum and US Presidential election were supposed to deliver outcomes which differed wildly from the actual results. With a general election now less than seven weeks away, they serve as a reminder that no result should ever be taken for granted.
However, markets seem to be doing the exact same thing as they did prior to those two results. They are pricing in what the polls are telling them, which is that the Conservative party will gain a large majority. This has sent sterling higher as investors feel a stronger UK government could mean a ‘soft’ Brexit is more likely, while it may also give the UK a stronger negotiating hand. Due to this, sterling has bounced in the immediate aftermath of the election announcement.
This could be an opportunity to buy companies which operate mostly outside of the UK. It may mean some weakness in the short run as sterling is trending higher. But companies such as theme park operator Merlin Entertainments (LON:MERL) could be strong performers in the long run.
Assumptions
While the polls currently say the Conservatives have a 20+ point lead over Labour, the polls have a poor track record in recent years. As well as the EU referendum and US election going against the polls, the 2015 UK general election was also some way off the ‘no majority winner’ prediction from the major polling companies. Therefore, I’m surprised that investors are assuming the polls will be correct this time around, since there is clear evidence that they are often plain wrong.
Due to this, there is a chance of another slim Conservative majority in the election, or even of a Conservative defeat. As the saying goes, ‘a week is a long time in politics’ and there are almost seven weeks until election day. Therefore, the appreciation of sterling seen in recent days may run out of steam and lead to continued weakness for the pound. This would create more positive currency adjustments for international companies such as Merlin.
Realities
Even if the Conservative party increases its majority at the upcoming election, there is no guarantee of a ‘soft’ Brexit. Theresa May has offered little hope of a quick deal with the EU. She has repeatedly stated that ‘no deal is better than a poor deal’, which indicates she will play hardball when it comes to negotiations. Likewise, a compromise from the EU on issues such as immigration and membership of/access to the single market seems unlikely. The UK and the EU could very easily run out of time in negotiations and this would leave the UK to fall back on WTO tariffs.
Merlin generates over 70% of its profit from outside the UK.
Such a situation may not be a disaster in the long run. Brexit could turn out to be a sound strategic move in an economic sense. However, in the short run there is likely to be a significant amount of uncertainty regarding the UK’s long-term future outside of the EU. This could cause sentiment towards the UK and towards the pound to decline, leading to further currency weakness.
Investment opportunity
Since Merlin generates over 70% of its profit from outside the UK, it is already a truly international operation. However, it is seeking to diversify its geographical exposure yet further. It is aiming to derive a third of its revenue from the Americas, another third from Asia-Pacific and the remaining third from Europe. Therefore, it has substantial scope to benefit from a weaker pound not only in the current year, but to an increasing extent in future years. Its move away from a reliance on the UK and Europe may also help it to avoid any potential fallout from Brexit discussions, as well as from UK and French elections this year.
Even if a depreciation of sterling does not take place over the medium term, Merlin appears to be a sound long-term growth stock. It has made progress on cost reductions and efficiencies during a time when many of its end markets have experienced substantial headwinds. It has also moved ahead with its growth strategy, which includes turning its theme parks into destination resorts. This could positively catalyse its sales and profitability. It also has a number of new developments in the pipeline, with over half of the planned developments between now and 2020 either opened, approved or under development.
Merlin is forecast to register a rise in EPS of 7% this year and 15% next year. In spite of an above-average growth rate, it has a PEG ratio of 1.2. I feel this represents good value for money given its long-term growth pipeline. Dividend growth which is set to match EPS rises next year may also mean it gains favour with investors at a time when CPI inflation is heading higher. A forward dividend yield of 1.9% could become relatively attractive when allied to fast-growing dividends.
Outlook
While a larger Conservative majority seems the most likely outcome of the general election, it is by no means guaranteed. As recent elections have shown, polls can be very wrong. This could mean sterling’s recent gains are eroded in the short run, which could present an investment opportunity in companies which are not UK-focused.
Likewise, the assumption that a larger Conservative majority will mean a ‘soft’ Brexit is more likely could be flawed. The UK and EU appear to be a long way from agreement on key issues such as immigration, which could mean no deal is signed by the end of March 2019. Uncertainty during the negotiation period and a lack of a deal could cause the pound to weaken, whoever is in government and whatever their majority.
Therefore, Merlin could be a sound investment. Its international exposure means it would benefit from a weaker pound, while its efficiency measures should help to boost its financial performance. Its growth strategy is ambitious and on track, while the current valuation does not seem excessive given its double-digit EPS growth forecast for 2018. With no guarantees and only assumptions to consider, Merlin could be a strong performer in the long run.