Daily Reckoning UK

The Pound Is Collapsing – Penny Shares Don’t Care

View of an American penny on a newspaper's chart.
Sean Keyes

by

Posted 19th October 2016

On a balmy afternoon on the 24th of August, sitting outside a café in Copenhagen, perhaps influenced by my tranquil surroundings, I wrote that “Penny shares have shrugged off Brexit ”.

At that point it had been two months since the vote, and things weren’t looking so bad. Sure, the pound had been clubbed. But it was starting to bounce back. So were banking and housebuilding stocks, which took a beating on the morning of the referendum.

“It’s been two months now. And so far, theres no sign of the collapse of the British economy (touch wood).”

Things have taken a turn since then. I’m back in London for starters. Winter is creeping in. Tessa May has been talking hard Brexit at the Conservative Party Conference. London house prices are dropping. Inflation is shooting up. And right now, the pound buys you less than a euro at Gatwick airport.

Today I want to talk about two things: what’s going on with the pound, and what it means for penny share investors.

Office row, trillions at stake

The pound is down 5% since I wrote that piece in late August, 15% since the morning of Brexit, and 22% since last November.

In case you were in any doubt, that’s not normal. The currency of the world’s fifth biggest economy is not supposed to drop 22% in 10 months. Last week, Chris Giles of the FT commented that the pound is trading at its lowest level relative to its trading partners since the data begins, 168 years ago.

What’s going on? Basically the currency markets are trying to figure out whether Britain’s going to leave the single market. If Britain does a hard Brexit on it and loses access to the single market, it’s going to be poorer. That means a weaker pound.

There are some in the Cabinet, such as Andrea Leadsom and Liam Fox, who are willing to give up the single market in exchange for control over immigration. Hard Brexit in other words. And there are others, such as Philip Hammond, who want to keep access to the single market, even if it means less control over immigration.

This month it’s started to look like the hard Brexit gang are winning: Tessa May and others came out with some tough talk at the Conservative Party conference. Hence the crash in sterling.

So that’s basically what’s going on. A huge row at the highest levels of government over what kind of Brexit we’re going to get. And the markets are watching on nervously.

What does it all mean for penny shares?

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How Brexit has hit stocks

The falling pound has hit stocks in two ways.

The first is that particular sectors took a beating: banks, housebuilders, and household goods companies. Earnings in those sectors are strongly correlated with demand growth in Britain. And Brexit is expected to hurt demand growth.

Companies in those industries have rallied a bit after the initial shock of the result. But most of them are down by between 5-15%.

The other way Brexit has effected stocks is to do with the currency. When the pound falls, companies that sell a lot overseas make more money. And conversely, companies which have to buy raw materials overseas make less money.

The FTSE 100 is the most famous stock index in the UK. But the thing is, it’s not a great gauge of the UK economy. It contains lots of big multinationals which are based in Britain but which make their money overseas – Royal Dutch Shell, Unilever, BP, HSBC and the like.

For that reason, the FTSE 100 has been on a great run since the referendum result. For BP, a 10% drop in the pound means a bump in earnings. The FTSE 100 is up 9.6% since the vote.

It’s important to remember that the FTSE 100 reflects the value of overseas earnings in sterling terms. It doesn’t tell you much about the health of the British economy.

Penny shares don’t care

Funnily enough, Aim is a bit like the FTSE 100 in that respect. Lots of Aim companies are in the oil and mining industries, and make money overseas. The companies in question are thousands of times smaller than the likes of BP and BHP Billiton, but the effect is similar. They make money overseas and report their profits in the UK.

Take a look at how Aim has performed since the referendum result on the 23rd of June:


Looking through the Penny Share Letter portfolio, I’m struck by how international most of these companies are. Nine of the fourteen companies in the portfolio so far make most of their money overseas. And not one of them are mining, energy or resource companies.

So that’s one explanation: lots of companies on Aim make money overseas, so the collapsing pound makes them richer rather than poorer.

Another explanation is just to do with their size. Penny shares have smaller revenues than big companies, so they’re just not as exposed to the overall health of the economy. For an Aim technology company selling a specialised product to say 20 customers, the broader forces in the economy won’t matter so much. For the likes of Tesco, the overall health of the economy matters a lot. Every 1% drop in consumer confidence might mean a 2.5% drop in profits.

When the average uninformed investor thinks penny shares they think risk. They might expect penny shares to be wiped out by a big unexpected shock like Brexit.

The last few months prove otherwise. Click here to read my in-depth research at The Penny Share Letter.

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