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Here’s What Stocks You Should Buy After Brexit

The City Continues To Struggle As The Stock Market CrashesThe City Continues To Struggle As The Stock Market Crashes
A city worker passes the Evening Standard headline board showing the words 'Black Friday Shares Crash' during lunch time on Friday on October 10, 2008 in London, England.Photograph by Cate Gillon — Getty Images

The shock from Brexit is pummeling investors on both sides of the Atlantic with huge losses.

But what looks like a cataclysm has unpacked a great opportunity for bargain-hunters: British stocks are now a huge buy. “I don’t know where the bottom is on this, but people who buy British stocks today won’t regret it in five years,” says Rob Arnott, chief of Research Affiliates, a firm the oversees strategies for $160 billion in investment funds. “In short, the returns on British stocks will be excellent.”

In fact, U.K. equities were cheap well before the big selloff made them even more alluring. A reliable yardstick for measuring whether valuations are rich or modest is the “cyclically adjusted price earnings ratio,” or CAPE, developed by Nobel-prize winning economist Robert Shiller. The CAPE eliminates distortions caused by spikes and valleys in earnings by smoothing profits to arrive at a long-term average. The lower the CAPE you buy in at, the higher your future returns are likely to be, because a lower CAPE delivers both a higher dividend yield, and for the same growth in earnings, a bigger capital gain. As of the end of March, the CAPE on U.K. shares—Arnott’s measure of large-cap British stocks—stood at just 11.

Today, Arnott reckons that the number is about a point lower, both because U.K. shares have fallen in price, and because their companies’ profits are buoyed by sales abroad in dollars and euros that are now worth more when translated into pounds. That puts the probable “real” expected return on British shares, he says, at around 9%. Add inflation, and you can expect to pocket annual gains of 11% or so over the next several years.

By comparison, the CAPE on the S&P 500––even after the upheaval from Brexit––is a lofty 25. At those prices, investors are likely to be stuck with real returns in the 4% range at best, half of what they can expect from UK stocks.

Arnott highlights a mostly-overlooked phenomenon in the market’s meltdown. Since shares crested on June 23 on optimism that “remain” would prevail, the FTSE 100 had slid 5.6%. Of course, the fall for U.S. investors was hugely amplified by the 10% drop in the pound sterling versus the dollar.

But the rout on the continent was far worse, The comparison isn’t perfect because Britain has more big multinational exporters than its continental partners, and the the enhanced value of their large dollar and euro earnings cushioned the fall in their stock prices. Even so, the disparity is striking. Over the same Friday-to-Monday interval, the Euro Stoxx 50 comprising the largest-cap companies in the eurozone, dropped 11.2%, twice the fall in the FTSE. Shares cratered 9.6% in Germany, 10.7% in France, 14% in Spain, and 16% in both Italy and Greece, all declines dwarfing the fall in the U.K. The disparity tells Arnott that “the danger of Brexit to the eurozone is a lot greater than the threat of Brexit to the U.K. That’s because Britain’s leaving is taking the stability out of the EU, even though the U.K. has its own currency. It’s a stark threat to the continued existence of the euro itself.”

Still, those outsized declines made already bargain stocks an even bigger bargain. Before the crash, valuations in Germany and France were 20% higher than in Britain, and they remain significantly richer. But Italy and Spain were both cheaper than the UK pre-Brexit, and are even more so today. Their CAPEs sank below 9, meaning they’re likely post long-term returns, including inflation, of well over 10%.

Arnott advocates purchasing British, Spanish, and Italian shares right now, but also keeping plenty of cash on the sidelines in case they get even cheaper. “It’s best to average your way in,” he says. Chris Brightman, Research Affiliates’ chief investment officer, recommends a great trade: Taking your big profits on overpriced long-term bonds, and plowing them into big cap European shares.

It’s uncertainty about the future, says Arnott, that drives stocks lower, and it’s impossible to know if we’re reached peak uncertainty––or maximum worry that more bad news is on the way––or if uncertainty will grow from here. His main worry is that the EU will try to punish Britain for departing. “If they choose to retaliate, it’s a lose-lose path,” he says. “The economic damage to Britain would be a lot, but not more than the damage to the EU”

But all that uncertainty, and more, is already reflected in these ultra-low prices. If you’re patient, it’s time to pounce.