Disclosure – Non-substantive Research
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm's behaviour.
Sometimes it seems that we live in an age of unparalleled hyperbole.
We are told that we work harder than ever, the climate is in crisis, gender wars rage, our schools and hospitals are crumbling, we face an obesity epidemic, and the Russians, the Chinese, or the Iranians (it really doesn’t matter just pick an ‘other’), are planning to destroy the world order as we know it next Tuesday.
There are two ways that you can deal with this. Either you can spend what little time remains on the doomsday clock staring desolately into your accursed iPhone and trembling, or you can pick up a history book and be reassured that – in the grand scheme of things – these troubled times are fairly ordinary by historical standards.
War, hardship, economic strife and social upheaval are not exclusive to 2023, and it is a conceit to frame them as such. In a country where the modal average age of death is 89 (or 82 if you’re a man) the often-spouted idea that we ‘work harder’, are ‘more stressed’ and have ‘less time for ourselves’ than ever than ever is evidently nonsense. Granted, though, never before in British history has a prime minister been outlasted by a lettuce.
This is not to diminish the horrors that we have been witness to in recent times, but nor should we believe – because such horrors exist – today’s woes are, any more than yesterday’s, terminal.
With that in mind, the palpable mood of despair in the City at the moment is interesting to observe.
Gloom amongst our clients is almost universal; and understandable. Investment trusts, Unicorn’s trust guru Peter Walls told the FT last week, are ‘under siege’ and the numbers stack up to support that observation. The average discount across the investment trust universe has widened from 2.2pc at the start of 2022 to 16.9pc at the end of October.
Among the debris of this bombed out sector, surely there must be opportunities for those who believe that ‘this too shall pass’ but finding a bargain in that environment is confusing; after all what is cheap if everything is cheap and – worse – what if you pick something that’s cheap because it’s crap?
We asked our analysts this question to choose four sectors which – in their view – are worth a closer look, and this what they said:
European equity valuations are low in comparison to both history and to US equities, and while it is true that US equities generally have a higher valuation due to the large exposure to technology, very low valuations afford investors the opportunity to get exposure to world-leading companies in sectors such as technology, healthcare and luxury goods. Europe is also seeing a lot of spending on the logistics of de-globalisation and re-shoring, as well as on the transition to renewable energy, and there are many large and small companies benefitting from these trends. So, while headline economic indicators may not be that strong, many European companies are relatively resilient to what's going on domestically as they address either a global market and/or trends that are relatively immune to short term economic ups and downs.
Property trusts have obviously been impacted by rising interest rates, as property values are very correlated to the cost of borrowing. But even as values have fallen, and share prices have fallen further, many areas of property have seen rents continue to grow and as time has passed, active managers have also begun to address issues such as office vacancy by repurposing some of these buildings. A notable bright spot has been the industrial and logistics sector, where strong demand from the "click and collect" economy is contrasted with an arcane planning system that makes it time consuming to develop new buildings. This strong demand for these types of buildings links in with our "re-shoring" theme in Europe, because clearly changing supply lines and locations of manufacturing requires more industrial real estate. UK REITs have also seen quite a pace of corporate activity in 2023, with take privates and mergers helping to reduce supply. In the very short term, positive news on inflation saw a strong positive reaction in property trust share prices.
Private equity is cheap because investors perceive that private equity valuations do not adjust quickly or efficiently to public market valuations, and so when public markets fall, it's usually the case that private equity trusts discounts will widen in anticipation of NAVs falling. Interest rate rises have also played a role as private equity often uses debt to gear individual companies and so rising interest rates will make this more expensive. But private equity tends to be focused on different sectors than public markets, with more emphasis on technology and services, so the read across in valuations isn't simple. Private equity managers are 'control' investors meaning that as things change, they can adapt businesses and make long-term decisions away from the stock market's "quarterly earnings" cycle, so when times are tougher, the best private equity managers will be able to make decisions that may see the companies they own emerge stronger than their competition when things improve.
UK Smaller Companies
UK Smaller Companies are also at very low valuations. In part this is tied up with the wider malaise of UK equities generally, which have been experiencing a gradual reduction in interest from domestic pension funds for many years as those funds have diversified away from UK equities, but also because UK smaller companies are viewed as riskier than larger companies, and large institutions tend to sell them when they want to reduce risk. This has been the case for the last two years and so UK smaller companies are now generally on low valuations. Given their size, it doesn't take that much money to change the direction, and smaller companies, historically at least, tend to perform very well in the aftermath of inflation and interest rate rises.