Flying under the radar

There once was an ugly duckling…

For the past five years the UK has been the ‘ugly duckling’ of the investment world, with global allocators shying away from the area due to the perceived political risks associated with Brexit. Furthermore, the UK market as a whole has historically tended to distribute a greater proportion of profits as dividends than most global peers, and its unpopularity amongst global allocators was thus exacerbated in 2020, as many large dividend payers were negatively impacted by COVID-19. Value stocks, which tend on quantitative screens to err towards high yielders relative to other styles, were hit particularly hard. This caused the UK to be one of the top ten worst performing global equity markets over the year according to Morningstar, as investors flocked to the US and Asia.

However, we have seen a resurgence in appetite for the UK, with investors starting to see light at the end of the tunnel with the issues of Brexit being resolved and the vaccination program well underway. Since the market lows in March of 2020, the FTSE 100 has risen by close to 30%, while average discounts in UK equity trusts within the investment trust universe have narrowed significantly relative to their 12-month averages, as can be seen below.

AIC UK SECTOR AVERAGE DISCOUNTS

Source: JPMorgan Cazenove, as at 19/02/2021

We think there remains considerable potential for this improved sentiment towards the UK to continue throughout the year, and in this article we look at why this might be the case, and a highlight a trust which offers exposure to the potential upside this creates, but has yet to see the benefits.  

A very fine swan indeed?

A number of fund managers that have been significantly underweight to the UK, have started to top up their holdings. According to a monthly survey of global fund managers by Bank of America Merrill Lynch, in January 2021 15% of managers were underweight UK equities relative to their usual historic asset allocations. This was down from 29% last June and 27% in the aftermath of the Brexit vote.

As can be seen on a forward price to earnings basis (Forward P/E), the UK continues trade at a steep discount relative to US companies.

UK STOCK DISCOUNT RELATIVE TO US PEERS

Source: Factset – Financial Times

Also using the price/earnings-to-growth (PEG) ratio, which measures the price to earnings ratio divided by the growth rate of earnings, the UK is significantly undervalued relative to the US and Europe. In fact, we estimate that, based on data from Yardeni, the PEG for the UK currently sits at close to 0.27x, less than half that of the Europe ex UK market and c. 75% lower than that of the US.

According to Citigroup, almost 60% of MSCI’s UK stock index is comprised of value shares. That makes the London market the most value-weighted of all its major peers. However, now that Brexit uncertainty has subsided and we are starting to see success in the roll out of the COVID-19 vaccines, we anticipate there to be potential for significant number of valuation re-ratings in the UK market should overseas investors continue to increase their UK weightings.

An option for exposure…

A trust which is well positioned to take advantage of this, but is yet to feature largely on many investors radars, is Seneca Global Income and Growth (SIGT). Unlike the UK focussed investment trusts which have seen significant narrowing of their discounts, as shown above, SIGT has seen its discount widen from a 12-month average of 1.5% to the current level of 2.6%. This is despite the high levels of exposure to the UK in the portfolio, currently c. 30%, in comparison to 4.4% of the MSCI World Index. As such, the trust offers flexible and differentiated exposure to any UK recovery.

Valuations are at the core of the investment approach, although positions are not initiated solely on the expectation of valuation uplift to drive returns. Instead, the team are looking for opportunities in stocks with strong operational positions or which show structural growth opportunities likely to feed into enhanced dividends, but where the perceived exposure to cyclical economic pressures continues to weigh on the share price valuation.

An example of a UK holding in the portfolio is Vistry, the UK housebuilder. Due to the nature of the business, many perceive the stock to be cyclical and, as such, trades at below its reported book value, and below reported revenues. However, whilst its business has been impacted by the COVID-19 pandemic, there continues to be a need for more housing stock in the UK, and the sector as a whole should enjoy tailwinds to top-line growth. According to the managers, even on conservative assumptions regarding housing prices, the company should remain profitable and currently exhibits strong profit margins on existing projects.

While waiting for these opportunities to potentially grow and re-rate, and we would stress that there is no guarantee that this will happen, investors can enjoy a yield of 3.8%. The board has recognised that the impact of COVID-19 has created uncertainty around dividends and has decided that the company will continue to at least maintain the 1.68p per share quarterly dividend rate for the next financial year, to 30 April 2022, barring unforeseen circumstances. The majority of the income generation comes from equities and alternatives and is diversified by both asset classes and geography as we discuss in our recent research note here.

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