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Jo Groves
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Updated 08 Mar 2024
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Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.

This week marked the first theme for our month-long 2024 ISA event, with “Bounce (maybe) bounce” focusing on four depressed sectors with the long-term potential to outperform. The respective fund managers talked about headwinds to recent performance, their portfolio positioning and the opportunities for investors across UK equities, China and the property sector.

UK small-caps

Richard Staveley, portfolio manager of Rockwood Strategic (RKW), started proceedings with a deep-dive into the UK small-cap sector. UK equities certainly qualify in the ‘ready for a bounce’ category given they’re currently trading at their lowest valuation (relative to their 30-year average) since the late 1980s.

Richard highlighted the cumulative effect of the outflow of money on UK small-cap valuations. He noted that pension funds held 30% of UK equities in 1989, but this fell to less than 2% in 2022. Richard also pointed out that the rise in the popularity of passive trackers has largely circumnavigated UK small-caps, accompanied by net outflows from active UK equity funds over the last 18 months. The rise in interest rates has also had a disproportionate impact on UK small-caps as a more cyclical sector.

This leads us to the million-dollar question: what factors will trigger the long-awaited bounce in UK small-caps? Richard believes that even a modest re-allocation of funds towards the UK, and small-caps in particular, could lead to a significant re-rating. He noted that the market cap of Microsoft exceeds that of the entire UK stock market, meaning that investors reallocating just 10% of their gains in US mega-caps could trigger a considerable inflow of capital. In addition, the expected cut in base rates over the next year should benefit the UK small-cap sector, as well as the government’s measures to stimulate investment in UK equities and significant ‘dry powder’ held by private equity firms.

It's also worth noting that Rockwood’s active approach to management and focus on value companies with recovery potential has paid off despite the challenging market conditions. It has delivered a five-year share price total return of 128%, relative to 27% for the AIC Smaller Companies sector (as at 05/03/2024).

Commercial property

The property sector has also suffered from rising base rates, with Michael Morris, CEO of Picton Property Income (PCTN), noting that the value of commercial property has fallen by 25% since its peak in mid-2022. That said, stable occupancy levels and solid demand has led to a rise in rents, with Picton achieving positive rental growth in each of its three sectors (retail, office and industrial) last year.

Picton takes an active approach to portfolio management, including the identification of opportunities to increase the size and quality of its properties. Michael spoke about one of the benefits of active management being their ability to weigh up balancing factors such as rental income against tenant quality and lease duration.

Another theme was the rising demand for sustainable buildings, or, put another way, the ‘green premium’ versus the ‘brown discount’. Picton has a high level of engagement with occupiers, who are increasingly focused on energy-efficient buildings that are also inviting for employees. Sustainability is a key facet of Picton’s asset management strategy with its upside potential for increased occupancy and rental income.

Michael views the re-pricing of commercial property as a positive for the sector, with continued supply constraints from land availability and tight planning regulations, particularly for industrial and logistics assets. He believes that appetite for these properties is at its highest level in some time, and, as with UK small-caps, falling interest rates should prove a tailwind for the sector.

Picton has achieved 10 consecutive years of outperformance against the MSCI UK Quarterly Property Index and the current discount of c. 34% (as at 05/03/2024) which could provide an added kicker to returns if valuations improve.

China

Sophie Earnshaw, manager of Baillie Gifford China Growth  (BGCG), joined us to talk through the challenges faced by Chinese equities over the last year. Sophie acknowledged that ‘macro gloom’ has weighed on the Chinese stock market over the last three years, which she attributed to government intervention in the private sector, geopolitical tension and a muted economy. This has left valuations well below the average for the emerging markets sector thanks to a rise in risk premium.

However, Sophie highlighted the importance of the private sector to the Chinese government, providing half of tax revenue, 60% of GDP and 80% of urban employment. She believes this co-dependence may prompt a more positive relationship going forward given that a healthy private sector is the lynchpin of the Chinese economy.

In contrast, Sophie spoke about a ‘micro bloom’ with strong secular growth drivers, including China’s leading role in the green energy transition, increasing wealth of consumers and a strong manufacturing presence. China has a broad investable universe of around 5,000 companies and, while it has a weighting of only 4% in the MSCI ACWI Index, it accounts for over 40% of the ‘growthy’ companies.

As a result, BGCG has found a number of interesting opportunities in sectors offering longer-term disruptive and structural growth themes. The trust currently holds around 60 companies and 85% of the portfolio’s revenue is generated domestically. As such, it is less dependent on international trade relations (given the pending US election) and is well-positioned to exploit China’s large consumer market. This is reflected in forecast earnings growth of 15% for portfolio companies over the next three years, relative to 9% for the benchmark.

UK equity income

Our final speaker of the week, joining us fittingly on International Women’s Day, was one of the City’s best known female fund managers Sue Noffke – head of UK equities at Schroders and lead portfolio manager on equity income focused Schroder Income Growth (SCF).

Noffke was bullish on the outlook for UK equities which are, according to the statistics she shared in the presentation, undervalued to such an extent they are significantly cheaper than equities in any other major comparable market.

Doom-laden headlines and miserable sentiment among UK investors do not in her view reflect reality, and valuations therefore do not make sense. She said: “This is not the ERM crisis, it isn’t Brexit, and it isn’t the fallout from the Global Financial Crisis.”

“The UK is by far and away the cheapest of the major international equity markets, and if you look at the UK on a sector by sector basis, comparing those sectors with their US equivalents, we are seeing really substantial discounts on businesses which are doing the same thing, which is particularly strange given how international the nature of many of these businesses are.”

The recent underperformance of UK equities has created, in her view, a significant opportunity which is already prompting overseas investors to snap up ‘bargains’ among Blighty’s battered businesses, with major acquisitions from private equity firms now occurring on a regular basis.

With interest rate tightening likely to go into reverse this year, she says, this is an ideal time for her team to buy into stocks which have historically delivered in income and growth terms at heavily discounted prices.

“For all of these reasons I think this is a great time to consider UK equities as a potential theme for your ISA in 2024.”

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