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.
Many of us would probably admit to having an unconscious (or indeed conscious) bias to our home stock market. There’s something comforting about putting your hard-earned pounds in familiar names, whether that be FTSE stalwart Marks and Spencer or Manchester United (depending on your preference for chocolate caterpillars or red devils?).
But the British investors’ approach to UK equities may just prove the exception to that rule. Earlier this week, the Office for National Statistics revealed that the proportion of UK shares held by overseas investors reached a record high of almost 60% (by value) in 2022. In comparison, the proportion held by UK-resident investors fell to a meagre 11%, a substantial fall in grace from their 50% plus share 60 odd years ago.
Staying with the glory days for a little longer, some investors may recall the iconic “Don’t tell Sid” advertising campaigns in the 1980s, when the government encouraged private investors to buy shares in privatised companies such as British Gas. In a bid to re-ignite this enthusiasm amongst UK investors, the government unveiled the Mansion House Reforms earlier this year, aimed at boosting investment in UK businesses by institutional and retail investors alike. Hot on its heels, the Chancellor announced “It’s time to get Sid investing again” in his recent Autumn statement to the Commons, ahead of the planned public sale of NatWest shares next year.
Government initiatives aside, our apparent lack of love for home-grown companies seems somewhat incongruous given current valuations. According to Yardeni, the MSCI UK index is trading on a forward price-earnings ratio of 10.3 times, compared to 19.2 for the equivalent US index (as at 29/11/2023) on that valuation measure, at least, making UK equities half the price of their brash American counterparts.
A cynic might argue that this is akin to comparing apples and pears given the UK is heavier in well-established and mature blue-chip companies rather than the high-growth, mega-cap tech stocks that dominate the US index. However, while past performance is no guarantee of future performance, it’s hard to argue that the UK isn’t looking attractive relative to historic valuations. The MSCI UK index is trading at its lowest price-earnings ratio in more than a decade and well below its high of more than 15x in 2016.
While UK companies may be out of vogue with their home crowd, bargain hunters from the other side of the Atlantic are capitalising on depressed company valuations. US infrastructure investor I Squared took the controls of London bus operator Arriva in October, followed by confectionary giant Mars gobbling up luxury chocolatier Hotel Chocolat in a £500 million plus deal last month.
The UK is also proving a fertile hunting ground for investment trusts, particularly in the small-cap sector, which has suffered a widening discount against its large-cap peers. While the small-cap sector has higher beta, it’s typically outperformed the larger-cap indices over longer periods of time, particularly after a downturn in valuation. As my colleague recently noted, when the FTSE SmallCap Index has traded below a price-earnings ratio of 10x, it’s achieved an average return of 36% over the following year.
It’s therefore interesting to note that Invesco Perpetual UK Smaller Companies (IPU) has recently used its gearing facilities for the first time in many years. The managers see valuations of UK small-caps as attractive relative to their 10-year average, with takeover activity highlighting the appeal of UK companies to would-be acquirers.
The managers employ a barbell approach which seeks to dampen volatility by investing in a balance of defensive, quality growth and more economically sensitive, value companies. IPU’s current discount of c. 7% should also provide an additional safety margin for investors.
The small-cap sector is often overlooked by income-seeking investors but IPU has an enhanced dividend strategy, targeting a 4% annual yield from both income and capital. This frees the managers to focus on the broader merits of companies beyond just their income-generating ability. IPU is currently trading on a yield of c. 4.5% which is significantly higher than the small-cap sector average of 3.0% (as at 04/12/2023).
M&A activity has also been a key theme for fellow small-cap specialist Rockwood Strategic (RKW), with private equity and trade buyers capitalising on subdued valuations. The trust has seen bids for portfolio companies Finsbury Food, Smoove, OnTheMarket and City Pub Group in the last three months alone.
Richard runs a highly concentrated portfolio, with the top ten holdings accounting for more than 60% of the overall portfolio (as at 30/09/2023). As a result, takeover premiums can have a significant effect on overall returns, with RKW delivering a one-year share price return of 19.4% (as at 04/12/2023).
Further bumps in the road could continue to weigh on UK valuations, particularly if another hike in interest rates threatens the hoped-for soft economic landing, but looking ahead, a more positive macroeconomic outlook may prompt a pivot in investor sentiment towards UK companies.
Those that think we are heading in that direction may be tempted to channel their inner Sid and look once again at UK equities.
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