The story of the UK equity market over the last decade has few uplifting moments. It has lost 25% of its companies[1], retail investors have pulled out more than £50bn, it has fallen off the radar of many international investors and even domestic companies are seeking to list elsewhere. It has also been a terrible performer, delivering an anaemic 2.2% annual return, compared to 9.6% for the MSCI World[2].
Policymakers are increasingly aware of the problem. In the March Budget, Chancellor Jeremy Hunt introduced a series of measures designed to stop the rot. The British ISA added £5,000 to the ISA allowance for those investing in UK assets. He also sought to galvanise institutional investors by pushing UK pension funds to disclose their holdings in UK equities[3]. Shadow Chancellor Rachel Reeves is also looking at the issue. In January, she vowed to ‘reinvigorate’ UK capital markets as part of the financial services agenda[4].
While this new attention on capital markets is welcomed by UK fund managers, most believe that, of itself, it is unlikely to move the dial. Cedric Durant des Aulnois, chief executive officer at Montanaro (which manages the Montanaro UK Smaller Companies Investment Trust), says: “We have been calling on the government to create a British ISA, so in some ways it is welcome news that it has come to life. However, on its own it may not make a significant difference.”
He says there are other initiatives that the government could have put in place. “The most important thing is for a government to say it is committed to turning around the structural decline in UK markets. Other initiatives could have included removing stamp duty on small- and mid-cap companies, as they did for AIM. They could have repealed the provisions in MiFID that deal with sharing equity research with clients.”
Other options might have been to raise SIPP and ISA contributions more broadly. Equally, he says, the post-Brexit regulatory environment needs to be addressed: “UCITS funds are well-recognised, but UK-domiciled funds have lost their UCITS status.” There are also tax breaks that could be employed to encourage IPO activity. “It needs to be an ongoing project,” he says. “It is all about trying to give people confidence.”
However, with myriad other priorities, it is difficult to see the government implementing any of these measures in the short-term, even if there is political will to address the problem. Do beleaguered UK investors just have to sit and wait? Some investment trust managers argue there are other factors that could make a difference in the meantime – buybacks and M&A activity in particular.
Ian Lance, manager of the Temple Bar Investment Trust, points out that around half of UK companies have bought back stock in the last 12 months. He adds: “We like to look at total yield – adding dividend yield to the buyback yield. The total yield in the UK market is 6.1%: around 4% dividends and 2% from share buybacks. The UK looks cheap on that basis as well.” This is significantly ahead of its peers, the next highest region is Europe, at 4.5%. The US is just 3.2%.
Lance says that buying back stock may be controversial, but when share prices are this low, it can be “phenomenally accretive to share price performance”. They recommend it to management teams of the companies they hold as an effective tool to boost share prices.
Equally, there are companies that are using the environment to their advantage and should emerge stronger. Iain McCombie, manager of the Baillie Gifford UK Growth Trust, says: “Higher interest rates have undoubtedly caused the economy to slow. It’s tougher out there. We are focused on working out how companies are coping, and whether they can weather a more difficult environment.”
He points to companies such as the kitchen retailer Howdens, which is taking market share as its competitors struggle. This puts it in a good position to forge ahead when the economy improves. There is a corporate Darwinism in the market that was largely absent when interest rates were low. “We want to see a management team that is willing to take these types of decisions and we want a company that is bold and courageous enough to invest.”
There are also specific sectors that are benefiting from this environment. While higher interest rates are hurting many companies, they are a boon for parts of the pension and insurance industry. The pension fund position for many companies has improved, meaning they no longer have to divert funds to top up their pension schemes, that money can now be used to invest into their businesses.
It is also a boost for annuity providers such as Just Group. As annuity rates have risen, sales have been soaring. Consumer Duty has also played a role in driving the ‘at-retirement’ market back to annuities. “There is around £60bn coming into the decumulation market each year, and annuities counted for only around 10% of that. However, interest is coming back, with sales up around 45% last year.” He adds that there are always opportunities for those looking hard enough.
However, in the meantime, outflows continue from UK funds. The latest Investment Association statistics show outflows from the UK market were £1bn in January, higher than for the previous two months. For 2023 as a whole, outflows were £13.6bn, its highest level since 2016. While there are tentative signs of improving sentiment – discounts on UK investment trusts have narrowed, for example – it is difficult to build a case for a self-sustaining shift in attitudes to UK equities.
A final question would be whether the cheapness of the UK stock market is enough on its own to galvanise investment into the UK. Lance says it is frustrating to watch money being directed to the US, which is far more expensive: “People will say ‘the UK is full of dying companies, and the US is full of technology companies’ – to some extent I agree with that. But it has always been the case. The gap today is particularly stark. Even if you’re very bearish on the UK economy, it doesn’t explain why global companies in London should be so much cheaper.”
It may be irrational, but UK stocks have been cheap for some time, and it may take more than low valuations to create momentum. Ultimately, a combination of regulatory intervention, buybacks, M&A, low valuations, and some improvement in the macroeconomic environment may draw investors to UK equities. For any other country it would be a powerful combination, but the UK needs to rebuild its standing after a long time in the wilderness.
[1] https://www.businesstimes.com.sg/companies-markets/londons-stock-market-has-shrunk-25-past-decade
[2] https://www.msci.com/documents/10199/587e9bae-0a65-49e8-b1c6-bb84cf061441
[3] https://portfolio-adviser.com/spring-budget-2024-pensions-to-disclose-amount-invested-in-uk-equities/
[4] https://www.investmentweek.co.uk/news/4168950/labour-vows-reinvigorate-uk-capital-markets-point-plan-financial-services