It is a well-documented fact that international investors have been shunning the UK equity market in recent years, leaving it cheap versus other regions. The reasons why have already been well-rehearsed, so I will not dwell on them here, but selected highlights would include the Brexit referendum in 2016 and the economic uncertainty that created; our handling of COVID, particularly in its early stages; a merry-go-round of prime ministers; the disastrous Truss-Kwarteng mini budget and the higher interest rates and sterling depreciation that followed. All of which largely served to inflame existing problems.
In truth, investors have found little to get excited about in UK equities. The recent change of government was welcomed by the investment managers we spoke to but was largely seen as a foregone conclusion and well baked into market prices by the time the results came through. The expectation was that this would lead to a period of much greater political stability, which, after a rocky start, seems to be coming to pass.
The hope was that greater political stability would allow businesses to better plan for the future but, on the flip side, there was little doubt that tax rises and spending cuts would follow, as the new government tried to get the UK economy back into some semblance of order. While such measures may bode well for the long term, they were not expected to enhance the growth outlook in the short term, which has left UK equities under a cloud.
The tide finally turns?
Investors have continued to head towards the exit and these outflows turned into a stampede with record outflows in October in anticipation of the well-trailed capital gains tax (CGT) increases that were announced in Rachel Reeve’s first budget that month. However, moving into November, there was a stark reversal with positive fund inflows for the first time since April 2021 (42 months or three-and-a-half years), with UK equity funds seeing net inflows of £317m. With signs that the tide is finally turning, this made us think how cheap is the UK relative to the rest of the world and where might the cheapest valuations within UK equities be found?
Bargain Britain
The answer to the first question is that, as a whole, UK equities are cheap versus most jurisdictions. As is illustrated in Figure 1, which compares the F12m P/E ratio for a number of major regions, the UK is way cheaper than both global equities as a whole and US equities in particular; noticeably cheaper than Asia, Europe and emerging markets; and is only more expensive than frontier markets.
The UK market is also cheap versus its own history – frontier markets being the only group in Figure 1 that is cheaper versus its own history. While the UK no doubt has challenges ahead, so do these other markets and this valuation discount looks overdone.
A narrow group of AI-related stocks has driven up the value of both the S&P 500 (our proxy for US equities) and the MSCI World, and while the US is home to many of the companies at the vanguard of this revolution, the reality is that the benefits of AI will be felt much more widely, lifting most if not all geographies and industries.
The small cap effect
Our next question was, within the UK, which areas of the market are cheapest relative to history? As is illustrated in Figure 2, which compares the five-year averages and current Forward 12-month P/E ratios for a range of UK indices, all areas of the UK market look cheap versus their history. Value stocks have been consistently cheap, but growth stock valuations are well below five-year averages. However, the biggest difference is small cap versus large cap, with the former having suffered the largest derating. Not surprisingly, small cap growth is the area that has been hardest hit, but it offers some of the strongest potential for outperformance now that interest rates are on a declining trend. Now that events such as the US election and the Labour administration’s inaugural budget are out of the way and fund flows are back in the right direction, the UK market could finally be set for a period of resurgence.
There is a wealth of UK smaller companies trusts to choose from. At the more growth-focused end of the spectrum, we would highlight funds such as Montanaro UK Smaller Companies (MTU), BlackRock Throgmorton (THRG), and abrdn UK Smaller Companies (AUSC). These are all decent sized funds, trading at low double-digit discounts. This offers additional upside, assuming that these discounts narrow as performance improves. JPMorgan UK Small Cap Growth & Income is similarly small cap growth orientated but is more fully valued than the other three, so does not have the benefit of offering this additional potential kicker.
MTU’s manager, Charles Montanaro, has become increasingly bullish on the UK and MTU’s portfolio as its holdings have become increasingly attractive from a valuation perspective. He has highlighted that many of MTU’s holdings continue to generate decent earnings, with several reporting their highest ever revenues, but its discount has proved to be quite sticky. Such is the management team’s bullishness on MTU’s prospects and the potential for the discount to close that they announced earlier this year that, collectively, they had purchased another 1% of MTU’s outstanding shares. In the meantime, MTU shareholders are being paid to wait. MTU has recently announced that it is hiking its regular quarterly dividend equivalent to 1.5% of the company’s NAV (from 1%), amounting to a yield of around 6% annually on the NAV, which is around 7% on the current share price.
BlackRock Throgmorton’s manager Dan Whitestone’s recent commentary echoes that of Charles. He thinks that the disconnect between the strong earnings growth and share price performance of UK companies represents an historic opportunity and that investors are overlooking the UK’s solid fundamentals. He notes that UK companies remain more than competitive versus international peers. THRG has long had a bias towards higher quality growth companies but has recently been adding housebuilders on the view that intense pessimism for the sector has seen several higher-quality companies aggressively oversold, offering a strong recovery play. THRG has provided an NAV total return of 16.2% over the last 12 months which is a strong uplift on the back of falling interest rates. The current 12.2% discount is at a five-year high and it seems reasonable to us that an improved climate could see this trust return to a premium rating again.
In its recent results, Abby Glennie, the manager of abrdn UK Smaller Companies commented that the buoyant performance of UK stock markets since October 2023 was driven by the awareness of how cheaply valued UK equities were; relative to international peers, their own history, and their earnings prospects – points she felt remain true in the second half of 2024. She thinks that falling rates should not only support absolute market levels but should help small cap relative to large cap. She noted that the number of elections around the world in 2024 had been an overhang and correctly predicted that once the outcome of the US election was known this could help drive markets forward. Smaller companies will always be a volatile asset class in her view, but she reckons that the current time offers an attractive entry point for new capital. AUSC has returned 25.8% over the last 12 months and can still be purchased at a 10% discount to NAV.
For those that are looking for more of a value orientated approach to UK small caps, Rights & Issues (RIII) and Aberforth Smaller Companies (ASL) are two funds that stand out for us. Both have seen their relative performance improve in recent years – particularly RIII which has had a slight shift in its approach (although it remains deep value) with the management contract shifting to Jupiter in October 2022. Both have provided strong performance over the last 12 months – RIII has returned 21.6% in NAV total return terms while AUSC has returned 23.2%, versus a sector median of 18.4% – benefiting from strong growth across their portfolios on the expectation of falling interest rates, and refreshed optimism around the UK’s political stability. There could be more to come.
RIII offers a concentrated exposure to UK small-and-mid-caps and, despite its recent strong performance, can be purchased at an 8% discount. Its managers highlight that valuations are now at historical extremes on both a relative and absolute basis for the UK small-cap sector to an extent that is now well past fundamental realties. Like other UK small cap managers, they point out that overseas and private equity buyers have been taking advantage of these cheap valuations, which is reflected in an uplift in M&A activity within the UK, some of which RIII has benefited from.
Like their peers, the managers of Aberforth Smaller Companies think that valuations offer a compelling opportunity in small UK quoted companies. It is overweight what it describes as ‘smaller small companies’ which has been helpful to its performance this year, as has been its value bias. Its managers think the market is now looking through the impact of the recession on profits and that this has driven an uplift in UK equities during the last year, noting that there are marginal buyers in the form of bigger companies, private equity and companies buying back their own shares. They highlight that the budget has placed a greater burden on businesses and that scepticism of this has been reflected in gilt yields and sterling. However, there has also been recognition that regulation has contributed to a lack of investment in the UK. They think that a profit inflection, as lower interest rates feed through to economic activity, should help to move UK small caps higher. ASL can be purchased on an 11.4% discount.