Last week, I wrote about a novel experience – for me at least – of joining a “speed dating” session, where analysts such as myself, and journalists, met six fund managers of investment trusts run by Schroders. In that article, I shared some of the insights I’d gained on Schroders’ suite of funds focused on Asia (you can read more about this here) and, this week, have revisited to complete the story by talking about the insights I gained on their UK focused funds, specifically, Schroder UK Mid Cap Fund and Schroder Income Growth Fund.

The UK – out of favour with global investors

It is fair to say that, while there have been signs of improvement recently, the past few years have been particularly difficult for UK equities. The market has been buffeted by a combination of political uncertainty, meagre economic growth and persistent inflation. This week’s readout for inflation – at 3.8% for the year to September – is just below the 4% level that had been feared and markets seem relieved. However, this is still well above the Bank of England’s 2% target and consumers will still be nervous about spending as they worry about the future direction of prices and therefore interest rates.

The upcoming budget is also a concern. The government finances are in a poor state and a combination of spending cuts and tax rises – despite manifesto commitments to the contrary – looks likely. As Rachel Reeves recently highlighted, there are also the lingering effects of Brexit to contend with – from weaker business investment to reduced labour mobility. A backdrop of US tech stocks making colossal gains on the back of the boom in interest in AI has not helped either. All of this and more has weighed on investor sentiment towards UK equities, which have suffered near continual outflows as international investors have continued to favour faster-growing areas of the market.

Reflecting this, UK equities that were already cheap relative to other markets and their own history have continued to get cheaper. While this has led to a series of takeovers, as overseas buyers with a long-term view snap up undervalued UK assets, it’s easy to see why the UK market has struggled to keep pace with its international peers, leaving many UK equity managers in a sombre mood.

Against this backdrop, I was surprised to find both managers in a buoyant frame of mind and excited for the prospects of the companies in their respective portfolios. Despite having quite different remits – one focused on uncovering the growth potential of Britain’s small and medium-sized companies, and the other balancing capital preservation with reliable income – both managers made compelling cases for why now might be an interesting time to be looking at the UK market.

A ‘date’ with Schroder UK Mid Cap

The first of my UK fund ‘dates’ was with Jean Roche, who has managed Schroder UK Mid Cap (SCP) alongside Andy Brough for over nine years. SCP aims to provide a total return in excess of that of the FTSE 250 Index (excluding investment companies) by investing in UK mid-cap companies. The managers look for companies that they believe are capable of compounding earnings through market cycles, often identifying opportunities that are overlooked or undervalued by the broader market.

Roche describes the strategy as targeting companies in the “sweet spot” of their growth cycle. These will typically be established businesses that continue to innovate, generate strong cash flows and offer attractive long-term returns. Roche and Brough use a framework that classifies stocks as “unique”, “flex”, or “avoid”.

Unique stocks will tend to have market positioning or pricing power that leads to relatively high returns on capital, very strong franchises, scarcity value – they may be the only way to get exposure to their niche, quality management, are able to finance their own growth and have strong balance sheets. These are potentially the FTSE 100 stocks of the future.

Flex stocks could be in an industry undergoing change; where capacity is being taken out, for example, or a company is undergoing change – new management or a change of strategic direction, for example. Target companies may also have the prospect of a cyclical upturn or re-rating, or buybacks may be improving return on equity. The valuations of these stocks must reflect the challenges that they face.

The managers construct a portfolio made up of unique and flex stocks. Simply put, it is a mixture of high-quality, cash-generative firms with scarcity value and cyclical recovery stories benefiting from operational or strategic change. On the flip side, they avoid companies that are in industries with overcapacity, are in long term decline, are failing to provide successful growth opportunities, have management teams that are destroying value, have significant accounting concerns, or are providing inadequate profitability/returns on capital.

The net result of all of the above is a portfolio that is relatively concentrated and high conviction – typically around the 50-stock level – and is also low turnover, typically around 15% per annum. The portfolio is also style-agnostic, rotating between growth and value depending on market conditions. The portfolio reflects the team’s best ideas rather than index weightings – current tilts include an underweight in real estate and selective exposure to industrials, for example. Crucially, Roche says that they are not short of ideas and valuations are still very compelling.

While patience may be required, it’s worth remembering that this process has borne fruit – since May 2003 when Brough began managing SCP, it has provided an NAV total return of 12.3% per annum, which is 2.2 percentage points ahead of the 10.1% per annum delivered by its benchmark. While not managed for income, it may nonetheless be of interest to some income focused investors – it is yielding 3.1% at the time of writing and, over the past two decades, has increased its dividend elevenfold, underlining the managers’ focus on cash generation and total returns.

A ‘date’ with Schroder Income Growth

My final date of the evening was with Sue Noffke, manager of Schroder Income Growth (SCF) since 2011. SCF invests primarily in UK equities with the aim of growing income ahead of inflation and, at the same time, growing its capital as a consequence of that growing income.

Noffke looks for companies capable of generating reliable, growing dividends that are supported by strong balance sheets and sustainable business models. Her process is bottom up, but has no inherent style bias, and the portfolio combines a core of established dividend payers with selective exposure to businesses offering income growth potential, and a balance of defensive and cyclical holdings. There is a focus both on companies with improving operational performance and capital discipline, such as Balfour Beatty and Smith & Nephew, and quality franchises like RELX, Sage, Compass, and Diageo (the latter was recently re-added to the portfolio once it had reached an attractive valuation). The portfolio currently shows a mid-cap bias and an overweight to financials, reflecting valuation opportunities across the market.

Noffke explains that the UK market is not the same as the UK economy. The UK market has global reach – c.75% of revenues are from overseas – and so is less sensitive to the UK’s economic cycle than it first appears. It also has global leaders across a range of sectors and company sizes. Noffke comments that, at around 4%, the FTSE 100 market has the highest yield across major developed markets, but shareholders are also benefiting from share buybacks that are at multi-year highs – around 2% of issued share capital per annum.

Valuations are also attractive in her view: at a P/E ratio of 13.0x for the FTSE 100 and 12.2x for the FTSE 250, there is 25% upside just to get back to historic norms, while the US is on 23.6x. Like Roche above, Noffke acknowledges the challenges that UK markets face, but nonetheless, sees a vibrant opportunity set, describing the UK market as a fertile ground for active managers looking to identify mispriced businesses with genuine upside potential.

The trust, which is now in its 30th year, has an enviable record of raising its dividend every year since launch in 1995. It currently yields just over 4.6%, and, since launch, has increased its dividend at an average rate of 4.1% per annum, comfortably ahead of inflation. Its closed-ended structure has played a role in providing this consistency, allowing the use of revenue reserves to smooth payouts through weaker income periods – a feature that proved invaluable during crises such as COVID-19 and the global financial crisis.