In their latest fact sheet, the managers of Witan Investment Trust noted that they had added to an existing position in the Vanguard FTSE 250 exchange-traded fund (ETF).
The managers argued that the UK’s attractive valuations are compounded by the fact that investment trusts in the index, which constituted close to a third of the ETF’s market cap at the end of January, are trading at an average discount of approximately 15%.
That figure has widened slightly since the managers penned their monthly commentary for the factsheet and sits at 16.1% as at mid-February.
This marks quite a change from the period prior to the start of the rate hiking cycle. In the heady days of November 2021, investment trusts in the Vanguard ETF had traded at an average discount of 2.1% over the prior 12-month period.
The most drastic change since then, on a sectoral basis, has been in private equity and real assets. Many of the trusts in these sectors were trading at double-digit premiums and had done so for prolonged periods of time.
Cheap credit and the paltry yields on offer in government bonds go some way in explaining that, as well as why discounts have widened out substantially since central banks began raising interest rates.
Aside from the investment trust sector, it almost goes without saying at this point that the UK stock market looks cheap relative to global peers. Brexit appears to have been the driving factor here, but pension funds and other financial institutions have also reduced their UK exposure substantially in the past decade, primarily by moving into cash and bonds so they can meet their own liabilities.
Despite this, private equity and corporate buyers clearly see the value on offer in the UK market, having picked off 56 companies last year at an average premium of 51%. That was up on premiums of 37% in 2022 and 43% in 2021.
Buyers are not typically eager to overpay and, even at these rates, some of these companies are being acquired at very low valuation levels. For example, the recent bid for Curry’s by US asset manager Elliott represented a nearly 40% premium on the prior day’s closing price.
But as noted in Bloomberg, even at those rates Elliott would be acquiring the electronics retailer at 8.4x current earnings and 7x projected earnings in 2025.
Companies listing abroad is another sign of fear that a UK listing won’t reflect their ‘true’ value. For example, gambling conglomerate Flutter recently launched a dual listing on the New York Stock Exchange and chip designer Arm chose to list in the US ahead of the UK.
Frustrating and worrying though this may be for UK plc, it is a sign that valuations in the UK are being more driven by sentiment than fundamentals – an argument one could make in the opposite direction about the US.
Going back to the investment trust sector, we thought it noteworthy that the managers of Invesco Perpetual UK Smaller Companies have used their gearing facilities for the first time in as long as our Kepler Trust Intelligence analyst covering them can remember. And while we don’t like to engage in agism, he is not a recent grad.
UK small-cap trusts have also been hard hit over the past couple of years. There appear to be fears here about how smaller firms will fare in an economic downturn and their ability to thrive if debt becomes trickier to access.
Going back to our discounts comparison, UK small-cap trusts in the FTSE 250 had averaged a 4% discount in the 12 months to the end of November 2021. Today they are at an average of 10.9%.
Of course, it’s one thing to be correct and say that UK markets are cheap, but it is another for valuations to actually revert to levels that better reflect the quality of companies on offer. One potential positive here is that prior drawdowns in the market have been followed by bounce backs.
As one of my colleagues noted at the end of August last year, 2022 was one of the worst years for UK small-caps since 1955. Research from Montanaro Asset Management found that in the subsequent three-year periods after similar drawdowns, average total returns were 84.4%. Since that article was published on our website, the Vanguard index ETF is up close to 5% on a total return basis.
That hardly suggests we’ve turned a corner, and valuations do remain low. As a result, there is always a chance that investors may be right, but still have to wait a long time for that to actually play out.
Nonetheless, for more value conscious investors, prepared to wait for the long term, UK small- and mid-cap offers plenty of attractive opportunities.
David Kimberley is an investment writer at Kepler Partners. The views expressed above should not be taken as investment advice.