Uninspiring, underperforming and deeply unpopular. Just a few of the adjectives that spring to mind given the divergence in the fortunes of UK equities and their US peers over the past couple of years.
April ushered in the 35th consecutive month of net outflows from UK equity funds and, putting this into context, UK investors poured more money into North American equity funds in the four months ending March 2024 than in the previous nine years combined, according to Trustnet.
It feels as if we’ve banging the drum of UK equities for an age but is light starting to appear at the end of the tunnel? Quite possibly, if the recent performance of the FTSE 100 is anything to go by: the leading UK large-cap index hit a record high earlier this month.
So what’s behind this sudden reversal in fortunes? One of the key catalysts has been an improving macroeconomic environment. The UK has bounced out of one of the shortest recessions on record with better-than-expected GDP growth in the most recent quarter, while April saw output rise to its highest level in almost two years.
That said, Britons are nothing if not a self-deprecating bunch and gloomy business and consumer confidence had become increasingly divorced from improving fundamentals.
However, both measures ticked up in March and, although the Base rate is frozen for now, Bank of England governor Andrew Bailey recently announced that rate cuts were “likely” with inflation predicted to fall close to its 2% target in coming months. All this paints a more positive macroeconomic picture.
Turning to the stock market specifics, valuations remain attractive relative to global peers. The MSCI UK index is trading on a forward price-to earnings (P/E) ratio of 12x, compared to 21x for the MSCI US index (according to Yardeni, as at 15/05/2024).
The rationale is usually attributed to US stocks offering superior earnings growth (and this is undoubtedly the case in some instances) but this valuation gap looks stretched given forecast earnings growth for the FTSE 100.
The FTSE 100 may be (rather harshly) labelled the ‘Jurassic Park’ of stock markets due to the dominance of ‘old economy’ sectors such as mining, pharmaceuticals and financial services. But that overlooks the strong secular growth drivers of mega-trends including the soaring demand for commodities in the move to net-zero and the increasing reliance of an ageing demographic on the pharmaceutical industry, amongst others.
And, in actual fact, some of those ‘dinosaurs’ have delivered superior returns to their glitzier US counterparts. And let’s not forget that the FTSE 100 boasts more than its fair share of leading multinationals too, with more than 75% of revenue generated outside the UK.
Despite the recent bounce, valuations also remain well below long-term averages, particularly further down the market-cap spectrum. A good litmus test of valuations is the level of M&A activity, and bargain hunters have continued to hoover up UK companies.
Last year saw the acquisition of 10% of the UK small-cap index, with overseas buyers accounting for almost half of these transactions. This year has seen interest move up the market-cap spectrum, with bids for FTSE 100 mining giant Anglo American and packaging company DS Smith.
M&A activity has also proved a tailwind for active fund managers, particularly those with more concentrated portfolios, such as Rockwood Strategic. Manager Richard Staveley holds a portfolio of around 20 companies with a focus on sub-£150m companies to exploit pricing inefficiencies from a lack of research coverage.
As a result, acquisition premiums can provide a significant boost to returns and Staveley believes that 80% of the trust’s holdings will ultimately be acquired by a trade or private equity buyer.
Recent bids for portfolio companies include OnTheMarket, The City Pub Group, Finsbury Foods and Crestchic. These acquisitions have contributed to Rockwood comfortably topping the AIC Smaller Companies sector with a five-year net asset value total return of 88%, compared to a sector average of 29% (as at 14/05/2024).
A recent addition to the portfolio was Funding Circle, a leading UK and US lending platform to small businesses. Rockwood acquired a 3% stake in January, when the market cap was £110m and substantially below book value (with the company holding £170m in unrestricted cash, plus a further £110m in restricted cash and loans at that point).
The management team has announced a focus on the UK business going forward, together with a share buyback program, resulting in a year-to-date share price increase of 106% (as at 15/05/2024). Funding Circle’s market cap is now approaching £290m, demonstrating the value of stock-picking skills in an under-researched market.
Looking ahead, it may be too soon to say UK equities are finally out of the woods given the backdrop of uncertainty, but the pendulum certainly looks to be swinging back in their favour. Improving investor sentiment could prove the final catalyst to spark a sustained recovery and maybe, just maybe, month 36 of fund flows will mark a change in fortunes of UK equities.
Jo Groves is an investment specialist at Kepler Partners. The views expressed above should not be taken as investment advice.