Many UK businesses tick all of the boxes that fund managers usually look for when selecting a stock, including earnings growth, returns on capital and good balance sheets, but remain unloved nonetheless, according to Laura Foll, co-manager of Lowland Investment Company,Law Debenture and Henderson Opportunities Trust.
It is “silly” that great stocks should fall below many managers’ radars – often simply because of market cap limitations or because they are unglamorous, she said.
Examples from her portfolio include meat processor Cranswick or Macfarlane Packaging, the UK's largest packaging supplier, which is one of the latest additions to the Lowland portfolio.
Lowland portfolio positioning
Source: Janus Henderson Investors
Both are “great compounders”, meaning that they “churn out good returns year after year” and give patient investors “very good long-term returns”. Yet, these opportunities remain largely ignored.
MacFarlane has grown its earnings in the teens over the past 10 years or so, it generates good returns on capital and has no debt, so it “ticks all the boxes that people say they're looking for” in companies. Its only problem is its £200m market cap, below the radar of the vast majority of UK fund managers.
What’s more, it trades on nine times earnings, a valuation that Foll “struggles to justify”.
In fact, the whole of the UK market still trades “well below the rest of the world”, no matter how you measure it, she added.
The average price-to-earnings (P/E) ratio of UK companies is 12x, while the US trades at 22x. At the same time, the UK pays “an enormous” 4% average yield (the US yields only 2%) and the average price-to-book ratio is also lower.
“It’s across every metric,” Foll said. “On a sector-adjusted P/E basis, UK equities are at a 20% discount to the rest of the world.”
Global and UK small-cap valuations
Source: abrdn, 30 Jun 2024
Abby Glennie, manager of the abrdn UK Smaller Companies Growth Trust, said small-caps globally have valuations below their historic averages but “the UK ties with Europe as the region where valuations are lowest”.
“This effectively suggests that investors would get much better value if they buy into UK smaller companies now than they would typically have done investing in them over the past 10 years,” she continued.
Global equity managers are starting to notice how cheap UK companies have become, Foll said, and their UK allocations have reached the highest levels in a long time. She expects an influx of foreign capital to play a big part in closing the UK’s valuation gap, in addition to companies buying their own shares and domestic investors returning to the fray.
Performance of trust against sector and index over 1yr
Source: FE Analytics
The UK economy has been “gently” beating economists’ expectations for at least two years, she continued.
Following a shallow recession in the second half of last year, economists forecast 0.3% growth for 2024, a “pretty pessimistic outlook” that turned out to be too gloomy. The country defied expectations and grew 0.6% and 0.7% in the first two quarters of this year, respectively.
Today, the average economist is forecasting 1.2% or 1.3% growth, said Foll, which is “not stellar, but a lot better than essentially nothing”.
“There is something about the UK economy that seems to be more resilient than the average economist thinks. That’s the consumer.”
Since the financial crisis of 2008, UK consumers have gradually been paying down debt. Then during the Covid pandemic, they “squirreled away” money from furlough schemes and benefit payments.
“Today, the average consumer has neither savings nor debt and is in a much better balance sheet position they have been for a long time. To use more technical terms of profits and loss, the consumer is back in real wage growth,” the manager said.
But while consumers are in a position to go out and spend, they don’t have the confidence to do so just yet. To Foll, this is a sign that “the underlying health of the economy is much better than consumer spending might indicate”.