abrdn: Outlook for UK equities

The UK equity market is one of the longest-established equity markets in the world. A FTSE listing is seen as a badge of honour for companies worldwide. And yet, as we continue into 2020, UK equities can lay a reasonable claim to being one of the most misunderstood asset classes. This offers a compelling opportunity for long-term investors.

It’s been easy for asset allocators to ignore the UK equity market in recent years. Brexit and perceived domestic political risks have turned ‘UK’ into a dirty word for many investors. But, look beneath the surface, and the opportunity this presents becomes clear.

First, the UK equity market is by no means simply a pure play on the UK domestic economy and the British pound. Over 70% of the revenues of UK-listed companies come from overseas, whether from the US, Europe or emerging markets. Crucially, UK-listed firms have world-leading corporate governance standards and shareholder protections. For long-term investors, that really matters. UK equities offer a high-quality means of accessing economic growth and investment opportunities across the globe.

 

Second, the remaining 30% of the UK equity market which represents genuine UK exposure should not be written off. Domestic political risk has receded following December’s decisive election outcome. Also, the drag on the economy caused by Brexit is well-understood by the market. With the Withdrawal Agreement signed and trade talks beginning, we will start to see greater clarity on the final Brexit outcome that investors have been waiting for.

The UK economy offers investors a number of fundamental attractions that are unaffected by Brexit – the rule of law, time zone and language advantages, flexible labour laws and, in London, a leading global financial centre, to name just a few.

It’s worth remembering that, despite all the negative headlines, the UK economy continues to grow, with employment at record levels and real wage growth having returned.

UK housebuilders have performed strongly in recent months, with their share prices rising by one-third to one-half, on the back of solid trading reports. This is an excellent indicator of how hard undervalued UK domestic stocks can rally as the mist begins to clear.

We’re in a world where yield is hard to come by. A number of countries are even able to issue debt at a negative yield. Therefore, the circa 4.3% yield offered by UK equities is a striking opportunity. Once forecast buybacks are included, the UK equity market is offering a circa 6% annualised return to shareholders before any growth or rerating (Source: Goldman Sachs, Thomson Reuters Datastream, IBES, Bloomberg, January 2020).

The ASI Research Institute forecasts a circa 6.5% return from UK equities over the next five years, with dividends a significant component (Source: ASI Research Institute semi-annual return forecasts, GBP, August 2019). The dividend-paying culture of the UK equity market keeps management teams focused on their ultimate responsibility to deliver cash returns to shareholders. Dividends also provide a strong underpinning to many individual stock valuations.

Moreover, the increase in M&A activity we’ve seen over the last year is a good indicator of the value in UK equities. Companies as diverse as pub-owner Green King, theme park operator Merlin Entertainments and satellite company Inmarsat have been acquired at meaningful premia to the market price. Asset allocators haven’t yet made a pronounced shift into UK equities but industry and private equity buyers have shown through their actions that they see value. This suggests to us it’s only a matter of time before there is a broader move towards allocating to this market.

What, then, is the role of the active manager in UK equities? Like most equity markets over the past few years, the UK market has become increasingly bifurcated. Stocks that have been in favour and have strong share price momentum have tended to keep rerating ever higher. Conversely, for unloved stocks, value has provided very limited support. Therefore, for stock-pickers with a strong grounding in business fundamentals and valuation, there is a great opportunity. We look for companies that are changing for the better, either structurally or cyclically, and which could be tomorrow’s well-loved momentum stocks.

With that in mind, where do we, at ASI, find particularly fertile hunting grounds in UK equities? Currently, it’s very much about leveraging our business-level insights rather than taking a macroeconomic view. We illustrate with a couple of stock examples the sorts of themes where we’re finding real value.

Convatec is a mid-cap medical devices company that has historically had a strong position in wound and ostomy care. Over the course of the last three years, the company has suffered from a number of mostly self-inflicted issues. However, we believe initiatives undertaken by the new management team have addressed these concerns, providing the platform for a successful future. Its well-known brands (the value of which is underappreciated by the market) afford the company the opportunity to increase margins and take advantage of the attractive oligopolistic end-markets that continue to demonstrate good growth rates.

A second example where we see significant upside potential is Bodycote, which provides a range of metal-treatment services to a variety of end-markets. The company is widely considered one of the lowest-quality and most cyclical within the industrial sector. This is because of the volatility it experiences as an asset-heavy, high-fixed-cost business. However, not only has its exceptional management team dampened this volatility, there has also been a significant shift in sales and profit toward specialist technologies. These are high growth, high margin, and high market share services. Such specialist technologies show greater stability throughout the cycle, most recently demonstrated during last year’s US-China trade discussions. Additionally, Bodycote announced a large acquisition in December which provides a further step-change toward these high-quality categories and accelerates the company’s evolution in this area. We therefore believe Bodycote has the potential for a higher market rating, given its structural profits growth. It remains one of our favourite ideas.

In our view, UK equities currently provide a highly attractive long-term opportunity

for investors. Political uncertainty is lifting and valuations are attractive relative to global peers. Additionally, the market offers premium levels of yield and a rich blend of internationally exposed and domestic opportunities.
In this environment, we believe our industry-leading, 16-strong UK team with full FTSE 350 market coverage is well-placed to deliver a broad range of investment outcomes to meet a variety of client needs.

 

RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.