Charlotte Meyrick, Portfolio Manager | Trevor Green, Senior Portfolio Manager
Despite hopes inflation will be brought back under control and that the prospects for the UK economy might not be as gloomy as feared, Charlotte Meyrick and Trevor Green explain why equity investors must remain disciplined in 2023.
Read this article to understand:
Why the divergence in large-cap versus small-cap performance that played out in 2022 is no longer so clear cut
Why inflation, rates, the value of sterling and consumer sentiment are among the key data points to focus on in 2023
Why individual stock selection is more important than getting the value versus growth call right
UK equities in 2022 was a tale of two markets. While the large-cap and internationally diversified FTSE 100 was one of the few major indices to deliver a positive return last year – albeit a modest one per cent gain – the small and mid-cap FTSE 250, which is more skewed to the fortunes of the domestic economy, was down 20 per cent.
With runaway inflation, rising rates and fears over the UK economic outlook, this divergence was not surprising. Those pressures have not disappeared, but better than expected retail sales in December and a positive GDP figure in November have helped get UK equities off to a good start in 2023. By February 1, both the FTSE 100 and FTSE 250 were up around 4.5 per cent.
So, is this the sign of things to come or does the recent turnaround have the hallmarks of a bear rally? Charlotte Meyrick (CM), manager of the Aviva Investors UK Listed Small and Mid-Cap strategy, and Trevor Green (TG), Head of UK Equities, give their take on what investors should look out for in 2023.
UK equities have rallied strongly in the past few months: what’s behind this and do you anticipate more of the same this year?
CM: It is worth remembering just how negative sentiment was for much of Q4, coming on the back of Q3 GDP figures that showed the UK in recession. The expectation was that things would get worse. Subsequently, we've had more supportive data. The November GDP number was positive and there are signs of softer inflation, which has led some commentators to argue we are close to the end of the Bank of England hiking cycle. Then we saw consumer retail results that were, on the whole, in line with or better than expectations. These factors, added to people naturally wanting to be more bullish after a tough period, have fuelled more of a risk-on mindset.
As to whether it continues, I’m circumspect. There’s a growing consensus any recession will be mild, inflation has peaked and central banks will stop hiking in Q2. Now, while all of this could happen, that is one of the more optimistic scenarios. The inflation question remains key – in reality, we don’t have certainty on energy prices or wage inflation. Those two factors could make higher inflation more enduring and, if that transpires, interest rates might have to increase and stay higher for longer.
On that basis, it’s hard to have conviction on the rate cycle, inflation and, as such, risk assets as well.
2022 was characterised by resilience among large-cap companies. How are things set for large-cap vs mid-cap stocks in 2023?
TG: Most people are aware of the nuances of UK sector weightings relative to other indices – the FTSE 100 has large weightings to big oil, mining, banks, tobacco and utilities. Many of the factors that supported the resilience of these sectors in 2022 look set to continue. We have seen momentum in mining continue, partly because of China’s reopening. Within banks, HSBC and Standard Chartered also stand to benefit from China’s reopening.
As an aside, there tends to be a lot of media attention on the outlook for UK retail and consumer discretionary, where they’ll obsess over the earnings of names like Hotel Chocolat, but the reality is that is such a small proportion of the FTSE 100.
CM: Over the long run, the FTSE Small Cap and FTSE 250 have shown significant outperformance versus the FTSE 100. With this in mind, investors are likely to start re-evaluating small and mid-caps after the degree of underperformance and valuation premium unwind last year (Figure 1).
The caveat is the FTSE 250 is still trading at a modest relative premium to its historic average versus the FTSE 100. The FTSE 100, despite delivering a small positive return in 2022, de-rated in the face of earnings upgrades. Valuation is therefore less of an impediment for UK small and mid-caps than it was at the start of 2022, but the asset class as a whole is not inexpensive.
However, for stock pickers, the opportunities remain plentiful with a continued bifurcation in valuations within the index; the upper quartile of the FTSE 250 is trading at a P/E ratio of around 18 times currently; the lower quartile is around nine times. To see even more enthusiasm for UK SMID, one would want more clarity around the risk of recession.
Figure 1: FTSE 250 index historic 12-month forward price/earnings versus FTSE 100
Past performance is not a reliable guide to future performance. Source: Barclays European Equity Strategy. Data as of January 2023
Are those heavily discounted names to be avoided at all costs or are there interesting narratives emerging?
CM: They should be avoided sometimes, and those are the value traps one wants to avoid, but it’s not always the case. Some companies can continue to show operational or financial resilience but de-rate in the face of structural concerns or a cyclical slowdown, tarnishing the sector they operate in. For our mid-cap strategy, we term this the “contagion effect”. In the initial outbreak of the pandemic in 2020, there were many opportunities in this contagion bucket.
Last year, we initiated a position in Cranswick, the leading supplier of pork products to the UK supermarket industry. The market became nervous about the company’s ability to manage inflation pressures in its food supply chain. It was, in fact, very successful in recovering the higher cost of production through higher prices, albeit with a lag leading to short-term margin pressure. The shares de-rated on this, which we saw as an entry point into a company with a strong track record of rising margins and returns and exciting medium-term growth angles in poultry, continental products and pet food.
Figure 2: Our four buckets of idea generation
Source: Aviva Investors, February 2023
After the de-rating in growth stocks in 2022, are you seeing more opportunities here?
CM: Yes, there have been more opportunities in this area lately. In our mid-cap strategy, this falls under our “growth outlook underappreciated” bucket. Retailer of luxury watches and jewellery Watches of Switzerland is a good example. As a retailer facing into the risk of a consumer demand slowdown, thematically it was out of favour in 2022.
However, what this overlooked, in our view, was that demand for luxury watches has been relatively resilient in previous downturns. With supply hugely constrained, with 12-24-month waiting lists for many premium watch brands, prices are likely to remain buoyant. Moreover, the company has exciting space expansion plans in the US and EU, giving it access to growth, in addition to the robust underlying market growth we suspect will persist.
We continue to find ideas across the spectrum of our mid-cap opportunity set, including “change” and “resilience” stories.
Are there any common themes you are focusing on?
TG: Every fund manager report you read will say they’re looking for quality management, resilient earnings, pricing power. That approach worked last year but remember everyone's looking for those qualities, and it’s not cheap to get those names.
It's about balance and not getting carried away by more positive forecasts that say we’re close to the bottom of the cycle and getting on top of inflation. There has to be a really good angle why you would add a name to your portfolio.
In terms of market signals, sterling is a key one. We are seeing recovery there, which would suggest a degree of confidence in the UK. The UK housing market is another area we monitor closely as it is a good indicator of consumer confidence, which looks to have recently stabilised at a low level.
One other point to note is around supply chains. It’s important not to make grand statements about things opening up post-pandemic; many companies still have issues getting hold of critical supplies, particularly smaller names. As investors, we have to look closely at how resilient company supply chains are and what they are doing to mitigate the risks.
CM: Most of our UK equity strategies were underweight consumer last year, which was the right call. But we are starting to look at that area again and where the opportunities are.
Real estate is similar. It was the worst-performing sector in the FTSE All Share last year, which has left some names trading at 30-50 per cent discounts to their net asset values. We think the yield expansion from rising interest rates has largely taken place. The focus now turns to the second-order impact of how a recession impacts rental income/ growth and how higher rates affect companies’ ability to finance new developments.
The important thing is to have a spectrum of ideas that could work in different environments. It’s not a value versus growth call; you need to think much more at the individual stock level and be open to a blend of styles.
TG: Data and analytics is another interesting area. One of the stories of last year was the massive underperformance of big US tech/media companies and also some UK media companies, both of which are heavily reliant on advertising revenues. By contrast, some of the UK-listed data and analytics companies held up well. London Stock Exchange, which bought REFINITIV a few years back, got that acquisition right in terms of diversifying into the right area.
Some UK-listed infrastructure names with operations in the US could also get a tailwind from the scale of the US infrastructure package, which kicks in this year. That’s another area to keep an eye on.
Sterling is recovering and borrowing costs are increasing. How does that affect the M&A outlook?
TG: If we’re looking at investment from outside into the UK, we’ll likely continue to see capital coming in from the Middle East. That’s been a trend for the last decade as Middle Eastern investors look to diversify and capitalise on favourable oil prices. Those investors want stakes in big companies. Activity from private equity, by contrast, is likely to be down. Those firms have really been put under pressure as the cost of capital has gone up, which limits their ability to leverage up deals.
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