Fidelity: Why UK equities offer attractive buying opportunities

Key points

• Attractive valuations and the large divergence in performance between different parts of the market create good opportunities for attractive returns from UK stocks on a three-to-five-year view.
• Other supportive dynamics include a more stable domestic political situation, attractive dividends, and the fact that a record number of UK companies are buying back their own shares.
• The types of companies we favor are trading at a meaningful discount to the broader UK market, despite resilient earnings, superior returns on capital and relatively low levels of debt.

What is your outlook for your asset class?

While UK equities have generated good returns since the pandemic, fund flows have remained negative, which is puzzling. Many domestic investors seem to have had their heads turned by the strong historic returns generated by US and technology stocks, whose lofty valuations make them very vulnerable to disappointments.

Despite their improved performance over recent years, UK equities still look cheap relative to other markets, and reasonable on an absolute basis. We believe that the combination of attractive valuations and the large divergence in performance between different parts of the market create good opportunities for attractive returns from UK stocks on a three-to-five-year view. Although the UK market continues to remain largely unloved by domestic investors, its attractive valuations are being recognized by other market participants such as overseas corporates and private equity firms. Underlining this interest has been a sharp spike in M&A activity, which typically benefits us given our focus on attractively valued businesses.

Other supportive dynamics include a more stable domestic political situation given the new government’s large majority, attractive dividends in a global context and the fact that a record number of UK companies are buying back their own shares. Despite this, and given the relatively robust performance of UK companies, it has been a surprise that we have not started to see the valuation gap between the UK and other global markets close. For us, this demonstrates the strong opportunity for savvy investors willing to invest in the UK market today. It is also worth reiterating that buying UK stocks does not necessarily mean buying the UK economy given many London-listed companies generate a significant portion of their revenues overseas.

How are you looking to position against this backdrop?

Our strategy remains diversified with around 90-100 individual holdings. Financials remain well represented given attractive valuations, a more conducive backdrop and plenty of opportunities with idiosyncratic factors driving their growth. We have been finding new ideas in cyclical areas such as industrials, advertising and staffing and also added back into select real estate and housing related names, where demand appears to be stabilizing and valuations remain low. Another area where we continue to find opportunities is Defensives, where having taken some profits from our support services holdings, we have added to a number of consumer staples businesses and utilities on weakness. Conversely, we remain meaningfully underweight Resources, a reflection of our lack of exposure to the large miners given our negative outlook for iron ore and thermal coal, as well as a reduction in energy exposure.

We are seeing value across the market cap spectrum, particularly at the smaller end where companies continue to trade significantly below long-term averages. For instance, we recently took advantage of pre-budget concerns over the removal of the exemption from IHT that applied to AIM-listed shares to add a few very attractively valued holdings in that space.

Overall, we believe we are well positioned to benefit from the improving economic backdrop and remain excited about the opportunity set on offer. Our geographic exposure is broadly diversified with around one-third of our holdings’ revenues generated in the UK and two third overseas. In aggregate, our holdings are trading at a meaningful c15-20% discount to the broader UK market, despite resilient earnings, superior returns on capital and relatively low levels of debt. This quality profile gives us confidence that the strategy can continue to deliver attractive returns to investors.

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