Finding value in a disrupted UK

Amid continued Brexit uncertainty, UK equities remain an ugly duckling globally, but many investors are turning bullish.

Investment managers at our recent roundtable in London are largely upbeat about UK equities – the least popular asset class for asset allocators globally.

The growing likelihood of a no deal Brexit on 31 October has taken its toll on UK assets, the latest Bank of America Merrill Lynch fund manager survey shows. UK equities remain the consensus underweight with a net 30% of global asset allocators underweight in September.

They are increasingly bearish on the currency too. A net 46% of respondents believe sterling is undervalued, down 19 percentage points from August and the lowest ever recorded by the fund manager survey. That is despite the pound being the weakest of all of the G20 currencies having sunk to its lowest level in 34 years in early September.

UK-based investors like Shard Capital and Smith & Williamson, who do not bear currency risk when investing on home turf, are turning bullish.

Shard Capital is even weighted to the UK and looking to overweight. ‘We quite like valuations, we quite like sterling, so we’re looking to position more heavily into the UK,’ said partner Mike Hollings, who heads its investment committee.

‘In general, the UK looks quite cheap. Obviously, we’re not sure what the outcome of Brexit is going to be but, the likelihood is, we’ll have some kind of a deal or an extension. At the moment, we’re keeping a neutral weighting. Nobody can time it perfectly, but we’re looking to increase exposure.’

Smith & Williamson has been underweight the UK for the last couple of years but has very recently narrowed that underweight.

James Burns, who co-heads its managed portfolio service (MPS) and leads its multi-manager team, said: ‘[We’re] not quite fully weighted to the UK, but we are moving towards that now. The currency has taken such a bashing that any potentially positive outcome that avoids a doomsday scenario might actually be quite good for the currency and, therefore, UK equities look pretty good value. The UK’s going to form a large part of our client portfolios.’

Get out of jail free

For Paul Wharton, chief investment strategist at Tacit Investment Management, UK equities give clients a ‘get out of jail free card’.

‘If we get a catastrophic Brexit, I’d expect to see a catastrophic reaction to the pound, and paradoxically that’s going to help the earnings of many of the listed companies in the FTSE 100 – we all know that a large part of UK earnings are derived from overseas,’ he said.

‘In that respect, I’d rather be invested in UK equities than in UK bonds, because you get that get out of jail free card with respect to the currency. We’re quite happy to be invested in UK equities.’

Moreover, those who shun UK equities are foregoing a lot of income from dividends. UK dividends rose 14.5% to an all-time high of £37.8 billion in the second quarter of this year, beating the previous record set two years ago by £4.4 billion, according to the latest UK dividend monitor from Link Group. That was partly driven by exceptionally large special dividends and the weak pound.
Wharton pointed to a prospective yield on UK equities of 4.2%, while 10-year gilts yield a mere 0.48%.

‘You are running quite a high cashflow cost if you’re not invested in UK shares, particularly when we regard them as relatively cheaper than bond markets,’ he said.

‘You’re costing yourself quite a lot of money in terms of foregone income by not being invested in some of those world leading international companies that happen to be listed on the UK stock exchange.’

Burns at Smith & Williamson, which has used investment trusts in its MPS since its inception seven years ago, points to a handful of equity income investment trusts trading on double-digit discounts. The average discount across the sector is 6%.

‘They’ve got revenue reserves so if you’re seeking income, they’re pretty attractive,’ he said.

Scratch beneath the surface

The opportunity for Invesco fund manager James Goldstone, whose Keystone investment trust yields 3.6% and trades on a 17% discount, lies in valuations – predominantly in domestically-exposed companies but also in a number of international businesses.

His portfolios are relatively balanced between UK domestic and international exposure, in both cases his emphasis being on trying to find the best value available.

‘[The UK] looks reasonable value at an index level, but if you scratch beneath the surface back to the polarisation of certain sectors and styles, there are certain areas of the market that look like they present really tremendous value, whether that’s on an earnings yield basis, a free cash yield basis, a dividend yield basis – there are really some great companies trading at what look to me to be really inappropriately depressed valuations,’ he said.

Against the backdrop of a strong UK consumer, the result of a sharp recovery in real disposable incomes, he has cherry-picked among UK retailers.

‘In retail, as well as the challenge to the consumer from Brexit, there are clearly some very entrenched structural challenges from online shopping and from rent, so I’ve been really careful in which ones I’ve chosen,’ he said.

He owns sizeable positions in Next and JD Sports, which he thinks are well-placed for growth while trading on attractive valuations. Other big weights are to banks like Barclays and RBS.

‘They’re trading at very big discounts to book value and notwithstanding a difficult backdrop for profitability, that just looks compelling to me,’ said Goldstone.

Certain lack of dynamism

Others around the table were more reserved on the UK. Guy Foster, head of Brewin Dolphin’s research team, deems UK equities to be ‘reasonable’ and ‘appropriately cheap’ amid Brexit uncertainty.

While Brexit being delayed would be pound positive in the short term, the longer-term implications – a general election and a ‘great case’ for a hung parliament – are not as supportive.

‘It’s difficult to work out where the cleansing moment comes – a hard Brexit is probably the most likely cleansing moment, but it looks less likely at this stage,’ he said.

‘We find stuff that we like in the UK… [but] it’s got a certain lack of dynamism at an aggregate level.

‘It’s appropriately cheap for the risks that don’t look like they’re about to get resolved on October 31st or any time roughly around then. In the absence of that resolution the opportunities are actually slightly better elsewhere.’