M&A surge highlights the opportunity in UK equities

A recent surge in M&A activity has underscored the compelling opportunity offered by attractively valued UK equities. Alex Wright, portfolio manager of Fidelity Special Values PLC, reviews the current backdrop and highlights the value that savvy investors are finding in the unloved UK market which remains cheap - despite improving relative performance.

While there continues to be a degree of economic and geopolitical uncertainty, the attractiveness of UK valuations versus history and compared to other markets, as well as the large divergence in performance between different parts of the market, has continued to create good opportunities for attractive returns from UK stocks on a three-to-five-year view.

And although the UK market continues to remain largely unloved by domestic investors, its attractive valuations are being recognised by other market participants such as overseas corporates and private equity firms who have been amongst the biggest bidders in the UK market.

Underlining this interest has been the sharp spike in M&A activity which remains a key feature of our portfolios. Indeed, we have seen a pickup in bid activity in recent months and last week’s announcement from Crest Nicholson that it had rejected two bids from Bellway makes it the seventh of our portfolio holdings that have been bid for in 2024 alone, with the number rising to 12 over the past year.

Corporates/Private Equity willing to step in and take a longer-term view

Portfolio holdings subject of bids over past couple of years.

Despite this strong interest and given the relatively strong performance of UK equities, it has been a surprise that we have not started to see the valuation gap between the UK and other global markets closing. For us, this demonstrates the strong opportunity for savvy investors willing to invest in the UK market today.

It is perhaps worth reiterating that buying UK stocks does not necessarily mean buying the UK economy. Over three quarters of UK companies’ revenues are generated overseas. Compared with their own historic averages, as well as stock markets across the globe, UK shares are cheap. The UK trades at around 12 times 2024 earnings, with the US on 22, the rest of Europe on 15, Japan on 16 and the Asia Pacific ex Japan region on 14, according to analyst consensus estimates¹. UK equities are trading at their lowest level compared to global peers in the past 20 years, and we are seeing value across the market cap spectrum.

The UK compares favourably versus other regional markets

Source: Citi Research, Worldscope, MSCI, Factset, 31 May 2024. Price Earnings ratio based on consensus estimates. For illustrative purposes only.

The opportunity

From a portfolio perspective, we remain disciplined, taking profits in stocks that have performed well and where the risk/reward is no longer as attractive, and recycling those into new opportunities. We have been on the lookout for companies that had seen their earnings rebased and traded on low valuations with limited downside and the potential for significant upside once the environment normalises.

We have been finding new ideas in cyclical areas such as industrials, advertising and staffing. We also added back into select real estate stocks and housing related names of late, where demand appears to be stabilising and valuations remain low.

Financials remain well represented in the portfolio given very attractive valuations. Higher interest rates have allowed banks to significantly improve their profitability, while their capital positions are far stronger than they were pre-GFC. Our holdings within the sector remain diversified in terms of geographic and banking model exposure, with idiosyncratic factors driving their growth. The higher rate environment has also been positive for life insurers, and their earnings continue to benefit from an acceleration in the pace of pension fund re-risking. Meanwhile, non-life insurers are benefiting from the improving pricing environment and moderating cost of insurance claims.

Another area where we continue to find opportunities is defensives, where we have added to the likes of Reckitt Benckiser, BAT and National Grid on weakness. Conversely, we remain meaningfully underweight to resources, a reflection of our lack of exposure to the large miners given our negative outlook for iron ore and thermal coal, and a reduction in our energy exposure. 

The potential for attractive returns

Overall, we continue to see potential for attractive returns given the upside/downside profile of our portfolio. We are encouraged by the performance of our holdings in the recent reporting season. We have seen an unusually strong full year 2023 reporting season, and in particular excellent results from some of our financials positions.

The portfolio has more than 100 stocks and remains very differentiated from many other UK funds. For those investors who have significant exposure to UK equities, there is little overlap between its holdings and some of the other largest UK funds in the IA UK All Companies sector. Moreover, the focus on picking good-value companies means the portfolio trades on a far lower average price/earnings ratio than many peers.

In our view, the portfolio is therefore well positioned to benefit from the improving economic backdrop and we remain excited about the opportunity set on offer. Our holdings continue to trade at a meaningful 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 we can continue to deliver attractive returns to investors.

¹ *Source: Citi Research, Worldscope, MSCI, Factset, 7 June 2024