The recent strong relative performance of the UK equity market has gone largely unnoticed by investors, reinforcing its unloved status. Alex Wright, portfolio manager of Special Values PLC, outlines why he believes value-oriented areas of the UK market represent a strong investment opportunity and highlights how he is positioning his portfolios to benefit.

Despite the UK being a value market, many of those who invest in the market don’t invest with a value bias. However, we look to construct portfolios focuses on unloved UK companies entering a period of positive change. The market is often slow to recognise change in out-of-favour stocks which creates opportunities to add value by identifying companies whose improving growth prospects are not yet recognised by other investors.

Our broad analyst coverage means that we are able to find ideas across the market cap spectrum, giving us many shots on goal. Our approach translates into a clear bias towards small and mid-cap value stocks, compared to most of our competitors who are often less differentiated.

Our philosophy is centred around the assumption that if general market sentiment towards a company is poor - and we don’t take unnecessary balance sheet risks and the market’s low expectations prove correct - there is limited downside as this consensus view is already reflected in the share price. On the other hand, if things unexpectedly improve, there is significant upside as the consensus view changes and new investors buy into the story.

These characteristics combine to create a portfolio with an asymmetric risk-return profile and a bias towards value stocks. By building a diversified portfolio of stocks across different stages of their recovery process, the aim is to deliver outperformance across the market cycle.

The value in UK value

The period following the global financial crisis was an anomaly where we experienced a prolonged period of subdued inflation, very low interest rates and modest economic growth, all of which favoured growth stocks. Over the last three years, we have once again started to see value outperform growth, and we expect to see this continue over the long-term as we return to a more normal inflation and interest rate environment.

More broadly, after a painful period of poor returns following the Brexit referendum in 2016, UK equities have started to outperform other markets - a fact that has gone largely unnoticed by investors. While corporate earnings have improved, valuation levels have remained largely unchanged.  The UK, which trades on 10-11 times price to earnings multiples, compares very favourably to the US market, which is trading on PE multiples of 17-18 times. And this valuation differential exists across the market capitalisation spectrum, making the UK a very attractive place to invest.

While the value in the UK market is not being recognised by investors, it is being acknowledged by other market participants, mainly US corporates and private equity firms whose bids have often been at significant premiums to prevailing share prices. The low valuations are also reflected in the substantial buyback activity among UK corporates.

How we are positioning our portfolios

Financials is the largest sector exposure in our portfolios, with holdings diversified across a number of different banks and insurers. In fact, the key source of our outperformance over recent times has come from banks, despite the volatility we saw early last year in the sector. Higher interest rates have enabled banks to significantly improve their profitability at a time when earnings in many industries are under pressure.

Our holdings here are diversified from both a geographic and business model perspective, with idiosyncratic stock stories. For example, our largest bank holding is AIB Group, which is not only an interest rate story but also benefits from an improvement in Ireland’s banking industry, where the number of competing groups has recently shrunk from five to three.

We have, however, recently trimmed back our exposure to UK-facing banks such as Barclays and NatWest on concerns that meaningfully higher rates would incentivise customers to seek higher returns on their cash and hurt profits, which has been subsequently borne out in recent results. We have also scaled back our exposure to life insurers, primarily by exiting Legal & General on near-term concerns over its fund management business and exposure to real estate. Some of these proceeds were reinvested in areas such as industrials, where some stocks have de-rated particularly sharply and factored in overly pessimistic scenarios, in our view.

Elsewhere, we are selective about our consumer exposure. A stock we like is low-cost carrier Ryanair, which has been a key contributor to performance. The company has a strong balance sheet and mostly owns its planes outright rather than having to lease them. As its peers have seen costs rise sharply, Ryanair has seen its profit margins expand as volumes returned to historic levels. As a low-cost provider, it is well placed to capitalise should consumers become more cost aware, while supply remains constrained as competitors are plagued by engine issues and plane shortages.

PAST PERFORMANCE
  Jan 19 - Jan 20 Jan 20 - Jan 21 Jan 21 - Jan 22 Jan 22 - Jan 23 Jan 23- Jan 24
Net Asset Value 11.4% -8.3% 30.1% 5.4% 1.4%
Share Price 9.2% -6.7% 29.8% -4.5% 2.5%
FTSE All Share Index 10.7% -7.5% 18.9% 5.2% 1.9%

Past performance is not a reliable indicator of future returns.

Source: Morningstar as at 31.01.2024, bid-bid, net income reinvested. © 2024 Morningstar Inc. All rights reserved. The FTSE All Share Index is a comparative index of the investment trust.

UK equities offer a relatively strong outlook

While the economic environment remains uncertain, it is important to recognise that the UK is a large and diverse market. To this end, we are finding overlooked companies with good upside potential across industries and the market cap spectrum. In aggregate, our holdings have significantly lower levels of debt and possess the strength and resilience to navigate a tough macro environment.

The relative attractiveness of UK valuations versus other markets - as well as the large divergence in performance between different parts of the market - continues to create good opportunities for attractive returns from UK stocks on a three-to-five-year view.

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