Why unloved UK equities make a compelling investment opportunity

In sharp contrast to the US markets which have recently hit new highs, UK equities remain generally unloved, despite improving relative performance. However, Alex Wright, portfolio manager of Fidelity Special Values PLC, believes there are reasons to be positive about UK equities. He reviews the opportunity set and potential catalysts for what, in his opinion, remains a very cheap domestic market.

The strength of US equities, led by the Magnificent Seven¹ tech-related stocks, has continued to dominate the market narrative in the opening months of 2024. With news closer to home that the UK economy has entered a technical recession, there has been no change in the generally weak sentiment towards UK equities that has marked the asset class since the Brexit referendum in 2016.

As a contrarian value investor, this is creating an interesting opportunity set. I would rather invest in attractively valued companies whose share price reflect low expectations, rather than ones - no matter how great businesses they are - that are priced for perfection and whose shares are likely to fall precipitously should they disappoint, or market assumptions prove unrealistic.

Indeed, the relative attractiveness of UK valuations versus other markets, as well as the large divergence in performance between different parts of the market, creates the potential for attractive returns from UK stocks on a three-to-five-year view. With its high dividends and low valuations, the UK market offers better prospective returns than many other asset classes, including global equities. 

Potential catalysts for UK re-rating

One of the questions that I get asked most frequently is what could be the catalyst for UK equities to re-rate? Some of the often-cited reasons for the underperformance are largely (geo)political and more recently the disproportionate impact of the pandemic. These headwinds are now abating and indeed UK equities have been holding their own of late, although few appear to have noticed.

The recent Spring Budget plans to launch a new ‘British ISA’ to encourage investment in UK companies have received mixed reviews so far. The proposal isto give investors an extra £5,000 allowance on top of the current £20,000 ISA allowance to invest in UK shares. Whilst admittedly this extra allowance in itself will not add up to a huge sum, it might just be the small nudge investors need to rekindle their interest in the UK. We believe it will incentivise investors to look more into UK stocks and funds and realise that many have had decent performance of late, remain very attractively valued and offer good upside potential.

We are not compromising on quality

There are other reasons to be positive. The UK is a large and diverse market with over a thousand companies to choose from and strong corporate governance standards. Its unloved status means we are currently finding overlooked companies with good upside potential across industries and the market cap spectrum. What’s more, the lack of interest from other investors means that, despite our focus on attractive valuations, we do not have to compromise on quality.

This is particularly the case for smaller companies, which have significantly underperformed over recent years. A company we bought in this space called Ascential really typifies the current market malaise. Ascential is a conglomerate made up of three different businesses and a little over 12 months ago it announced that it was to sell one, and list another, to focus on its core events business. The stock initially went up around 20% on that announcement. But a high proportion of the shareholder base were UK equity funds that were seeing redemptions so the shares retraced their gains, despite the fact nothing had changed.

This looked really interesting to us. There was a plan in motion which made strategic sense and the valuation looked very attractive compared to similar businesses listed overseas. We started buying the stock in the summer of 2023 and our thesis played out very quickly, with Ascential announcing in October that it had found buyers for their two assets and the stock performed very strongly.

This is a good example of what we are seeing with several UK stocks, where overseas corporates and private equity firms are seeing the value and are taking advantage of those attractive valuations. We have had decent success with M&A across the portfolio in the last 12 months. After a lull in the middle of last year, activity seems to have picked up over recent months, with bids for portfolio holdings Direct Line and DS Smith announced in the last two weeks alone. The low valuations are also reflected in the substantial buyback activity among UK corporates.

Opportunities abound in financials

Financials remain the largest sector exposure in our portfolios, although we have taken some profits after a period of strong performance. Banks in particular have been boosted by higher interest rates which have significantly improved their profitability. While we retain a sizeable exposure to banks, our holdings 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 also rejigged our insurance exposure. Last year, we sold our holding in Legal & General on near-term concerns over its asset management business and real estate exposure and invested some of the proceeds into Direct Line, which has since been bid for. More recently, we also switched some of our Phoenix exposure into Just Group, a move that paid off handsomely in light of the very strong set of results they recently announced. Elsewhere, we have been finding opportunities in cyclical areas such as media and industrials, where some stocks have de-rated sharply and factored in overly pessimistic scenarios, in our view.

Overall, we continue to see potential for upside given the high quality profile of our portfolio and our small-cap bias. We are also encouraged by the performance of our portfolio holdings in the recent reporting season. We remain confident that our holdings - with lower levels of debt - possess the strength and resilience to navigate what remains a tough macro environment.

¹ The Magnificent Seven tech-related stocks include Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia and Tesla.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments are subject to currency fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. The trust invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. This trust uses financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference in this article to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment.  If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.