Why we believe there is still life in the UK market rally

Despite the UK stock market’s positive performance in recent years, many investors have either reduced their exposure or remained on the sidelines, seemingly more enthused by high-growth US technology stocks. However, with UK equities trading at their most attractive levels combined with corporate earnings and an improving domestic economy, we believe now is the time to capitalise on the upside potential still on offer. 

There's more to the UK market rally

UK equities have performed solidly over the past four years since the pandemic. In fact, the UK market has very much held its own against global markets since 2020.Interestingly, the performance of the UK has been powered by corporate earnings rather than the narrowing of the valuation gap versus other markets. This is one of the key reasons why we believe the UK rally still has further to run. 

The renewed strength in the UK market mirrors the broader trend of value stocks outperforming growth stocks in recent years. This shift aligns with the long-term success of Fidelity Special Values which has consistently delivered stellar returns over the last 30 years. While the FTSE All Share has grown by just over 700% during this period, the share price of Fidelity Special Values has risen by over 2800%. This outperformance underlines the potential for active management to exploit undervalued opportunities in the UK market. 

While UK equities have been gaining momentum, domestic investor flows have stayed negative - a curious disconnect which could be explained in part by the allure of high-flying US technology stocks which have delivered outsized returns. However, the recent pullback in tech stocks may well trigger a shift in investor allocations towards more undervalued regions, such as the UK.
 

Past performance is not a reliable indicator of future returns.

Source: Morningstar as at 30.09.2024, bid-bid, net income reinvested. © 2024 Morningstar Inc. All rights reserved. The FTSE All Share Index is a comparative index of the investment trust.

The case for UK equities

What makes UK equities particularly compelling are the valuations on offer. The UK market remains undervalued not just compared to global peers but also relative to its own historical levels. Trading at around 12.6 times 2024 forecast earnings, UK stocks are significantly cheaper than their counterparts in the US, which are priced at 24.2 times, or Europe at 15.5 times. These low valuations are a key reason why we see strong opportunities for UK stocks over the next three to five years.

Dividend yields in the UK also remain highly attractive, particularly in a global context. The combination of solid dividends and the increasing prevalence of share buybacks have added to the case for investing in UK equities. In fact, a record number of UK companies are repurchasing their own shares, further underscoring their confidence in the value on offer and future growth prospects.

Finding value in cyclical and defensive sectors
 
In our portfolio, we maintain a diversified approach with a focus on undervalued stocks and sectors. Financials are a key component, particularly banks as they benefit from attractive valuations and a more conducive operating environment due to rising interest rates. We have been finding new ideas in cyclical areas such as industrials, advertising and staffing, and also have added back into select real estate stocks and housing related names, where demand appears to be stabilising and valuations remain low.

We continue to see value in defensive stocks such as Imperial Brands, Reckitt Benckiser and National Grid. These companies with their strong balance sheets and steady revenue streams are well positioned to perform even during periods of market volatility. Conversely, we remain meaningfully underweight in sectors like mining, a reflection of our negative outlook for iron ore and thermal coal and have also reduced our energy exposure. 
 
Closing window of opportunity

Despite some near-term uncertainty, we believe the outlook for UK equities remains positive. The valuation gap between UK stocks and global peers is unlikely to persist indefinitely given the strong earnings growth many UK companies are experiencing, the generous dividends on offer (at a time when deposit rates are starting to decline) and the marked pickup in share buybacks. This presents a narrow window of opportunity for investors willing to take a long-term view.

While the UK economy faces challenges, we are encouraged by the resilience of UK businesses. Their ability to adapt and deliver earnings growth combined with the current valuation levels offers the potential for good returns over the next three to five years.

Overall, we believe the portfolio is 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.