There are signs of light at the end of the tunnel for the out-of-favour UK market. We explain how investors can find value.
The Bank of England is in remarkably upbeat mood. The UK economy is set to claw back almost all the ground lost during the Covid-19 pandemic over the next 12 months, according to the latest assessment published by the Bank’s Monetary Policy Committee in early February. Despite a sharp contraction in the first quarter of this year – as lockdown continues – the economy will return to its pre-crisis size by March next year, the Bank predicts.
Such optimism reflects a marked change of tone, given the Bank’s previously downbeat forecasts of Covid-19 impacts. But the arrival of vaccines – and the UK’s rapid roll-out rate – has changed the game, its economists believe. And they’re not the only ones; the strength of global stock markets since the UK became the first country in the world to give regulatory approval for a Covid-19 vaccine has been striking. In the UK, the FTSE 100 Index rose by almost 10% over the following five weeks.
Brexit deal removes another significant headwind
It is not just light at the end of the tunnel on Covid-19 that is buoying UK equities. The eleventh-hour trade agreement between the UK and the European Union, signed just a day before the 31 December deadline, has removed another significant headwind holding back the stock market. The agreement may be far from perfect, but its inconsistencies and difficulties are small beer compared to the chaos that would have ensued in the event of a no-deal Brexit.
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The clouds are lifting, it would appear, and stock market bulls are now champing at the bit. “Two clear catalysts that we were hoping for have now occurred; I believe the approval of multiple vaccines for Covid-19 and a Brexit deal will quickly increase the interest in UK equities from domestic and foreign investors, and from corporates, as we are already seeing with increased M&A activity in the UK market,” says Alex Wright, portfolio manager of Fidelity Special Values (LSE:FSV) investment trust. “Now these two key uncertainties have passed, the incredible value in UK equities cannot be ignored for much longer.”
“Since peak Covid-19 uncertainty around the time that the World Health Organization declared a global pandemic in early March, we’ve seen many companies get back on track,” adds Sue Noffke, head of UK equities at Schroders. “In terms of potential, the UK market for stockpicking is comparable to the one that followed the global financial crisis.”
Will there be a sustained recovery for value stocks?
In which case, what is the best way to exploit that opportunity? The short answer is that there are no sure things; still, some investors are focusing on particular strategies and segments of the market.
One idea attracting interest is that we may now see value stocks – those languishing below the valuations they fundamentally deserve – returning to favour, displacing growth stocks admired for their potential to outperform. Much of the past five years – and 2020 in particular – has proved difficult for value investors, particularly in the UK, where much of the market is undervalued compared to international peers.
But happier times may lie ahead, with investors looking beyond classic growth-stock territory, such as technology, given the heady heights such sectors have hit.
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“During the pandemic, technology and growth stocks enjoyed tailwinds from a boost to earnings and lower discount rate, but these tailwinds should become headwinds once a vaccine is available and lockdowns have been eased,” argues Andrew Pease, global head of investment strategy at Russell Investments. “This should allow the normal early cycle recovery dynamics to resume.”
Stronger pound will boost domestically focused stocks
Smaller and mid-sized companies are another promising area, according to some experts. For one thing, international confidence in the UK is set to increase now Brexit uncertainty is out of the way, which should be positive for sterling. A higher pound is a negative for larger companies, which sell more of their products and services in overseas market, but less of an issue for more domestically focused businesses in small- and mid-cap territory.
This area of the market is also a focus for M&A activity, points out Andy Brough, head of the pan-European small and mid-cap team at Schroders. “Much of the recent recovery in deals involving UK companies has been driven by bids for domestically focused small and mid-cap companies,” he says. “And in the past, these companies have attracted a relatively greater part of the M&A pie.”
Banks have the go-ahead to pay dividends again
A third idea for where to look for value in 2021 is the equity income sector. Dividend stocks suffered during the pandemic as investors fled companies cutting their payouts; the UK market as a whole generated 40% less dividend income last year. But now recovery looks likely, these stocks may bounce back more quickly than expected, says Laura Foll, co-manager of the Janus Henderson UK Equity Income & Growth fund, Lowland Investment Company (LSE:LWI) and Law Debenture (LSE:LWDB). “There are already signs that businesses are regaining confidence with some resuming dividends,” she says.
In the banking sector, for example, the Prudential Regulation Authority has now given banks the go-ahead to begin paying dividends again, after ordering a suspension last year. Businesses such as supermarkets also look well-placed to offer more generous dividends in the year ahead.
Fund and trust ideas for the ‘unloved’ UK
As for how to play these themes for 2020, advisers and analysts have several suggestions.
Taking the value theme first, Teodor Dilov, fund analyst at interactive investor has two suggestions. “We like R&M UK Recovery Fund, run by Hugh Sergeant since its launch in 2008, which invests in good businesses currently experiencing below-normal profit levels that are depressing their valuations,” he says. “We also like Man GLG Income Professional, which aims to achieve a level of income above the FTSE All-Share index together with some capital growth. Manager Henry Dixon takes a value-based investment approach which results in a relatively concentrated portfolio.”
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As for UK smaller companies, Darius McDermott, managing director of FundCalibre, suggests TB Amati UK Smaller Companies and Marlborough UK Micro Cap as two potential fund opportunities. “Smaller companies is all about stockpicking and meeting companies, which is definitely the approach at Marlborough, which knows management from a large percentage of smaller company and AIM businesses” he says. “One of Amati’s big advantages is how early they see and invest in companies thanks to the venture capital part of their business.”
Alternatively, “Odyssean Investment Trust (LSE:OIT) offers a different play on the UK smaller company market given its private equity-style approach to public markets and its concentrated portfolio,” says Simon Elliott, a research analyst at Winterflood, the investment trust analyst.
Finally, turning to equity income, Elliott picks out Murray Income (LSE:MUT) investment trust, which has recently merged with Perpetual Income & Growth. “We see manager Charles Luke as a natural successor to Job Curtis, the veteran manager of City of London (LSE:CTY) investment trust as the torchbearer for the UK Equity Income trusts that offer dependable and growing dividends.”
Elliott also likes Law Debenture, where the “income that its subsidiary business generates is highly attractive at a time of general dividend uncertainty”.
In terms of a fund idea, McDermott suggests Montanaro UK Income, which has a focus on small and mid-cap stocks.
Downside protection for the anxious
Not everyone is confident about the year to come. After all, the Covid-19 crisis is far from over and many worry that virus mutations may yet cause problems that render vaccines less effective. Nor is the Brexit deal story an entirely happy one: those sectors covered by the trade agreement complain of real difficulties and the services industry, which dominates the UK economy falls outside its scope.
Moreover, even leaving aside the risk of better news crumbling, markets face some tough challenges. The UK suffered a worse pandemic recession than any other G7 nation according to data from the International Monetary Fund, which is much less bullish about its prospects of recovery in the year ahead than the Bank of England.
The IMF sees growth of just 4.5% in 2021, following a 10% decline last year.
In which case, it might be sensible to have some downside protection in your portfolio – particularly if you are one of those investors who ploughed record sums into investment funds in November, as market exuberance returned.
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“Diversification [across asset classes] is a possible answer,” suggests McDermott. “Multi-asset funds such as TB Wise Multi-Asset Growth, or absolute return vehicles such as Church House Tenax or Janus Henderson UK Absolute Return could be a good idea.”
“Going global would mitigate region-specific risk by diversification of themes and income streams that are are less correlated with each other,” adds Dilov. “Vanguard Global Bond Index GBP Hedged could provide pure market exposure, while for investors with a lower risk profile, global fixed income could be a good fit; M&G Global Macro Bond offers a flexible approach.”
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