Brave investors who ‘buy low’ can be richly rewarded. Cherry Reynard looks at the most unloved fund sectors and considers whether there are potential value opportunities.
Like a US high school, the past five years have seen markets divide firmly into cool kids and dirtbags. At one end, there were the US technology names – the prom queens everyone voted for – while stuck in the corner with no friends were all the UK fund sectors and Europe. Is it possible that these unloved sectors will take off their glasses, shake down their hair and win investor favour again?
There was, very briefly, a moment when the fortunes of the UK stock market looked like they might turn. In November last year, there was a stable government at last, some reluctant consensus on Brexit and the UK stock market began to limp forward, finally setting four years of poor performance behind it.
Investors will be familiar with the narrative from there. The UK had a “bad” pandemic, the European Union proved a formidable foe and the apparently stable government started to disintegrate. Any tentative revival for the UK stock market was stopped in its tracks.
It is worth noting just how extreme this underperformance has been. Over the past five years, the average UK All Companies fund is up 15%, this compares to 105% for the average North American fund, according to FE Analytics to 6 October. Bottom of the heap has been the UK Equity Income sector, where the average fund is up just 4% over this period, while UK direct property is up a dismal 10.4%.
The one bright spot – almost - is UK Smaller companies, which have risen an average of 38% thanks to some judicious stockpicking.
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‘Unloved UK’: time to buy or steer clear?
It would be easy to attribute this weakness to Brexit. And certainly, Brexit has created significant uncertainty for UK companies, while also deterring both international and domestic investors. The UK All Companies sector was the worst-selling UK retail sector for 2016, 2017 and 2018.
In just over two years from the Brexit vote, £9 billion was withdrawn from funds investing in British companies. The pandemic triggered another wave of selling, with UK funds showing their largest ever monthly net outflow in March 2020, with £8.7 billion withdrawn, figures from Morningstar show.
However, it isn’t just about Brexit. If the UK had a wealth of competitive global technology companies, investors might have overlooked its messy divorce from the EU. The make-up of the UK market has been a significant problem. Gavin Haynes, a consultant at Fairview Investments, points out that many of the UK’s largest companies are suffering not just cyclically but structurally. Oil, for example, is seeing a change in demand as consumers switch to renewable energy; while tobacco is in structural decline.
It does not help, says James Calder, research director at City Asset Management, that these sectors are old-fashioned and do not score highly on environmental or social metrics, which are an increasingly important part of investor decision-making.
The more recent underperformance by the UK market isn’t simply sentiment driven. Research from JP Morgan Asset Management shows that UK companies are projected to have the weakest earnings of any developed nation over the next 12 months. The US may be an unfair comparison because of the strength of the tech sector, but even compared to Japan or Europe, UK companies score poorly in comparison.
The dividend debacle in the wake of the pandemic has completed the gloom for UK companies. Just over half of UK companies in the FTSE 100 index have cut, suspended or cancelled their dividends. Its typical high dividend yield had been a key reason to invest in the UK market, but investors have lost faith. John Monaghan, head of research at Square Mile Investment, says: “The UK market has traditionally delivered a healthy level of income. People are looking elsewhere and using global income funds instead.” He believes the market had grown increasingly reliant on a small number of stocks that were over-distributing at the expense of growth. The pandemic made this unsustainable.
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Amid this grim assessment, can there be a positive outlook for any of the main UK sectors? Could it be, for example, that the UK has just been kept low by Brexit and is primed for a revival? Whatever the catalyst, it is unlikely to be a revival in the UK economy - high debt, high unemployment and a lingering pandemic is not a recipe for growth. Equally, the make-up of the UK market is unlikely to change in the short term.
Haynes says that the UK market has price on its side. He points out: “It would be easy to write off sectors and markets that have performed very badly, but if you take a contrarian stance and are happy to be patient – the market is so unloved, the market is cheap, the currency is cheap and there are opportunities.” This may, in itself, be enough to bring investors back to the sector if there is some resolution on Brexit and companies can forward plan once again.
For the UK Equity Income and All Companies sectors, the biggest difference may come from the revival of “value” and with it, some enthusiasm for sectors such as banks, oil and gas or tobacco.
The valuation gap between value and growth companies is now as wide as it has ever been, points out Haynes. He adds:
“If a vaccine comes through, or if there is any certainty on Brexit, value could return to favour.”
The UK is still a relatively good source of income, with the yield on the FTSE All Share index still well over 4%. However, Calder believes that many UK income companies are only higher yielding because there is no growth. Investors need to prioritise dividend growth. If investors are still keen to invest, he believes they should look to an investment trust trading on a discount with a decent revenue reserve to shore up the dividend – Merchants investment trust, for example.
Fund selectors can muster more enthusiasm for the smaller companies sector. Haynes believes investors should be encouraged by recent moves by Schroders (LSE:SDR), Buffetology and Tellworth to launch “best of British”-style investment trusts. He says they certainly aren’t doing it because there is lots of demand for UK equities (in fact, Tellworth ultimately abandoned its launch due to lack of demand), they are doing it because they can see real investment opportunities.
“We like managers investing in smaller, idiosyncratic opportunities, the ideas of tomorrow. These are likely to be in a specific niche and not reliant on UK GDP.”
He likes smaller companies trusts such as the Gresham House UK Micro Cap fund, which runs a concentrated portfolio of technology-focused businesses.
Monaghan says UK smaller companies have seen a lack of buyers – pension schemes are maturing and are less interested, while changing regulation has also had an impact – but the effect of this is diminishing.
He believes the association of small caps with the flagging UK economy has been overdone and eventually investors will recognise this.
“Lots of companies in the small and mid-cap area have overseas earnings and there are plenty of growth stories.”
Opportunities among niche property markets
UK commercial property has also been out of favour. There are sound reasons for this. Rents have slumped. This has been worse in retail, but the office market has also suffered. Many of the largest commercial property funds are closed to redemptions and many, says Calder, still hold retail assets they cannot sell.
This may get worse before it gets better. Valuations can be slow to shift in the commercial property sector. Buildings change hands slowly and it can take time for weakness to emerge. No one yet knows whether companies will eventually encourage staff to return to the office, or whether they allow more people to work from home permanently. This clarity is unlikely to emerge while the pandemic is ongoing.
Nevertheless, Calder is clear that there are opportunities among niche property markets: “We are focused on specialist managers, notably logistics operators such as Tritax EuroBox (LSE:BOXE)or LXI REIT (LSE:LXI).” These specialise in areas such as last-mile delivery warehousing, which plays to the e-commerce trend. There may also be opportunities in areas such as healthcare REITS, or care homes.
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Europe’s in the doldrums, but this could change
Finally, it is worth talking about Europe. Europe is perennially unloved, but here there may be a genuine opportunity. Money moving out of the US on political uncertainty, a declining dollar and fears for the tech sector. It has to go somewhere and some of it may find its way to Europe.
Monaghan says: “Europe has been in the doldrums but has historically been a geared play on global growth.” In particular, he says, it does well when China and Asia are doing well, which they are. The BlackRock European team has been one of the strongest performers and the BlackRock Greater Europe trust (LSE:BRGE) still trades on a small discount to net asset value of 3.9%, as at 19 October, data from Winterflood shows.
It is the nature of an unloved sector that it tends to reveal its charms slowly. It is not quite as obvious as removing the glasses, shaking down the hair and everyone realising its beauty. The UK and Europe still have a lot of headwinds, but those problems are amply reflected in share prices. A Brexit resolution may yet prompt a re-examination of these markets and investors will find opportunities there.
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