Why the UK rally has legs - and what we’re buying
RGI UK Recovery manager Hugh Sergeant explains why he’s optimistic about the UK stock market and reveals the business sectors and companies he’s investing in, as well as his best new and long-standing ideas.
7th August 2024 09:00
by Sam Benstead from interactive investor
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RGI UK Recovery manager Hugh Sergeant tells ii’s Sam Benstead why he’s optimistic about the UK stock market and how he’s investing to profit. He reveals the business sectors and companies he’s investing in, as well as his best new and long-standing ideas. The fund is one of ii’s Super 60 list of recommended funds.
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Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Hugh Sergeant, manager of the RGI UK Recovery Fund. Hugh, thank you very much for coming in.
Hugh Sergeant, RGI UK Recovery manager: Morning Sam. Good to see you and thank you for inviting me.
Sam Benstead: We last had you in the studio in October 2022. At the time, you said it was the best time to buy UK shares since the 2008 global financial crisis. Since then, your portfolio is up about 35% versus about 27% for the FTSE All-Share. So, what's been behind this rally in UK markets?
Hugh Sergeant: Oh, very good question Sam, and thank you for, I suppose, that quite flattering introduction.
Obviously it's been good to generate strong returns over that period of time and to be in ahead of the benchmark. When we chatted last time two years ago, we were at the depth of the dislocation associated with Liz Truss' desire to up the ante in terms of growth but obviously it upset financial markets with that approach.
So, UK equities in particular were very weak in that context and also there was the background in terms of the cost-of-living crisis.
What we identified was first of all really attractive valuations and that's obviously always been a key part in terms of how we think about equity returns. Really attractive valuations. And also the outlook, the medium-term outlook, being more positive than the doom and gloom that framed the conversation at that time.
Subsequently, obviously we had a quick rotation in terms of who was running the Conservative Party and leading the government. We had a return to more stable, more considered, policies under Rishi Sunak and Jeremy Hunt, and that allowed a confidence to return to the UK.
We've had elements of the economic background improved, so the cost-of-living crisis abate. So, you had a global equity market background that was reasonably supportive and also a lot of M&A exploiting the really low valuations and I suppose underpinning the valuations in UK equities.
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So, all those factors have allowed equity markets to recover. We were buying quite aggressively into some of the very heavily discounted shares and they've been able to bounce quite aggressively. So, hence, our ability to participate fully in that rally.
As we speak today, equity markets have obviously moved up, have recovered. We're still actually very bullish on UK equities. Starting valuations remain really attractive. And we think the economic fundamentals two years on are clearly improving.
We do think there's significant room for the Bank of England to cut interest rates, and they should start moving ahead of the curve by cutting in August. We do think also that the background for the consumer is positive. And also corporate fundamentals are starting to blossom as the companies are starting to meet expectations.
So, low starting valuations and the fundamentals improving should underwrite an ongoing strong performance from UK equities. Plus we're more investable now with the new government, and should be able to attract international capital into the UK market.
Sam Benstead: You're bullish on the UK. Can you explain how the portfolio is run and how you're positioned at the moment to benefit from this benign economic outlook?
Hugh Sergeant: The portfolio was established during the depth of the global financial crisis. So, that's when we launched the UK Recovery strategy and we've been running it along the same lines ever since.
Our overall philosophy we call PVT, short for Potential Valuation and Timing. So, we're looking for companies with potential, companies that can grow their shareholder value at above average pace over the medium term. We like value, buying things cheaply for 50p in the £1. And we put a lot of focus on the timing side of things, so trying to apply capital when things are starting to improve.
So we're trying to avoid, in the value space, things like value traps. Obviously for the recovery approach, we're focused on recovery, PVT, so recovery, potential valuation and timing. And just very quickly that means good-quality business franchises when profitability is temporarily depressed, impaired for whatever reason, that creates a big value gap because other investors will value the company off depressed profits rather than recovered profits.
And then we're thinking about the timing for recovery stocks. So we want self-help, cost-cutting and things like that. We want evidence on the share price technicals. So, other investors starting to get interested and the share price is moving up and the fundamentals are improving as reflected in earnings revisions turning positive. So that's the focus. That's what we've done day in, day out.
We use quants to help us efficiently identify those ideas. Now where we are in the cycle, from our perspective, we're towards the beginning of a classic recovery cycle. So, the UK economic background has been somewhat tricky over the last couple of years. Likewise for profits.
So, we think there is a lot of potential for the UK economy to start to recover, as I mentioned earlier, briefly, interest rates being cut. We think consumer fundamentals are much stronger than the quite negative narrative at the moment. And then we also think that corporate fundamentals, profitability, is starting to pick up and companies are starting to beat expectations.
So we think we're at that very supportive stage in the economic cycle, which is really beneficial for recovery-type stocks. The key focus at the moment would be valued as well in the recovery phase. So, cheap stocks tend not to get de-rated further as confidence returns, they tend to get re-rated.
Classic cyclicals that are exposed to the economic pick-up, so I talk about things like the consumer side of things, house building, companies that benefit from interest rates falling tend to benefit. And then in particular at the moment there's been a big bear market in small-cap stocks down to micro-cap stocks. And as confidence returns, they [will] do well.
There's been quite a buyers' strike in small and mid-cap stocks. We see more interest returning, they will be big beneficiaries of the recovery part of the cycle. And we've been increasingly gearing the portfolio up to that recovery element. So, adding to all those key parts, key beneficiaries of the more positive cycle.
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Sam Benstead: So, what types of business sectors and companies does that therefore lead you to invest in?
Hugh Sergeant: A great question. So, on the value side of things, traditional value stocks would probably highlight the UK domestic banks. So, the likes of Lloyds Banking Group (LSE:LLOY) and NatWest Group (LSE:NWG) have been beneficiaries of interest rates moving up. And, while interest rates will fall from here, we think there's going to be much more credit creation over the next few years.
If you look at the balance sheet of consumers, they're in a strong position to borrow a little bit more, and the banks are much better capitalised than they were when we came out of the global financial crisis. So, they'll be able to grow their balance sheet, which would be supportive for their profitability. So, that's one example of classic value.
On the classic recovery parts, we like the consumer side of things. We like housebuilding, for example. A favoured stock would be MJ Gleeson (LSE:GLE), which will benefit from the recovery in demand for housing and is also a company that has a niche, is relatively small, and we'd be able to grow, much more than, say, some of the really large housebuilders such as Persimmon. So, we'll have a classic recovery in profits and be able to grow. So we like that.
We like things like Marston's (LSE:MARS), which are exposed to the consumer, a traditional pub co. They're improving the efficiency of their balance sheet, de-leveraging, and that will mean equity holders will be big beneficiaries of that.
Companies that benefit from the peaking of interest rates. So, in particular real estate. We've been adding to companies exposed to real estate. Our favoured stock there would be Shaftesbury Capital (LSE:SHC) that has a great real estate portfolio in the West End, in Covent Garden, Soho, in particular, and that's seeing strong fundamentals, meanwhile its valuation is depressed, and interest rates will benefit that.
And then the small and mid-cap end, from my perspective, there are lots of opportunities. Almost too many to name in this conversation, but it's quite interesting, that area has seen quite a de-rating of the structural growers, and that's an area of interest, as well as looking for classic recovery stocks. When structural growers get significantly de-rated, we find that area quite interesting.
Sam Benstead: You own about 400 companies. How do you keep track of all these shares, and how do you balance the qualitative and quantitative elements of fund management?
Hugh Sergeant: Another great quick question. I suppose it's somewhat unusual, the fact we have quite a diversified portfolio. It's something that I've been comfortable running throughout my career. I think in particular running a value and recovery portfolio, I don't think the rifle shooting, or very concentrated approaches to portfolio construction, necessarily works in that area because each individual stock has quite high-risk characteristics. So, do you want to put lots of capital into a small number of stocks?
What we like to do is buy things very slowly. So, we take 15 (0.15%) to 20 (0.2%) basis points as a starter position. And then as news flow comes through, the timing side of the thesis starts to pick up. Then that's when we get more aggressive and put more capital in. So, we do have this more gradualist, more diversified approach.
We're able to do that because we've got a lot of heritage, I suppose, fundamental knowledge of the companies that are listed in the UK. And then, as you suggested, we've always used quants. So, quants has always been important.
To us, we call our quants platform Moneypenny; it systematically looks for new ideas that have the recovery PVT characteristics that we focus on, but also monitors existing positions in portfolios from a quants perspective. So, if their timing is weakening, for example, it will flag that we actually need to do a review of that stock. So, it's a very efficient way of managing a large number of stocks and monitoring those large number of stocks.
But we think that diversification has worked well over the years and been an important contributor to a strong, but also consistent, performance.
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Sam Benstead: And like you said, you've been running this portfolio for just over 15 years now. But there's lots of change. You look for new ideas constantly. Are there any companies that have been in there for a long time that you still like?
Hugh Sergeant: There are, [and] there are some that haven't worked as well as we might have liked. So actually Lloyds. I talked about the UK domestic banks. I was somewhat bullish of them coming out of the global financial crisis, just because valuations were so low and they've improved their returns over the last five years, but have not really been re-rated, for various reasons. So, that's been a disappointment, but we're stuck with it and we do think the environment for the next five years, I think in particular, because they're going to be able to deliver this growth aspect that perhaps other investors have been looking for alongside being very, very cheap.
Somero Enterprises Inc Ordinary Shares (LSE:SOM) is a good example of a small-cap stock that we've held consistently. It has this fantastic niche position in big pieces of kit that make concrete very level, very flat. It essentially has a global monopoly on this kit and it's been very important for building out warehouses and data centres and things like that.
We bought it as a very deep recovery micro-cap stock during the global financial crisis when the market actually thought it might run out of money. We were comfortable with the new management team and their ability to generate cash, and to survive what was a very deep decline in their revenues. So, they came through that, the stock went on to go up, say, 10 times. Towards the back end of its recovery, we were taking capital out.
We've held a position in it and we're getting higher conviction on it now. It's obviously exposed to cyclical elements, that's why it struggled during the global financial crisis. So, the market's been a bit nervous about it over the last couple of years, and that's led to a big de-rating. But we do think it's end markets, data centres, etc, big warehouses, are going to remain a structural area of growth and it will benefit from that. And we'll then have a bit of a cyclical recovery with a very low starting valuation.
Sam Benstead: Hugh, thank you very much for coming in.
Hugh Sergeant: Thank you very much for your time and all your insightful questions.
Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel,where you can like, comment and subscribe. See you next time.
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