Interactive Investor

Will this be the catalyst for ‘cheap’ UK shares?

UK shares outside the FTSE 100 have been hard hit by sharp interest rate rises. However, history shows that when the rate cycle peaks, better times lie ahead. Kyle Caldwell reports.

27th September 2023 11:32

by Kyle Caldwell from interactive investor

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UK stocks in focus 600

Sharp interest rate rises since the end of 2021 have changed the investment landscape.

The 14 rate increases over that period, during which the base rate moved from 0.25% to 5.25%, caused a re-pricing of all risk assets.

In particular, alternative approaches to generating income are now out of favour, given that yields of around 5% are available on lower-risk cash and bonds.

UK equities also remain out in the cold. The latest statistics for funds show that £1 billion was withdrawn from UK strategies in July.

However, in terms of performance over the period since interest rate rises began, UK larger companies have generally held up well, with the FTSE 100 index showing a positive return of around 5%.

The same, however, cannot be said for medium and smaller-sized companies. Since mid-December 2021, the FTSE 250 index is down around 20% and the FTSE Small Cap index has lost 17%.

The key reason is that companies listed below the FTSE 100 tend to have more of a domestic footprint, which means they are sensitive to the performance of the UK economy. Due to being more domestic, a slowdown in consumer spending is a headwind. 

Fund managers investing in the UK market – particularly those focusing on mid-caps and small-caps – are patiently waiting for a recovery.

The peaking of the interest rate cycle could spark a turnaround in fortunes. Data from Martin Currie shows that when interest rates peak, it has historically led to notable outperformance for mid-cap shares.

Its research found that between 1985 and 2022, the average FTSE 250 index return after rates peaked was 12.3% over one year (2.1 percentage points ahead of the FTSE All-Share Index); 20.3% over three years (5.5 percentage points); and 31% over five years (10.9 percentage points). 

Richard Bullas, fund manager of the FTF Martin Currie UK Mid Cap fund, says that “like a coiled spring, when sentiment starts to shift the market will move quickly”.

His view is that interest rates are close to a peak, while inflation will continue to cool.  

Bullas said: “We think we are close to a point in which investors will start to re-valuate the investment case for both mid-caps and small-caps. The macroeconomic pressures have caused investors to reduce risk, with even the better-quality names being sold down heavily. In terms of valuations, I think this is the great opportunity in 15 to 20 years.”

According to Bullas, an example of a stock that’s suffering from low sentiment towards this part of the market is Cranswick (LSE:CWK). The firm produces high-quality meat products such as pork, sausages, bacon and chicken. “This is a great example of a company that took a big step forward during Covid-19. It has continued to grow, become more profitable, and has an attractive return on capital. In addition, it has a 33-year track record of unbroken dividend growth. However, if you look at its share price performance over the past four years, it is unchanged.”

Ken Wotton, fund manager of Strategic Equity Capital (LSE:SEC), agrees that a turnaround in performance for mid-caps and small-caps is on the cards. 

He says: “Similar to 2009-10, we believe with the benefit of hindsight that investors will look back at the UK small-cap market and see the present period as optimal for capturing long-term shareholder value growth.

“In periods of economic weakness, equity investors are often drawn to the stable earnings and robust profit margins offered by established larger-cap companies. As a result, larger entities often outperform smaller peers during the initial stages of a downturn.

“However, this advantage is usually short-lived, as the agile small-cap space is renowned for its inherent ability to swiftly adapt to changing conditions, relative to their larger peers, which are slower-moving and often financially leveraged.”

One attractively priced company highlighted by Wotton is XPS Pensions Group (LSE:XPS), which provides specialist advice to defined benefit (DB) occupational pension schemes.

He says: “Buoyed by a large market, the company has seen robust and growing demand, driven by regulatory factors and the increasing complexity of running DB schemes, and is also benefiting from inflation.

“However, its current valuation on a high single-digit enterprise value-to-EBITDA multiple represents an attractive discount to its peers – as well as to the multiples seen in M&A activity in the sector.”

Not all UK fund managers are as bullish. Carl Stick and Alan Dobbie, managers of Rathbone Income, have been finding opportunities among mid-caps, but have introduced more defensiveness into the portfolio through increasing exposure to the pharmaceutical sector.

At the early stages of the pandemic, the duo positioned the portfolio towards value and cyclicality, holding the view that the risk of inflation taking off was not being reflected in valuations. However, that portfolio tilt is no longer in place.

The pair said: “It is only very selective opportunities we are seeing in UK mid-caps. We are seeing value, but we’re not gung-ho.”

Examples of mid-cap stocks they are finding value in include Computacenter (LSE:CCC) and IG Group Holdings (LSE:IGG).

However, they also point out that there are plenty of cheap valuations among larger companies in the FTSE 100.

Stick and Dobbie note that while FTSE 100 stocks are seen by some as “old economy dinosaurs”, the index has outperformed the FTSE 250 over the past one, three, five and 10 years.

They add: “Mid-cap stocks are seen as more exciting, but they are not the only way to outperform.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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