UK equities: the silver lining to an otherwise gloomy outlook?
This article was written by Kamal Warraich and originally published by CGWM.
At Adam & Company, we believe we are seeing a generational opportunity to invest in UK equities. While the global economy is slowing, valuations have fallen to multi-decade lows in both absolute and relative terms. Things are even more extreme across UK medium and small companies (known as SMID caps), where companies sit at a discount to their larger competitors.
This is creating a rare investment opportunity, as evidence suggests that smaller companies should outperform larger companies over time – so if you can buy them cheaply, potential returns could be very powerful. This is because UK SMID caps have historically been valued at a premium compared with large caps for most of the history of the indices.
What are small and mid-cap companies?
A general rule of thumb is that small-cap companies have market capitalisations of between £100m and £2bn, and mid-cap companies between £1bn and £5bn.
We currently have a bias towards UK SMID caps within the equity allocation of our multi-manager models (the models within which funds are bought, as opposed to direct equity), and hope to take advantage of this valuation disconnect.
A gloomy take on the UK economic outlook
Many well-known financial institutions, including the International Monetary Fund (IMF), have issued glum verdicts on the UK economic outlook. While GDP has grown in real terms compared with the pre-COVID-19 era, and is marginally ahead of Germany this year, Brexit is still clearly having an effect. Business investment is lower here than in any other G7 country (and has been for some time), sterling is perennially weak, and the average defined benefit pension fund allocation to UK equities has fallen from over 50% in the 1990s to less than 2% in 2022. Furthermore, global fund managers are still most bearish on UK equities relative to all other markets, according to the latest Bank of America Merrill Lynch Fund Manager survey.
Don’t confuse the stock market with the economy
This is a well-known investment adage, and in the UK’s case it’s an important distinction. More than two thirds of FTSE All-Share revenues come from overseas, and it’s upwards of 50% for the FTSE 250, the oft-touted ‘domestic bellwether’. Many UK smaller companies are actually international businesses which are plugged into long-term structural growth trends, but they’re being valued as if they’re intrinsically linked to the UK economy, or they’re in structural decline.
Why does that matter? Primarily it’s to do with valuations and investor perception. Market participants have long suggested that UK public limited companies (PLCs) deserve a lower valuation rating compared with our international peers – and specifically the US. This is usually due to investors pointing to profitability ratios such as ‘return on equity’ and ‘return on invested capital’ lagging behind the US, as well as our companies being prone to higher levels of cyclicality.
In fairness, these points are entirely justified. At an index level, our companies tend to be less profitable than those across the pond and, all things being equal, sensible investors should ascribe lower valuations to them. It is also true that our relatively high exposure to commodities and banks implies an inherently higher level of cyclicality. This is because energy prices and raw materials are often pulled in two different directions at the same time by supply and demand issues, while bank earnings are overwhelmingly influenced by interest rates.
However, we would contend that things have gone too far, and if November’s moves in the stock market are anything to go by, some investors agree with us. Earlier in the year, Morgan Stanley raised eyebrows when it reported that the UK was the cheapest stock market in the world. In fact, it was the cheapest it had been in decades, as well as being the cheapest compared to other markets. According to the data, the UK was trading 30% cheaper than global equities, versus a longer-run average of 10-15%.
Is the UK the ‘poor relation’ of the investment world?
Some critics might suggest that index level valuations do not provide adequate guidance, and you need to dig a little deeper to assess the quality of the companies. But the story is the same no matter how you cut it. Like-for-like valuation comparisons (Unilever vs. Proctor & Gamble, or Shell vs. Exxon, for example) show us that UK companies trade at a discount to international peers; i.e. those with near identical business models, cash flow profiles and end markets. Then there are other points of reference, such as investment trust discounts, which are back to levels last witnessed in 2008, and the colossal level of short-selling by hedge funds.
Perhaps starkest of all, when one looks beneath the surface at our small- and medium-sized companies, you will find that valuations have reached extreme lows. As at 31 October, the Numis Smaller Companies Index was trading at a Shiller price-per-earning (P/E) ratio of 13x. This is close to its all-time troughs, seen on three previous occasions: during the depths of the Great Financial Crisis, the tech bubble aftermath and the early 90s recession. After these troughs, smaller companies went on to produce significant returns over many years. As Mark Twain wrote, “history doesn’t repeat itself, but it often rhymes,”and we hope it will do so again.
All these factors suggest that market forces are throwing babies out with the bathwater and wrongly assessing innovative global companies as ‘low-quality UK domestics in terminal decline’. Some readers might challenge the use of the word ‘innovative’ in the context of UK equities. But innovation comes in many forms, and not just US technological disruption.
RELX, for example, is the world’s largest publisher and exhibitions company. Diageo owns the best-selling whisky and vodka brands in the world, which incidentally have been adapting to consumer tastes for hundreds of years. Further down the market-cap spectrum we can also boast about engineering brilliance, with the likes of Spirax-Sarco and their world leading thermal and steam systems, and Rotork, a global market leader in valve actuators.
Silver linings share buybacks
The silver lining is that the government and businesses themselves have taken note. The percentage of companies initiating buybacks* in the UK has reached historic highs (almost 45% last year, compared to the 2017-2019 period of just over 20% on average, according to Schroders).
Mergers and acquisitions
In terms of mergers and acquisitions, while the numbers are lower year-on-year, they are still higher than before COVID-19, and it’s mostly US companies who are interested. This makes some sense, given the shared principles on financial law and accounting practices, plus softer factors such as language and culture.
It’s worth pointing out that this is a double-edged sword, because it means we’re losing quality businesses to overseas owners, and all the while the stock market is shrinking. The great de-equitisation process has seen over 500 companies de-list from the London Stock Exchange since 2015; about a 35% reduction. However, this has captured the attention of the Chancellor’s office and the best and brightest within our industry. The cogs appear to be whirring and the campaign to save UK equities has begun.
Are UK equities and in particular small and mid-cap companies a good investment?
Although small and mid-cap investing does not come without risk, we believe there is currently an opportunity to buy UK equities at attractive prices, and we will continue to favour UK SMID caps within the equity allocation of our multi-manager models.
At Adam & Company, we have extensive small company investment expertise, and we believe smaller companies can be a very important part of a truly diversified and well-balanced portfolio – whether you’re investing directly in the shares of smaller companies or via a specialist fund.
Find out more
If you would like to learn more about how SMID caps and UK equities can feature in your investment portfolio, please get in touch.
You may also be interested in:
- Autumn Statement 2023: A statement for growth?
- Investment Outlook November 2023
- Balancing the risk and rewards of investing
*What is a buyback of shares?
A buyback of shares is when a company buys its own shares to reduce the number available on the market. This reduction means the remaining shareholders have a larger stake in the company, and, often increases the value of the stock.
For further information on any of the terms used in this article please see our glossary of investment terms.
Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.
Investments in smaller companies, including AIM stocks, carry a higher degree of risk than investing in more liquid shares of larger companies, so they may be difficult to sell at the time you choose. Investments in smaller companies are more volatile and, while they can offer great potential, growth is not guaranteed.
The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.
This is not a recommendation to invest or disinvest in any of the companies, themes or sectors mentioned. They are included for illustrative purposes only.
The information contained herein is based on materials and sources deemed to be reliable; however, Adam & Company makes no representation or warranty, either express or implied, to the accuracy, completeness or reliability of this information. Adam & Company is not liable for the content and accuracy of the opinions and information provided by external contributors. All stated opinions and estimates in this article are subject to change without notice and Adam & Company is under no obligation to update the information.
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Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.
Investment involves risk and is not suitable for everyone.