The diminishing size of the FTSE as a proportion of global indices could mean it enters a “vicious circle” where international investors find it easy to overlook the market and it shrinks even further, according to Laura Foll, co-manager of the Henderson Opportunities Trust.
However, she said it wasn’t all bad news for investors in the UK, as the low valuations in the market meant private buyers would continually swoop in to boost share prices to their true worth.
The UK has been out of favour with international investors since the vote to leave the EU in 2016 and Foll said “2021 did nothing to reverse this”. Numerous UK fund managers have pointed to the low valuations of UK assets compared with global peers and recommended buying in before international investors inevitably return.
However, while Foll accepted that the UK was on a valuation discount “on almost any metric you choose”, she warned its plummeting popularity may have reached the point of no return.
“There's an element that is self-fulfilling in that the UK equity market is actually a very small portion of the MSCI World now,” she said.
MSCI World index
Source: MSCI
“Unless it materially outperforms, it is very easy for global asset allocators to ignore. And then it effectively becomes a vicious circle: performance needs to correct, but you need people to pay attention to get performance.”
Despite Foll’s misgivings about whether the UK’s discount to the rest of the world could close, she said its lowly valuation hadn’t gone unnoticed by everyone, pointing out holdings across her portfolios were the subject of numerous takeover bids last year.
“For as long as there is a valuation discount, there will be other players that will seek to close it,” she added.
“Whether it’s for strategic or financial reasons, there will be players that will look to arbitrage that, just as we saw last year.”
This is not the only way in which Foll has benefited from deals made between portfolio holdings and other businesses. Henderson Opportunities Trust is the most unconstrained portfolio run by her and co-manager James Henderson, with 54% of assets in AIM stocks and 25% in the FTSE 100.
Foll said these span categories as diverse as steady compounders, recovery names, high-growth small caps and very early-stage companies.
She said working out a fair price for an early-stage alternative energy company, such as Ceres or ITM Power, for example, was far more difficult than doing so for a blue-chip name such as Marks & Spencer. Fortunately, help has come from the major players in the industrial sector.
“What really sparked the outperformance was when they entered these commercial partnerships. With Ceres it was Bosch and with ITM it was Linde – huge commercial partnerships that we and others took as validation of the technology,” she said.
“It can be really hard as an outsider, trying to work out which of these companies has credibility, and a lot of the time we're only seeing the UK version. You don't know if there's some Japanese fuel cell company that has got far superior technology.”
She added that it was also difficult to know which one was going to be the winner when assessing early-stage businesses, admitting that “we're still going to get a few wrong”, but noting that these partnerships strengthened the due diligence process.
While these ‘blue sky’ companies were major contributors to performance in 2020 – Ceres rose more than 400%, while ITM rose by more than 600% – they struggled in 2021 and are down again this year. Foll said this has nothing to do with performance of the underlying businesses, but reflected the fact these companies had become overvalued, particularly in light of increased inflation expectations.
Performance of stocks over 5yrs
Source: FE Analytics
This is why the managers hold a variety of stocks that can help them perform through a range of conditions, including a top holding that is at the other end of the scale to Ceres and ITM: Serica Energy.
Serica is a North Sea oil & gas company, with an emphasis on the latter. It bought numerous assets from BP after the oil major embarked on a disposal programme.
“Our view is that gas in particular will be used as a big part of the energy mix for a very long time,” Foll continued.
“Five years out, the forecast for net cash on the balance sheet is more than the market cap. Even on some very basic metrics, it still looks lowly valued relative to its cashflow ratio.”
The manager said this gives her enough of a cushion to enter an area of the market where knowing when to sell is as important as knowing when to buy.
“We definitely can't assume that BP or Shell will come along and buy these, which always seemed to be your way out with these smaller energy companies.
“You definitely can't assume that anymore. There has to be a clearer margin of error in the valuation, and I think we can make that argument.”
Data from FE Analytics shows Henderson Opportunities Trust has made 372.8% over the past decade, compared with gains of 149.5% from the IT UK All Companies sector and 104.2% from the FTSE All Share.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
The trust is on a discount of 9.8%, compared with 10.3% and 15% from its one- and three-year averages.
It has ongoing charges of 0.88% and a performance fee of 0.21%. It has gearing of 16%, according to its latest factsheet.