The UK is now so out of favour it is possible to find “digital winners” on the FTSE at prices that make them attractive to value managers, according to Simon Gergel of the Merchants Investment Trust.
Ever since the vote to leave the EU nearly five years ago, the UK market has been unpopular among international investors. It is now at its biggest discount to European peers since the 1970s, with Gergel pointing to a chart showing it is the only major asset class that looks undervalued on a historical basis.
“I should point out the people who put this together are in Frankfurt, they're not UK buyers,” the manager said.
“It's not just us telling you UK shares are about the only cheap asset in the world. If you look across government bonds, corporate bonds and equities, UK equities do stand out as cheaper than the long-term average, whereas pretty much every other asset class is looking more expensive.
“In this case, I think the UK is an interesting place to be.”
Gergel said that not only is the FTSE cheap overall, but a polarisation of valuations has pushed large areas to extreme levels. Close to 20 per cent of stocks are on P/E (price/earnings) ratios above 24x, just 10 per cent are on 14 to 18x, and more than a third are below 14x.
P/E ratios in Merchants trust and FTSE All Share index
As a value manager, his portfolio is skewed towards the latter group, which he said has led to accusations he is just buying value traps that are cheap for good reason. However, he refuted this.
“Some people use the word ‘rubbish’ or other derogatory terms, but we would argue very firmly we're not doing that and to some extent our performance has borne that out,” he continued.
“As an example of the type of company we’ve been buying, we've talked about people having more money in their pocket and wanting to spend it on their home environment, particularly if they have been stuck at home for over a year and sitting on an uncomfortable sofa or if their bathroom is falling apart.
“In some cases, they might want a bigger home, so housebuilders like Redrow are seeing pretty strong performance, a strong trading recovery.
“That whole area is seeing good trading: building products, housing products and so on. They have gone up a lot recently, but the valuations are still pretty sensible.”
Source: MSCI/Allianz
Despite Gergel’s value bias, not all the stocks in his portfolio are trading on lowly P/Es and he will also invest in those that initially appear expensive if he believes the market has underestimated their potential.
This can even take him into what he calls “digital winners”, despite the tech sector’s surge in share prices last year and its association with growth investing.
One example is betting group Entain. Although its most visible brand is Ladbrokes Coral, Gergel is more interested in its digital businesses.
“Entain has really grown its online operations, particularly in America where it is growing explosively,” he said.
“It just announced last week that Q1 growth in America was up over 100 per cent on Q4 last year, and more than 400 per cent on Q1 last year.
“Now that is a special case because of the way the American market is regulated: state-by-state, it is allowing online gambling.
“But that is quite exceptional, and you are able to buy Entain at a really attractive price.”
Returning to the polarisation of the FTSE All Share, Gergel said the market appears to have been split between growth stocks, which are expensive, and value stocks, which are cheap.
However, he said this is a gross oversimplification and that “life isn’t like that”. He added that any competent management team of a company regarded as being ‘low growth’ or in structural decline will do everything they can to turn it around.
This throws up opportunities to pick up growing stocks on attractive valuations, with Gergel pointing to Tate & Lyle as a case in point.
“Tate & Lyle is a classic example where half of the business is making commodity products such as high-fructose corn syrup, which goes into fizzy drinks in America, but the other half is making high-value ingredients for food,” he continued.
“What that allows the business to do is take out sugars and fats and replace them with either low-calorie or natural ingredients, or dietary fibre, making the product far more appealing to consumers, either because of the taste, texture or dietary characteristics.
“That area is seeing good growth, much higher returns, much higher margins, much higher returns on capital, and it announced this week it is considering selling its primary product business. That would transform the business almost overnight.”
He added: “Why that's really interesting is that in this polarised stock market, high-quality ingredient companies trade on high valuations, whereas primary-product businesses trade on low valuations.
“The business mix is improving organically at Tate & Lyle, but if it could do this sort of deal, it could shift the gears quite quickly.”
Data from FE Analytics shows Merchants Investment Trust has made 149.02 per cent since Gergel took charge in March 2006, compared with 123.62 per cent from the FTSE All Share and 117.42 per cent from the IT UK Equity Income sector.
Performance of trust vs sector and index under manager
Source: FE Analytics
It is on a premium of 1.2 per cent compared with discounts of 0.41 and 0.44 per cent from its one- and three-year averages.
The trust has ongoing charges of 0.59 per cent and is yielding 5.32 per cent.