What a difference six months makes. After a tremendous 2022 for the UK’s FTSE All Share, compared to overseas markets, the index has fallen by the wayside versus foreign peers so far in 2023.
The US, Japanese, European and emerging markets have all performed better. So what’s behind the change in fortunes for UK stocks?
The problem comes back to that source of many of our country’s ills of late – inflation. The UK consumer price index for June came in below expectations at 7.9% (versus estimates of 8.2%), with a core inflation rise of 6.9%. But UK inflation this year has been stickier than in the rest of the developed world, with services inflation particularly strong.
This, said Hugh Sergeant, portfolio manager of the ES R&M UK Recovery fund over at River and Mercantile, “caused a re-pricing of interest rate expectations last quarter and a material fall in the valuation of UK equities and streams of income exposed to either bond yields or the chance of a recession”.
However, Hugh sees this as a “big opportunity”. “Recent inflation numbers seem to have confirmed everyone’s worst fears about the UK, encouraging the valuations of things that were already cheap to become even cheaper,” he said.
Valuations are low in the UK, and in many cases at “giveaway” levels, he argued, “providing an amazing opportunity to pick up bargains”. Panmure Gordon calculated earlier this year that valuations of UK companies are on an average discount of 18% to comparable businesses in other developed markets.
Chris Kinder, portfolio manager of Columbia Threadneedle’s CT UK Extended Alpha fund, said this opportunity for bargain hunting is keeping steam in UK mergers and acquisitions. “There is still a lot of M&A going on despite the weak lending environment, confirming the cheapness of the UK to international capital,” he said.
One fund manager who has seen this rush for cheap UK M&A first hand is Eustace Santa Barbara, co-manager of the IFSL Marlborough Special Situations fund. “In recent months we have seen three companies we hold in our smaller companies funds targeted for acquisition,” he said.
Veterinary drug maker Dechra Pharmaceuticals is one. It received a private equity bid at a 46% premium to its share price. Smart meter and housing maintenance company Sureserve has also agreed a private equity bid, at a 39% premium. Finally, restaurant operator Fulham Shore was bought at a 35% premium by a Japanese company that plans to expand the business internationally.
“This flurry of M&A activity reinforces our view that UK companies are undervalued,” said Eustace.
The discount increases as you move down the market-cap spectrum into smaller companies, which look cheap in absolute terms, in comparison to other developed markets and relative to their historic averages. “We don’t think this discount will last forever,” Eustace said. “However, while it exists, it’s enabling us to invest in high-quality UK smaller companies at significantly reduced valuations.”
He has been deploying cash to add to Marlborough Special Situations’ existing positions in quality companies he believes look significantly undervalued. These include IG Design, which supplies leading global retailers with wrapping paper, and Genus, which is a world leader in animal genetics.
“The companies we favour are those we believe have strong long-term growth prospects, high-calibre management and robust balance sheets, with relatively low levels of debt, which means they are well positioned to navigate challenging macroeconomic conditions,” he said.
Looking ahead, the long-term case for innovative and agile UK smaller companies, and their ability to outperform slower-moving corporate giants, remains strong. “It is rare to have the opportunity to invest in outstanding UK smaller companies at the share prices we are seeing today,” said Eustace. “For investors with a medium- to long-term perspective, we believe current valuations represent an exceptional long-term opportunity.”
Brexit, Boris Johnson, Liz Truss, high inflation, low productivity – these are all reasons the valuations of UK companies have been hit in recent months. But as the latest inflation figures show, the UK is seeing falling energy prices, and easing food and household goods costs, in a relief to markets and central banks.
Hugh Sergeant is looking on the upside: “In contrast to the overwhelming narrative that the UK is doomed, I actually feel that the short-term fundamentals are reasonable and the medium term is getting really quite exciting as this government delivers the Windsor, Edinburgh, and Mansion House reforms.”
Domestic stocks are currently unloved and mispriced – but these could be two good reasons to revisit the investment prospects of the UK market.
Darius McDermott is managing director at Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.