UK equities are now at their cheapest level since the second world war, according to Schroders’ Jean Roche, who says investors shouldn’t allow the pessimism surrounding Brexit to blind them to the value available in the sector.
The co-manager of the Schroder UK Mid Cap trust highlighted a graph from Citigroup going from 1914 to the end of October showing the premium on UK equity yields over gilts is now at its highest since 1941.
Roche said that if the chart was updated to the current day, the premium would be pushing levels not seen since the first world war.
Despite these figures, the November Bank of America Merrill Lynch Fund Manager Survey showed the UK is now the most out-of-favour asset class among global investors compared with historical levels.
“They asked all the fund managers ‘where are you allocating assets?’ and you can see the UK right down there at the bottom,” she said.
“People dislike the UK more than emerging markets, more than they dislike tech, more than they dislike even the eurozone and you know there was a capital city on fire there last week.”
However, despite this pessimism, Roche said that the UK could well be in position to win “a least ugly competition” among all those sectors perceived to be in trouble, with the underlying data painting a more upbeat picture
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For example, the UK consumer spent £661.7bn in the first half of 2018, an increase of £22.8bn over the same period in 2017.
And it is not just being spent online, either. The UK consumer spent £900m more on clothing in the high street during the first half of 2018 than it did in the same period for 2017.
Of course, Roche said you need to be extremely selective when looking for value in areas facing structural decline – for example, she said the fact that House of Fraser and Debenhams had no Christmas decorations up two weeks into November was “a pretty depressing” sign.
Instead, she has increased her position in JD Sports.
“I think as a country and around the world we are seeing this, we are still very interested in shopping for the coolest sportswear and that’s spilled over into everyday wear as well,” the manager said.
“A lot of millennial customers don’t have debit cards, they don’t have Apple Pay. About 30 per cent of JD Sports’ customers want to go into a JD Sports store and pay for the coolest trainers using cash.”
Another trend JD Sports’ stores are benefiting from is the sale of exclusive brands, such as Adidas’s Yeezy trainers, which cost £175 a pair but invariably sell out by the end of the first day.
That is not to say that the company is blind to the threat of online shopping and, similar to the likes of Amazon and ASOS, it offers same-day delivery through its website. Roche said that e-commerce’s disruption of the high street could even work in its favour.
“I saw a property company last week and they were saying to me the last few retailers in negotiations with the landlords are going to have huge pricing power because you have all of these CVAs [company voluntary agreements] going on.”
Company voluntary agreements are used to lessen the risk of insolvency. They allow troubled retailers, for example, to opt out of leases with landlords on loss-making stores, while negotiating rent reductions on others.
“So, all of the retailers that stay on are going to get 30 per cent discounts off their landlords,” Roche continued.
“There was a landlord I saw last week called LondonMetric and they want to move out of retail into urban logistics and so on. And they accept they are going to get a lot less in rent than they were from retailers because the world is changing and is being disrupted.”
The manager added: “The other thing I like about JD Sports is they are one of only two quoted players in the sector, and their margins tend to drift between 40 and 48 per cent, so that’s a good place to start.”
When taking this sort of value approach to stockpicking, it is important to have a strong sell discipline. While Roche said she hopes all the companies in her portfolio reach the FTSE 100, one hard rule involves selling out as soon as they do.
Most often though, the reason the manager sells out is based on valuations.
“I tend to look at ‘PEG’ ratios which is P/E divided by forecasted three-year growth,” she said.
“It doesn’t work for every sector, but if I see a PEG ratio getting much above 2 or 2.2, or it starts to move out of the boundary where it has been before, I take a highly scientific approach where I arrange my stocks every week in colour-coded bands. If my stocks move out of my bands, I think ‘why is that?’ What has been going on here because it suddenly looks very expensive?”
She also pays close attention to company accounts and if she sees a lot of exceptional items on the balance sheet, high debt to working capital or excuses that don’t add up, she meets with the management team.
“For example, we have had chemicals companies saying they have had rising raw materials prices when the oil price is going down, so we started looking at shipping out,” she said.
“Also, if we have a meeting with a management team, and they are not able to answer my questions sufficiently, or if a market is being disrupted and I feel like a management team isn’t tackling that, then that will definitely see me heading for the door.”
Data from FE Analytics shows that Schroder UK Mid Cap has made 9.64 per cent since Roche joined Andy Brough as co-manager in September 2016, compared with 11.24 per cent from the IT UK All Companies sector and 3.96 per cent from the FTSE 250 (ex IT) index.
Performance of trust vs sector and index under manager tenure
Source: FE Analytics
The trust is trading at a discount to net asset value [NAV] of 16.53 per cent compared with 15.64 and 16.01 per cent from its one- and three-year averages.
It has ongoing charges of 0.92 per cent and is not currently geared.