UK equity investors who believe the outlook for the market has improved since the Conservative party’s landslide general election result should think again, according to Artemis Fund Managers’ Adrian Frost.
The UK equity market has been the consensus underweight position since the EU referendum of 2016 introduced considerable uncertainty regarding the UK’s future relationship with the bloc, its largest trading partner.
A minority government subject to the whim of its backbenchers and the goodwill of other politicians made the protracted negotiations to exit the EU even harder.
But for investors in the domestic market, it has been harder still.
“We are fond of saying that aspects of investing are akin to being asked to complete a cryptic crossword,” said Artemis Income manager Frost (pictured). “What is not in doubt is that the crossword investors in the UK currently face is a particularly challenging one.
“The task of solving the local riddles of Brexit and politics is further complicated by the global conundrums of escalating and de-escalating trade tensions and oscillating bond yields.”
In the UK, Frost said worries over Brexit have prevented the market from rallying during the “bouts of exuberance” that have been seen elsewhere in the world.
These so-called ‘bouts of exuberance’ haven’t been fuelled by any particular improvement in corporate performance, which remains mixed, he said.
“The result is that the UK stands at a marked valuation discount to other major markets,” he explained.
And things are starting to look up for the domestic market, with improving sentiment driven by a strong general election result for the Conservative party, giving the economy greater certainty over the direction of Brexit and seeing-off the threat of an anti-business, left-wing government.
Yet, as the below chart shows, over the past three months the FTSE 100 has lagged its other peer indices, in local currency terms.
Performance of indices over 3mths
Source: FE Analytics
“Despite the recent strength of UK equities, their appreciation has been noticeably less than that of many other major equity markets,” said Frost.
“So the Brexit discount persists – this can be seen both as a source of upside and as a margin of safety.”
In addition, the equity income manager said it may take some time for international investors to return to the market given that “the possible ways forwards for Brexit and politics remain as overgrown and indistinct as ever”.
Nevertheless, for those with different objectives and timelines there will be opportunities to exploit such a disconnection in markets, said Frost.
“The longer this discount persists, the more we expect M&A activity,” he explained. “This represents a dilemma for shareholders as although at first sight the handsome takeover premium looks attractive, referring back to a company’s pre-referendum share price often diminishes this apparent generosity.”
Frost said the Artemis Income fund had benefited from M&A activity as long-term holdings aerospace manufacturer Cobham and satellite telecommunications company Inmarsat received bids last year. Another holding – London Stock Exchange Group - also profited from a takeover bid that eventually lapsed.
Proceeds from the takeovers of Cobham and Inmarsat were reinvested into drinks manufacturer C&C following the purchase of distributor Matthew Clark.
“Since 2010, the UK has seen 199 new distilleries opened. Since 2015, 1,937 new beer or cider brands have been launched,” he said. “This is bolstering the demand for distribution.”
Another new addition to the portfolio was National Grid, which – following the general election has seen the threat of a regulatory review and renationalisation recede – now looks more compelling.
“A substantial part of its business is in the US where these assets are more highly valued,” said the manager. “Furthermore, the further development and expansion of the electricity networks is a critical component of decarbonising economies and thus a structural tailwind for companies such as National Grid.”
Price performance of National Grid over 6mths
Source: FE Analytics
In addition, the Artemis manager said there had been some opportunistic buying – adding to positions in Barclays, ITV and Tesco.
“Some might see this as a tactical move towards more Brexit-sensitive stocks,” he said. “In reality, the weakness of these companies’ share prices relative to their underlying investment cases that were largely unchanged prompted us to buy.”
Sales from the portfolio included BBA Aviation – which disposed of prixed infrastructure assets – and Royal Dutch Shell – which may need more cash to fund an energy transition, putting pressure on dividends.
Frost has managed the £5.2bn Artemis Income fund since 2002, working alongside Nick Shenton since 2014 and latterly joined by Andy Marsh in 2018.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
Over the past three years, Artemis Income has made a total return of 22.89 per cent, outperforming both the FTSE All Share benchmark (21.05 per cent) and the average IA UK Equity Income peer (18.26 per cent). The fund has a yield of 4.38 per cent and an ongoing charges figure (OCF) of 0.8 per cent.