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UK smaller companies still appeal despite political headwinds

17 May 2018

Phil Harris, manager of the EdenTree UK Equity Growth fund, considers the outlook for the UK small- and mid-cap stocks with Brexit dominating the headlines and as the retail sector continues to suffer.

By Phil Harris,

EdenTree Investment Management

  Investors in UK markets are once again faced with complex economic, political and financial cross currents.

Domestically, the key issue is clearly Brexit and the economic and political matrix accompanying the continuing negotiations. Upcoming talks on trade are likely to be more difficult than many of the elements already agreed, while the government’s minority status leaves it vulnerable in key votes. Indeed, a forced general election, which ushers in a decidedly business-unfriendly administration, is the largest risk.

While heightened political risk emanating from the precarious state of the UK’s present government does not inspire much confidence, the underlying economic picture, supported by a strong global growth backdrop, offers a glimmer of hope.

Investors will need to keep a close eye on consumer spending, which is a key determinant of UK economic growth. The past year or so has proved challenging for consumers, where we witnessed real wages decline as currency-induced inflation came to the fore. If inflation has peaked, there may be some real wage gains coming to the aid of the beleaguered UK consumer.

 

Opportunities down the market-cap spectrum

What does the economic environment mean for UK equity markets? It is important to consider long-term valuation multiples to understand the attractiveness of stocks in light of historical trends. The price to earnings ratios for the FTSE 100 and FTSE 250 indices continue to trade at multi-year highs.

Earnings expectations for the market show continuing steady growth. However, should sterling hold its recent level in excess of $1.40 against the dollar, large-cap stocks – which are dominated by overseas earnings – are likely to see substantial earnings downgrades.

Mid and small caps, which have a larger domestic earnings base, trade at a very low premium against large caps versus history – suggesting to us there are more attractive opportunities down the market capitalisation spectrum. However, after a strong run for the FTSE 250 last year, the opportunity is not as compelling as a year ago.

 

Housing robust, but avoid secondary banks

While generally optimistic over UK economic prospects, some sectors – particularly retail and large-ticket consumer areas – will continue to suffer cost pressures and deferred orders.

Consumers are rationally prioritising spending on low-ticket ‘essentials’, such as dining out and holidays, while delaying purchasing larger items – such as a new car.

The housing market remains robust despite this trend, supported by continued low mortgage rates, as well as the ‘Help to Buy’ programme and recent stamp duty changes for first-time buyers. While price rises are modest, so is cost inflation for the all-important land. With valuations still low and cash flows robust, expect continued outperformance from house builders.

Another concern is some of the newer UK secondary bank entrants, especially the groups with significant motor loan books.

Car manufacturers and other finance houses have significantly relaxed motor lending criteria over the last two years, with loan-to-value ratios of more than 120 per cent on rapidly-depreciating second hand cars being offered to customers with poor employment histories and low salaries. This is surely storing up significant write offs. History suggests the banks that are growing loan books at more than 30 per cent per annum, are taking on borrow qualities and risk levels likely to be detrimental to equity shareholders.


Equity appeal continues relative to bonds

Examining the ratio between equity yields and bond yields, the relative value of UK equities against competing asset classes continues to be attractive – despite this being the case for several years. Nevertheless, with rates predicted to continue to stay low, the higher and rising yields offered by equities continues to appeal.

As mentioned earlier, while many large cap yields look stretched, given low cover and low earnings growth, we remain bullish on the underlying dividend cover and growth prospects within the mid and small-cap area of the market.

Phil Harris is manager of the EdenTree UK Equity Growth fund. All views are his own and should not be taken as investment advice.

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