UK stocks are the “cheapest in the world” and remain unloved by many investors, making them attractive to contrarians, according to River & Mercantile’s Hugh Sergeant.
Concerns over the future direction of the UK economy following Brexit have built since June 2016, while the potential for an anti-business Labour government led by Jeremy Corbyn have also forced valuations downwards.
Investors have shunned the UK market, with £1.6bn in outflows from the IA UK All Companies sector in 2017 alone and a further £2bn exiting the IA UK Equity Income sector.
In comparison, just £158m exited the IA UK Smaller Companies sector, which delivered an average return of 27.18 per cent last year.
Performance of sectors in 2017
Source: FE Analytics
However, Sergeant, who oversees the five FE Crown-rated R&M UK Equity Long Term Recovery fund, said the UK stock market has become attractively valued compared with other major indices.
On average, UK shares are nearly as cheap now compared with global peers as they were during the financial crisis when stock markets crashed – and are significantly below their late-1990s peak, he said.
“The UK has rarely been this cheap and after recent Brexit and Corbyn fears, it now leads the rest of the globe in terms of value for money,” he explained.
Like many investors, the River & Mercantile manager has been cautious on what impact the potential factors named above could have on the stock market, positioning his portfolio accordingly.
However, Sergeant now believes things have corrected too far and that is creating new opportunities for valuation-aware investors.
“Where we stand today is that these uncertainties are now largely discounted, that the policy uncertainty is reducing, that consumer sentiment is bottoming out and, perhaps most importantly, that the UK equity market is global in nature as is the source of its revenue and profits.”
As such, the manager said the UK is the most attractive equity market globally, particularly when factoring in the long-term value that domestic equities have historically delivered both from a capital gains and income perspective.
Indeed, since 1986 – the furthest data point available on FE Analytics – the FTSE All Share index has returned 1,951 per cent to investors on a total return basis.
“As the Barclays Equity Gilt Study for 2018 reminds us, UK equities have generated a real compound return of 5.1 per cent per annum over a 118-year period that has on average been as eventful as the last couple of years; so buying our domestic market as cheaply as it is today should be a good idea if you have a medium-term time frame,” Sergeant said.
As such, the manager has upped his weighting to out-of-favour stocks such as mining (10.5 per cent) and financials (27.5 per cent).
Conversely, the fund is underweight “defensive” sectors, in particular utility (1.3 per cent), telecoms (2.9 per cent) and consumer staples companies (17.6 per cent in consumer goods and consumer services sectors combined).
Banking is an area the manager is finding particularly interesting currently, despite the sector’s underperformance for most of the last decade since the financial crisis of 2008.
Indeed, the sector has underperformed the wider FTSE All Share by 109.89 percentage points over the last decade, making a loss of 12.37 per cent.
Performance of indices over 10yrs
Source: FE Analytics
As such, Sergeant owns stocks such as HSBC, Lloyds, Standard Chartered and Barclays within the R&M UK Equity Long Term Recovery fund.
“Banks are lowly valued around the world, have strong balance sheets, generate lots of free capital, are shareholder value focused and, in a number of cases, are able to grow again after many years of restructuring,” the manager said.
Sergeant has run the £273m R&M UK Equity Long Term Recovery fund since its launch in July 2008. Over his tenure, it has returned 260.03 per cent – a top quartile performance in the IA UK All Companies sector over this period.
It is more than double the FTSE All Share’s 126.29 per cent and almost double the sector’s average – 132.34 per cent.
Performance of fund vs sector and benchmark since inception
Source: FE Analytics
Analysts at Square Mile Research said in a recent factsheet that the fund is not for the “feint-hearted” however.
Indeed, while it has made top quartile returns and has a top quartile Sharpe ratio of 0.48 (a measure of risk-adjusted returns), it has been the fourth-most volatile fund in the sector over the period.
“We have a high regard for Sergeant who has been investing in recovery type stocks throughout his career and he has built an enviable performance record running similar mandates,” the analysts said.
“However, this is a high-risk, high-return strategy that really needs to be considered over the long term. Recovery stocks tend to offer a lot of share price upside potential but are extremely volatile and particularly vulnerable during market downturns.
“In our view the experience of the manager and the underlying philosophy and portfolio biases, as well as the investment approach and supporting resources of the firm, are of a pedigree that should enable the fund to meet its performance objectives over time.”
R&M UK Equity Long Term Recovery has a 1.83 per cent yield and a clean ongoing charges figure (OCF) of 1.15 per cent.