Our UK team discuss the exciting opportunity for actively managed UK equities to generate globally competitive returns.
At Majedie we have been focused on delivering long-term UK equity returns since first investing on behalf of clients in 2003. Throughout this period, we have applied a consistent investment process of managing stock-driven portfolios, underpinned by deep fundamental research and a flexible investment style.
Despite UK equity returns lagging global equities in recent years, we are encouraged by the present potential for actively managed UK equities to generate attractive returns. In our view, UK equity returns should be at least as good as those of global equities in the years ahead. Indeed, for the reasons we outline in this note, we believe they could be better. The key reasons for this optimism are:
• The attractive valuations of many UK stocks versus their international peers
• The UK market is deep, with a wide pool of best in class global businesses
• The UK represents a more balanced, diversified index than before.
We explore each of these points in further detail below.
Valuations for UK-listed stocks are compelling
Investors in the UK market can access strong businesses at attractive valuations relative to their global peers. We illustrate this in Figure 1 with a selection of UK stocks drawn from our portfolios. Even when the profitability of a business is lower than that of its peers – we have used return on invested capital as a proxy – we believe the scale of discounts is often unjustified.
We are firmly of the view that stocks such as these offer the medium-term investor excellent opportunities in both absolute and relative terms.
An element of these valuation discounts has arisen because of the prolonged Brexit process. The withdrawal process has led to severe underperformance of the UK market relative to global equities, including the technology-rich US equity index. Regardless of which way Brexit goes, we believe the stocks we hold are ready for it and will trade through it. We have been discussing with management teams the issues of Brexit trading for many months. Those businesses that we hold with big trade flows with Europe are ready. Prime examples of preparedness include food retailers. In the same way that they smoothly handled rapidly changed trading conditions at the onset of the pandemic, we expect them to handle any Brexit trading challenges too.
The stock drivers of our UK portfolio returns are well diversified, and our funds have not been skewed in anticipation of any particular Brexit outcome. Resolution – in whatever form it takes – should lead to improving clarity. By remaining flexible and open minded about any investment opportunities that arise, we expect to pursue opportunities caused by any ensuing short-term volatility to enhance further the long-term return potential of the portfolio.
Figure 1: UK stocks versus international peers
Source: Exane, Morgan Stanley. ˟Held in Majedie UK Equity Fund; ˠHeld in Majedie UK Focus Fund
The UK is the home of best-in-class global businesses
The UK is one of the world’s largest equity markets by market capitalisation. It contains a deep and broad selection of businesses for stock pickers. Today, approximately three quarters of the index’s profits come from outside the UK. Our analysis and investment process has always taken account of this by taking a global perspective. When assessing prospective UK-listed investments, we compare and contrast them with their international peers. To make it into a Majedie portfolio, a business must compare well globally.
Figure 2: The UK equity market appears lowly valued compared to global averages
Source: FactSet, as at 30 September 2020
We find no shortage of compelling investment opportunities in UK-listed stocks that are leaders in their fields. Current examples include Tesco, a best-in-class food retailer on a double digit FCF yield; Fever-Tree, a high return, capital light global leader in premium mixers that is early in its assault on the jewel of the US market; and Unilever which has unrivalled emerging markets (EM) distribution and sustainability credentials. There is BAE Systems, the defence contractor with advantaged positions in US programmes that is valued on a steep discount to peers; and Ashtead*, the equipment hire operator with an attractive market position and compelling US growth opportunity. The increasing digital footprint of RELX, the long-term EM growth opportunity at Diageo*, and the global supply chain muscle in a fragmented sector at Compass* are others. There are many more.
The UK market also benefits from a strong culture of corporate governance. Part of this comes from the market’s long history of standards and practices, and part from a robust regulatory backdrop that continues to lead many international businesses to seek UK listings.
The UK now has a more diversified stock market
As Figure 3 illustrates, the UK market structure has changed significantly in recent years. The UK market now has smaller weighting in sectors such as banks and oils. It has higher weightings in areas that are more likely to generate attractive future growth, such as consumer goods, wealth management and pharmaceuticals. This greater diversification should bring more balanced returns from the index. More importantly, it affords active stock-pickers like us even greater flexibility to target the most attractive available investment opportunities.
Figure 3: The changing shape of the UK equity index
The UK market continues to offer a premium dividend yield relative to global equities. The good news is that this is no longer driven by sectors such as oil and banks: this feature is again much more diversified with income increasingly coming from sectors such as health care and industrials. After Covid-19 we also expect dividend policies to be more prudent, but still globally competitive. As a result, we think the UK dividend premium is now more sustainable.
The flexibility to invest up to 20% in global stocks
We do not pretend that the UK market is perfect. Like all markets, the UK index has biases. But as we have illustrated above, the index is now more balanced than previously. Nevertheless, we recognise that there will be times to hold stocks outside the UK. These may provide exposure to areas that the UK market is still relatively light in, such as technology. Or it may be because certain stocks are simply more attractive than UK peers, as we currently find in some parts of the pharmaceutical sector.
At Majedie, the process of comparing UK and overseas stocks is seamless: our investment team operates as one unit, with ideas and analysis from around the world exchanged and scrutinised by all. Current examples of overseas stocks in the UK portfolios include:
• Roche – best in class pharmaceuticals and diagnostics
• Etsy – a niche e-commerce platform for artisanal goods
• eBay – a leading e-commerce platform
• NXP Semiconductors* – a leading designer of semiconductors, focused on the automobile market.
We are confident that there are attractive returns potentially available from actively managed UK equities in the years ahead. Arguably, this market looks “cheap” – a view certainly supported by both the operational strength of the holdings in our portfolios, and their valuations.
Sterling may also be undervalued. We monitor the currency closely but believe underlying stock-driven dynamics will trump any headwinds for the overseas earners in the portfolio – to say nothing of individual companies’ own hedging programmes.
We also note the steady inward investment into the UK by international investors. Whether this be by corporates or by other institutions, the UK remains an attractive market for long-term capital.
In short, UK equities are ripe for a recovery, and we believe they may offer returns at least as good as those of global equities in the years ahead. We will exploit this with a flexible, style-agnostic, stock-driven process. We look forward with confidence.
NOTE: All stocks mentioned are examples of holdings found in both the Majedie UK Equity and Majedie UK Focus portfolios, unless otherwise indicated and with the exception of those marked by an asterisk (*) symbol which are held in the UK Equity Fund only.