UK equity: The not-so poor relation

A lack of enthusiasm for UK equities has seen ownership decline both domestically and globally, but a change in the UK economic environment could bring about a reversal of fortune. Nigel Yates, portfolio manager on the AXA Framlington UK Select Opportunities Fund, outlines why we think everything could be about to change for UK equities.

It’s a national pastime in the UK to look on the gloomy side of things, and it seems that when it comes to the economy the media can’t get enough of it. However, whisper it quietly: things are starting to improve. This is even before we see the inevitable interest rates cuts later this year as inflation falls to around the target level of 2%.

What is the evidence for this? There has been a whole raft of economic data points recently that clearly show things are turning around. For example, the Asda Income tracker¹  is at a two-year high thanks to falling inflation, robust wage growth and tax cuts. Higher incomes are feeding through to higher levels of consumer confidence²  and business confidence is also at its strongest level since 2017³ . Peaking rates and falling inflation are usually positive for equities. Just don’t expect to hear this widely reported in the mainstream press.

There’s more to the UK market than meets the eye

Another common misconception is that the UK market is made up of cyclical, capital-intensive, ‘old economy’ companies. Scratch beneath the surface and you will find plenty of exciting companies aligned to the global mega-trends of digitalisation, energy transition and changing demographics.

We look for companies with the following key characteristics:

• strong balance sheet
• high margins
• defendable economic moat 
• Capital allocation policy that prioritises organic investment 

However, probably the most important metric is their return on capital employed (ROCE) as this is ultimate measure of profit and performance and the main driver of free cash flow.

I know you will have been inundated with Charlie Munger quotes recently, but this is one of my favourites:

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

I like it because it speaks to being patient and to investing in quality companies, the same investment philosophy that we use for the UK Select Opportunities strategy.  

The chart below shows the 2024 ROCE of the strategy and its comparison to a variety of markets. What is pleasing to see is that it is above Charlie’s 18%, significantly higher than the UK market and comparable with the S&P 500. 

Is shareholder value being created?

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Source: AXA Investment Managers/Factset/Bloomberg, as at 26 February 2024. Calculated in sterling. Past performance is not a reliable indicator of future results.

The UK market is also renowned for its global leadership in corporate governance standards. Unlike many global companies, UK corporates have been quick to have their carbon reduction targets validated by the Science Based Targets Initiative (SBTi) and employment practices aligned to the Living Wage foundation.

We look for sustainability as a superior business model. This can take many forms. For example:

• Is the board adequately rigorous and experienced to challenge and support the management teams?
• Can a company’s products and services capitalise from their superior efficiency or reduced raw material use (such as Weir’s products within the mining industry)?
• Companies that prioritise engaging, training and empowering employees are often rewarded with higher retention levels, more innovation and better customer satisfaction (such as Cranswick).

Is Mr Market looking the other way?

So, we have a portfolio of good-quality companies in an improving economy that has falling inflation and possible interest rate cuts. Surely the stock market has seen this coming and priced the recovery?

In short, no. In a global context the UK divergence looks to be increasing.

UK stocks are cheap compared to other markets

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Source: AXA Investment Managers/Factset, March 2024. Price-earnings, calculated on a sterling basis. Past performance is not a reliable indicator of future results.

While the global divergence isn’t really news, even within the UK investors seem to be overlooking the potential: the FTSE 250 and FTSE Small Cap (the markets most geared into a UK recovery) are both trading well below their 20-year average.

Valuations are well below 20-year averages

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Source: AXA Investment Managers/Factset, March 2024. Forward price-earnings, sterling basis, NTM. Past performance is not a reliable indicator of future results.

While investors, globally and locally, may be ignoring the opportunity, it has not gone unnoticed by global private equity and international corporations with a notable recent pick up in M&A activity such as the fund’s position in Spirent Communications. There have been nine approaches of note so far this year accounting for a total of £17.5bn, compared to less than £17bn for the whole of 2023.

You know what they say: if you can’t beat them, join them.