Why investors should consider backing battered UK equities

To say the UK stock market is unloved by investors would be an understatement. The reality is, UK PLC has been largely out of favour since interest rates were cut to record lows in the wake of the Global Financial Crisis in 2008.

Lower interest rates have supported growth companies, such as technology firms, with the likes of the FAANGs (Facebook, Amazon, Apple, Netflix and Alphabet/Google) reaching new highs, courtesy of this accommodative monetary policy.

Growth stocks represent companies that have demonstrated better-than-average gains in earnings in recent years and are expected to continue delivering high levels of profit growth – although this is not a guarantee.  Investors tend to pay a premium for these stocks – in the hope these companies continue to grow at pace.

This is one of the reasons why UK equities have suffered as they do not have the same exposure to these growth sectors. For example, only 1% of the FTSE 100 sits in the information technology sector*. Instead, it has a bias towards value companies – with strong exposure to traditional sectors like financials, energy and industrials, all of which have struggled when compared to these growing tech giants.

Of course, there have been other factors which have played a role in the challenges facing UK PLC – namely Brexit and other ongoing political uncertainty – all of which have hit sentiment hard towards UK companies. The former really has seen investors vote with their feet, with over £30bn of retail asset withdrawn from UK equities between 2016 and 2022**, while international buyers have also steered clear of the market.

The result has been marked underperformance from companies on these shores, with the UK’s FTSE All Share returning 148% in the past 15 years, while the S&P 500 (the largest 500 companies in the US market) grew by some 527%***.

There are other concerning trends emerging, notably the number of companies listed on the UK stock market has shrunk by almost 30% in the past 21 years (2,762 vs. 1,938)****. Regulatory changes have also disincentivised pension and insurance funds from holding equities – to the point where institutional investors now own less than 5% of the UK stock market.

The UK also appears to have stickiest amount of inflation in its system versus its global peers - principally due to wage demands and low levels of unemployment in the UK. The Bank of England is hopeful inflation will fall to around 5% by the end of this year and reach 2% by early 2025*****. Nevertheless, interest rates are still expected to peak at 6%, placing significant pressure on the mortgage market, for those who are rolling off their existing deal.

Darkest before dawn

But it is not all bad news. The UK recorded some growth in the second quarter of 2023, beating many commentator expectations. Meanwhile, the International Monetary Fund has also reversed its view that the economy would enter recession this year. The UK consumer also appears to be showing resiliency towards the higher prices (inflation) in the economy, this is aided by the £200bn of savings made by UK investors during the Covid pandemic.

We thought we’d look into some of the reasons why UK equities look attractive from here. These are five areas which stand out.

1. Valuations

UK companies are now incredibly cheap when compared to their peers and their own history. Between 2015 and 2020, UK stocks have moved to a 45-50% discount when compared to their US counterparts^. Meanwhile, figures from Franklin Templeton show UK equities have not been this cheap - both on an historical basis and relative basis since the Global Financial Crisis^^.

UK All-Companies stock pickers to consider: JOHCM UK Dynamic and Jupiter UK Special Situations

2. QE to QT

The move away from quantitative easing (aiding growth companies) and raising of interest rates (quantitative tightening) has also helped the UK tiptoe its way back into the fold of fashionable markets – with many of the old fashioned sectors previously mentioned looking more attractive again. Artemis Income co-manager Andy Shenton says this suggests the UK is tiptoeing its way back into the fold of fashionable markets to be seen around town and that the case for a more balanced portfolio is valid. He believes factors such as inherent quality and long-term investment in innovation will serve UK equities well in a sustained period of higher, normalised interest rates^^^.

Funds to consider: GAM UK Equity Income and Man GLG Income

3. Small caps always come up smelling of roses

Battered, bruised, and beaten at the moment - UK small-caps always seem to pass every test with flying colours, but the past 18 months has been particularly unkind. Rising interest rates made it more expensive for smaller companies to borrow to finance their growth; while higher volatility raised liquidity concerns.

Simply put, the outlook for UK smaller companies is brightening. This is highlighted by a recent report by Marlborough Fund Managers, which shows the FTSE SmallCap Index (excluding Investment Trusts) has begun to outperform the FTSE 100 and the FTSE 250 over the past six months, returning 4.5% (vs. 3 and 1.1% for the FTSE 100 and 250 respectively)^^^^.

Valuations now look incredibly attractive in this space and small caps have a history of leading markets (in terms of performance) out of challenging periods.

Funds with UK small-cap exposure to consider: ISFL Marlborough Special Situations and Liontrust UK Micro-Cap

4. Global focus offers recession proofing

As previously mentioned, the UK has been able to dodge recession thus far. Part of this is down to the global nature of many of its larger companies.  The FTSE 100 derives an incredible 74% of revenues from overseas, while the FTSE 250 gets 51%^^. This global diversification offers a degree of insulation from recession.

Funds to consider: Artemis Income (which typically has around 75% or more in the FTSE 100) and Schroder Recovery 

5. The home of income

The UK is the most mature market in the world when it comes to dividend payments (income). The Barclays’ annual study demonstrates just how important reinvesting dividends is to long-term returns. An investment of £100 in UK shares in 1899 would have been worth only £173 in real terms at the end of 2018, based on capital growth in the Barclays UK Equity Index alone. If, however, all the dividends had been reinvested, the total value of the portfolio would have soared to £30,776 over the same period^^^^^.

Funds to consider: Schroder Income and Rathbone Income 

*Russell factsheet, FTSE 100, 31 July 2023
**Source: Investment Association
***Source: FE fundinfo, total returns in sterling, figures for FTSE All Share and the S&P 500, 21 August 2008 to 21 August 2023
****Source: Courtiers: Why Courtiers is backing unloved UK market
*****Source: Bank of England – When will inflation in the UK come down
^Source: Fidelity
^^Source: Franklin Templeton – UK equities: Change the narrative for the real story
^^^Source: Artemis – UK equities on the comeback trail – Part 1
^^^^Source: Marlborough: Why the tide may be turning for UK smaller companies
^^^^^Source: Liontrust

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and do not constitute financial advice.