Actively allocating to an improved UK outlook

George Godber on how investors can make the most of opportunities against an improved UK outlook.

The UK stock market offers a fabulous breadth of opportunities as one of the most diverse equity markets in the world. Investors can access almost any global market and investment theme through the incredible array of businesses that have chosen to list on the London Stock Exchange over the years.

However, since the Brexit referendum investors have chosen to shun exposure to the UK and sterling-based assets. International investors have reduced their UK holdings to multi-decade lows while even domestic investors have reduced exposure to UK equities in favour of overseas markets.

Source: The Investment Association

Broadly speaking, UK domestic shares trade at a substantial discount to those that are more internationally focused. We estimate that purely domestic-focused shares listed on the FTSE 100 trade on average at 12.8x PE compared to those that earn the majority of their revenues overseas at 15.7x.

Source: Bloomberg as at 20 April 2018

This divergence of valuations in part stems from the perceived weaker outlook for the UK economy as it travels through Brexit compared to the steady, synchronised global growth the rest of the world is delivering.

However, is this starting to change? The perceived wisdom at the start of this year was that the outlook for the UK was weaker than for the global economy whereas now real wages are finally increasing in the UK while the outlook measured by global PMIs are weakening. So is the early-2018 view now open to challenge?

We believe it is, but we also believe the top-down picture is not that clear or that simple. The UK domestic economy still faces notable headwinds in the form of a continued tough outlook for take-home pay, notably from council tax rises and auto-enrolment pension increases. So, while wages are rising, disposable income is not. And while the overseas picture is less clear than it was, there is still a fairly healthy outlook for the global economy despite the introduction of trade wars and increased geo-political tensions. Neither is perfect, but both still offer good opportunities.

Making top-down investment decisions means you are open to fast-changing short-term data points that can force you into too many U-turns.  It is difficult to interpret noise from something more fundamental or identify the start of a trend - often, you only know the right answer after the event. 

Our deep-rooted belief is that sound investment decisions can only be made through a detailed understanding of the exact fundamentals of a business.  A thorough analysis of a company in terms of its financial position, capital investment and outlook coupled with a firm view on the price you are willing to pay gives a far greater chance of investment success than simply looking at volatile economic data.

The active share of a fund is a measure of how differently a fund invests compared to the make-up of its benchmark. It shows how much importance an investment manager places on active stock-picking as opposed to hugging the index.  In other words, it is a measure of how selective managers are in making their investment decisions and the importance they put on in-depth analysis. 

Many ’active’ funds in the UK still have a very low active share, with similar holdings to the index itself, in effect focusing their investors’ capital on a concentrated, narrow group of very large companies, overlooking the fabulous breadth and diversity the UK stock market has to offer. Given the issues both the UK and global economies face at the moment it feels more than ever that now is the time to be selective in your investment approach. 

In fact, the recent spike in UK M&A activity and the breadth of companies that have attracted the interest of corporate buyers is perhaps indicative that despite people shunning UK investments there is genuine absolute value in the UK. The longer-term prospects for these businesses is perhaps better than the stock market’s implied valuation. 

Being active in itself does not imply better investment returns. That can only be done alongside an assessment of how a manager deals with risk and the robustness of their investment process. However, right now it feels it is an essential thing to consider. 


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