The main UK stock market indices have struggled this year and many of the biggest investors rank UK stocks as the most unpopular asset class. Is now the time to go against the grain and increase exposure, buying when others are uninterested? We believe it is.

A survey by Bank of America Merrill Lynch of 235 fund managers overseeing $684bn of assets of under management found that institutional investors were flocking to US equities, saying that part of the market has the best corporate profit outlook.

However a closer look at the survey published earlier in June also revealed that this group of fund managers had made their biggest monthly increase in allocation to UK equities since before the Brexit vote.

We spoke to four managers with large exposure to UK equities to understand why they remain committed to the space.

AREN’T THERE OBVIOUS CONCERNS ABOUT THE UK?

Neil Hermon, director of UK equities at Janus Henderson Investors and manager of Henderson Smaller Companies Investment Trust (HSL), says at first glance there are several reasons why investors may be cautious on UK equities, such as lacklustre GDP growth, consumers under pressure, higher inflation, the FTSE 100 having a high weighting to resources stocks, and unresolved Brexit issues.

However, he argues that the UK is a trusted global brand, the easiest place to do business in Europe and perhaps most importantly the revenues of many FTSE All-Share constituents are geographically diverse.

For example, FTSE 100 constituents generate more than 70% of their revenue outside the UK and the FTSE 250 just under half.

He adds that on a 12 month forward price-to-earnings (PE) basis, UK equities are great value, trading at an average of just 14.1-times. Only Japan trades on a cheaper PE among developed nations.

Cheap valuations plus favourable foreign exchange rates have stirred takeover interest in UK equities over the past few years, particularly from overseas companies looking to expand. Hermon believes small cap stocks, in particular, are sought-after targets.

REGAINING CONFIDENCE

Georgina Brittain, manager of JPMorgan Mid Cap Investment Trust (JMF), says she shifted her portfolio when the result of the Brexit vote came in and reduced exposure to consumer stocks. She was also worried that companies would stop investing following the shock result.

Brittain says many companies are now reviving growth projects which she believes ‘bodes well for the outlook’.

The fund manager is incredibly bullish on the FTSE 250, saying it has produced some of the best returns ‘in the world’. She argues that mid cap companies are in an earlier part of their life cycle and have great scope for growth.

Brittain says that FTSE 250 companies are great challengers to their FTSE 100 peers. For instance she cites discount retailer B&M European Value Retail (BME) as being a great alternative to Tesco (TSCO); and Wizz Air (WIZZ) is less encumbered than International Consolidated Airlines (IAG).

UNDERAPPRECIATED OPPORTUNITIES

Brittain and Hermon at Janus Henderson make the point that small caps and some mid-caps have fewer analysts covering the stocks than large caps which can lead to investors having very limited information on earnings potential for many companies.

This creates an opportunity for savvy stock pickers to pounce on certain stocks where the opportunity is underappreciated by the market.

This resonates with The Mercantile Investment Trust’s (MRC) strategy which is most interested in UK companies outside the FTSE 100 that have significant room for growth and are not recognised by other investors.

While small and mid-sized firms are perceived to have more Brexit-related risk than the blue chips, Mercantile’s co-fund manager Guy Anderson stresses: ‘When we look at our universe, yes it is more domestic than the FTSE 100, but actually from a revenue perspective, it is about 50% from the UK and 50% international.’

Mercantile also has a firm focus on valuation. ‘We look at a range of metrics but the key thing we look at is the cash the business generates because that should be the ultimate arbiter of what it is worth,’ says Anderson, seeking firms with solid fundamentals.

‘We meet about 300 management teams a year – asking them what they think are the prospects for the business and how they allocate capital.’

The fund manager looks to identify positive change, such as a management-led restructuring, a cyclical turning point or a company with underappreciated growth momentum.

Despite the prolonged bull market for equities in many parts of the world, Anderson is still finding new opportunities in the UK-listed space for Mercantile, such as new stock market entrants providing a stream of new ideas.

LARGE CAPS CAN still BE A GOOD HUNTING GROUND

The appeal of UK equities isn’t restricted to the middle and lower end of the market. The large cap FTSE 100 also contains many attractive companies from an investment perspective.

And sometimes the companies don’t have to be entirely healthy to warrant buying the shares as long as there is a catalyst to help drive a recovery back to good health.

Alastair Mundy, manager of Temple Bar Investment Trust (TMPL), is among the institutional investors who look for recovery situations which are present in FTSE 100.

‘I sometimes buy truly terrible companies. My goal is to take them from truly awful to merely bad, then from merely bad to good, then good to great,’ says Mundy.

Although he jokes about looking through dustbins for awful companies he actually employs a sophisticated system to figure out if a company can recover or is a dreaded value trap.

He particularly likes so-called ‘fallen angels’, namely companies once at the top of their game which could return. Examples include Tesco (TSCO), EasyJet (EZJ) and Next (NXT). (DS/JC)

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