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Earnings recovery and attractive valuations strong reasons to see a brighter future for British shares  
Thursday 22 Jul 2021 Author: Steven Frazer

UK stocks represent a ‘once in a generation’ opportunity for investors, say fund managers. After years dogged by political and economic uncertainty, and soggy stock market performance, this is a welcome change of mood music.

‘UK equities are on a 30 year low versus peers, and we see this as a once in a generation opportunity to get involved in some fantastic businesses,’ said Rory Bateman, manager of the Schroder British Opportunities Trust (SBO), which is hoping to capitalise on the return of confidence to the UK.

Bateman suggests that we are at the start of a ‘long journey for the UK,’ but with the worst of business uncertainty seemingly behind us, investors can at last look to the broad sunlit uplands promised by returning confidence in the UK stock market.

More sceptical investors may scoff at Bateman’s apparent dose of British pluck, yet his optimism is shared by an increasing number of colleagues, peers and analysts. Shares has made it easy for investors wanting to play the ‘Blighty Bounce’ by pulling together a selection of top stock picks and fund options geared to UK stock market recovery and prosperity, including supermarket chain Sainsbury (SBRY), bikes and car parts retailer Halfords (HFD), funds Odyssean Investment Trust (OIT), Henderson Opportunities Trust (HOT) and more.


‘We have held the view for some time now that with Brexit behind us and the population vaccinated Britain’s long sojourn in the wilderness could make it an attractive destination for investors in a world where valuations are high in many key markets,’ said Pascal Dowling of research firm Kepler Partners.

Kepler recently ran a survey among clients asking them to describe their outlook for UK equities, and the findings were overwhelmingly positive about the prospects for a continued catch up for UK stocks. According to the study, 77% of the 87 fund management respondents said they’d increased their exposure to UK equities since the third quarter (Q3) 2020, and a similar proportion said they think UK equities remain undervalued as we approached the 19 July unlocking deadline.

This emerging attack of positivity is in stark contrast to recent years, where the UK has been one of the most unloved markets among fund managers during the post-referendum period. But numbers crunched by Kepler analysts demonstrate just how scorned Britain had become.

From 23 June 2016 to the end of September 2020 (just before the vaccine rally), the FTSE All Share fell 3.5% in dollar terms, with the MSCI AC World Index up 50.5%, thanks in part to the pound falling 12.9% versus the dollar. Even as late as April this year, fund managers were ‘underweight’ the FTSE All Share, according to the Bank of America Merrill Lynch Fund Managers Survey.

That research showed fund managers were around 1.5 standard deviations below their historical average positioning. Standard deviation is a mathematical measurement that shows how far away from the average something is.

This was despite the market being one of the best performers in the reflationary rally. Since 1 October 2020, the FTSE All Share is up 37% in dollar terms compared to 27.2% for the FTSE World ex-UK, helped by a 7.9% jump in sterling versus the dollar. Treasure Island to ‘Plague Island’, as the New York Times dubbed Britain in early December 2020.

‘Remarkably, the same survey in May [2021] found that fund managers were 1.5 standard deviations overweight versus their historical average,’ said Kepler’s Dowling.

If this recovery is to have legs it will need overseas help. Majedie’s James de Uphaugh, manager of Edinburgh Investment Trust (EDIN) and the UK equities arm of Majedie Investments, said a crucial element of the rally would be driven by the return of international capital to UK equities.

‘2016 was a big issue – at one point the UK was classed something like Italy in political terms. That is hugely rear-view mirror now; there is political certainty and we have seen an increasingly sure-footed Covid campaign of late, after a bad start, and we can see that international investors are starting to come back.’

Uphaugh says that the risk premium of the UK market is now falling and has scope to fall further. ‘Brexit is no longer the suppurating sore that it once was,’ the manager said.


As for the pandemic, in the short term there    may have been a vaccine boost to sentiment towards the UK, as its faster rollout allowed it to open-up some activities earlier than countries on the continent.

According to BlackRock Throgmorton Trust’s (THRG) Dan Whitestone, the UK’s    positive outlook is based on far more than a simple ‘reflation trade’, although he stresses that active management is the key to unlocking the UK’s potential.

‘There are some phenomenal companies out there and some really awful ones, which makes it a very exciting place for active managers,’ said Whitestone.

Gamma Communications (GAMA:AIM), Electrocomponenets (ECM) and YouGov (YOU:AIM) are among his top portfolio holdings.

Georgina Brittain, who has managed the JPMorgan Smaller Companies’ Investment Trust (JMI) since 1998, echoes Whitestone’s rallying cry for UK smaller companies, saying that the opportunity for UK investors away from the blue-chips is, at this point, like nothing she had seen before in her lengthy career.

‘We are in sell to buy mode, literally crawling through the portfolio looking for things we can bear to let go so we can raise money to add others,’ she said.

It’s not just new listings either. While exciting companies like cybersecurity firm Darktrace (DARK), e-commerce play THG (THG), online auction platform Auction Technology (ATG) and online greeting cards seller Moonpig (MOON) have undoubtedly helped to re-energise investor interest, established companies are also lengthening Georgina Brittain’s stock hit list.

‘We are seeing lots of fresh blood coming to the market, but it is across the board; I only wish that we had more money to buy without having to sell first,’ she said.

Future (FUTR), Games Workshop (GAW) and Dunelm (DNLM) are her portfolio’s three biggest stakes right now.


While this renewed and widespread optimism among experts is hugely encouraging for the future of the UK stock market and individual companies, threats remain that could yet nip recovery in the bud.

Inflation remains on the collective minds of economists and investors everywhere and latest Office for National Statistics data showed the UK economy speeding up again with the UK inflation rate hitting 2.5% in the year to June, the highest for nearly three years, as the unlocking of the UK economy continued, rising beyond 2.1% expectations and ahead of the Bank of England’s 2% inflation target for a second month.

JPMorgan’s Georgina Brittain continues to believe that wage inflation in particular is likely to be a short-term problem for UK companies.

If you look at what is going on in this country – the unemployment numbers and the number of people on furlough – there is something of a disconnect between that and the wage pressure we are seeing, which suggests it is somewhat transitory. This is a very exciting time,’ the fund manager said. Other clouds on the horizon include mounting Covid cases linked to the Delta variant which raises the sceptre of restrictions being reimposed.

Brexit is also not entirely dead in the water as a threat. The UK could yet invoke Article 16 over Northern Ireland, which could throw the whole EU deal under a bus. ‘For this reason we think sentiment is probably still more depressed towards the UK than it could be, which is potentially both an opportunity and a threat,’ said Kepler analysts. The hope is that this tricky issue can be managed and any UK discount will dissipate over the medium to longer term.


A final element to consider is the cyclicality of the UK stock market, and it may help explain why the UK is suddenly in favour with fund managers, and why the earnings outlook is so much better than our global peers. The FTSE’s exposure to energy, basic materials and financials is worth 40.2% of the whole index compared to just 16.8% in the S&P 500 (and 29% in the MSCI Europe), according to Kepler’s data.

‘Perhaps this helps explain why the UK market has performed strongly in the reflationary rally since Q3 2020,’ analysts wonder.

Some of the global reflationary/recovery trends which have been

supportive in recent months may have peaked, with industrial commodities weak in recent weeks and CPI numbers possibly at their peak.

That said, this cyclicality and the weighting to value stocks that caused earnings to collapse during the teeth of the pandemic could now act as a tailwind.

The UK’s earnings recovery is one reason why the latest JPMorgan Long Term Capital Market Assumptions study now forecasts the UK market to have the highest return potential out of all developed world markets over the next five years – and only marginally below the expected return from emerging markets.

That UK equities are on lower starting valuations may not make them screamingly cheap relative to its history, but it might suggest long-term returns won’t be as hindered as other markets by any reversion towards the mean.

Shares believes that the UK still looks attractive as a recovery story, with international investors only now looking at the market more seriously after years of under-owning it.

But the risks explained above means that it is probably wiser to look for growth stories and individual stock picks rather than hoping to make easy gains by buying the index, with parts of the small and mid-cap space expected to throw up interesting opportunities on valuation grounds.

Overleaf we highlight some our own best ideas as well as some of the UK-focused funds we’d back to take advantage of a renaissance for the London market.

UK stock picks

AB Dynamics (ABDP:AIM£21.60

Market cap: £488.6 million

West Country-based AB Dynamics (ABDP:AIM) is a real British corporate success story. Joining the UK stock market at 86p per share in May 2013, its market value has since increased more than 20-fold as it has successfully positioned itself to support an automotive industry in transition.

The shares aren’t cheap based on traditional metrics –2022 forecasts from Berenberg imply a price to earnings ratio of more than 50 times. However, this partly reflects a dip in profitability related to the pandemic and we think its exposure to trends in vehicle safety as well as electric and autonomous vehicles will power it forward and generate strong returns for shareholders in the long term.

The company has a track record of investing in the business for future growth, backed by a strong balance sheet with net cash of £31 million at the last count, developing a suite of unique testing products which are critical in the development of more sophisticated vehicles. Berenberg believes the company can deliver annual organic revenue growth of 10% to 15% in the medium term while also improving its margin performance. [TS]


Halfords (HFD367p

Market Cap: 735.9 million

The leading UK retailer of car maintenance products and bikes Halfords (HFD) has established an increasingly service-led business model with a strong digital presence.

This means that for the first time, customers can access an integrated services offer across stores, garages and mobile through one website.

The company has benefited from the pandemic as more people took up cycling and driving as an alternative means of transport and exercise.

One of the key strengths of the business is its wide UK footprint of 370 auto service centres and around 470 bikes stores which have added extra convenience through the ‘click and collect’ sales model.

Despite the gradual removal of restrictions Halfords is still seeing pent-up demand for bikes and ongoing foreign travel disruptions should continue to support future sales momentum across both areas of the business as staycations gain ground.

Longer term there is a significant opportunity  to consolidate the fragmented auto services market and the company is targeting a network  of more than 1,000 locations. [MG]


Halma (HLMA£27.89

Market cap: £10.6 billion

The FTSE 100 electronics engineer has an almost unblemished track record and shareholders have benefitted from this reliability for years with capital returns close to 1,000% since the end of 2009.

The health, safety and environmental technology group has earned a reputation for operational excellence and consistent growth, and up until pandemic struck, would almost certainly have delivered an 18th consecutive year of growth in revenue and profit.

Let’s also not forget its underappreciated income story, where the business has also delivered 40 years of dividend growth.

While UK-based, Halma (HLMA) is exposed to global trends around health and safety regulation and demand for healthcare and life-critical resources. It makes and sells worldwide in to highly regulated markets, such as hazard detectors to environmental protection kits and sensors, which makes revenues and profits very resilient.

The company’s objective is simple. It aims to double its earnings every five years while still generating strong returns. You need to pay up for this growth. The stock currently trades on 50-times expected earnings for the current financial year to 31 March 2022, falling to a price earnings multiple of 45 the year after. We think this is justified by the track record and continuing growth potential. [SF]


Sainsbury’s (SBRY281p

Market cap: £6.3 billion

With a 15% share of the £100 billion per year grocery market, Britain’s second-largest supermarket chain plays an integral part in national life.

Trading in the 16 weeks to the end of June produced organic sales growth of 1.6% on the same period last year, ahead of expectations for a 1.7% fall and 10% ahead of the firm’s pre-pandemic sales.

Moreover, data from Kantar shows it gaining market share after sales increased by 0.4% in the 12 weeks to mid-June while its three big rivals saw their sales fall.

Management raised its full year earnings guidance, leaving analysts scrambling to upgrade their forecasts, yet the stock remains the second most shorted in the UK market.

While we don’t anticipate Sainsbury falling prey to private equity, the recent bid battle for rival Wm Morrison (MRW) has highlighted how cheap the business is by comparison, trading on just 4.5 times EV to EBITDA (enterprise value to earnings before interest, tax, depreciation and amortization) against a multiple of 8.3 times for its smaller rival. [IC]

UK fund picks

Henderson Opportunities Trust  (HOT) £14.12

Market Cap: £112.9 million

This relatively small UK investment trust is focused on finding the next generation of ‘leaders’ across different sectors irrespective of market cap and trades at a discount to net assets despite a good track record.

The co-managers Laura Foll and James Henderson have a strong bias towards smaller, earlier stage companies that hold significant growth potential while they are also looking to grow dividend income.

The investment style is value driven with a focus on out of favour and under-researched companies trading at attractive valuations.

Over the last three and five years the trust has grown its net asset value by an annualised 7.9% and 13.5% respectively compared with 4.6% and 8.4% for the Morningstar investment trust all company category.

The fund’s largest positions include banks Natwest (NWG) and Barclays (BARC) as well as property group Springfield Properties (SPR:AIM), construction firm SigmaRoc (SRC:AIM) and transport infrastructure analytics software firm Tracsis (TRCS:AIM). The trust has an annual ongoing expense charge of 0.9% and a dividend yield of 1.9%. [MG]


Herald Investment Trust (HRI£22.85

Market cap: £1.47 billion

This is another small cap focused trust geared to technology and technology-enabled businesses - although these days small cap to manager Katie Potts includes companies up to £3 billion – it is now more global in its approach yet remains heavily exposed to UK equities (approximately 49%) where it cut its teeth as a fund.

Trading 10.6% below the value of its  underlying assets versus a 12 month average of 11%, this discount seems to poorly reflect an outstanding returns track record. Sure, over one-year, when growth has largely been out of favour, it has largely tracked its Investment Trusts Global Smaller Companies benchmark, returning 37% versus 36.2%. But if we take a longer view the outperformance shines through, trumping the benchmark’s 79.3% five-year record with a 220% return.

Top holdings at the moment include ID and anti-fraud security business GB Group (GBG:AIM), online media firm Next Fifteen (NFC:AIM) and Pegasystems, the Nasdaq-listed process automator. Ongoing charges stand at 1.08%, fair compared to most other tech and high growth funds. [SF]


Montanaro UK Smaller Companies (MTU) 167.8p

Market cap: £280 million

Over the past 10 years investment trust Montanaro UK Smaller Companies (MTU) has achieved a creditable annualised total return of 10.1% according to data from SharePad and since launch in March 1995 it has returned 842.7% against 238.2% for its benchmark, the Numis Smaller Companies index.

Montanaro invests in smaller companies on AIM and London’s Main Market. These are only small caps in relative terms as more than 80% of the portfolio features companies valued at £500 million or more.

It has an emphasis on quality which saw it underperform in the recent value rally. In the longer term, its focus on the best businesses should pay off.

Manager Charles Montanaro and his team generate their own ideas through detailed financial analysis and company site visits and are conservative on valuation.

Top holdings include cyber security consultant NCC (NCC), ingredients specialist Treatt (TET) and animal drug company Dechra Pharmaceuticals (DPH). The ongoing charge is 0.82%. [TS]


Odyssean Investment Trust (OIT) 158.5p

Market cap: £147 million

Odyssean buys stakes in UK businesses when it believes the market hasn’t recognised opportunities for them to be better companies.

The investment trust’s fund managers come from a private equity background, so they are looking for many of the qualities being sought by private equity players in takeovers.

These attributes include companies with market leadership, ability to make good returns, operating in growing markets and doing something that is difficult for other businesses to replicate.

Six of its portfolio holdings have been subject to takeover bids in the past two years, including Vectura (VEC) and Elementis (ELM).

With private equity currently on a big spending spree, one could easily imagine that more of its investee companies could be takeover targets. Its current holdings include Chemring (CHG) and Clinigen (CLIN:AIM).

Odyssean typically invests when valuations are lower due to short-term trading issues or because there’s been a business setback. It says the market often values stocks on short-term performance, but it takes a longer-term view. [DC]

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