Finally, everyone is talking about UK stocks. The spotlight is back on the country after the UK’s FTSE 100 was one of the few major indices globally to record positive returns in 2022 and this year it has broken through the 8,000 level and hit a new record high. Hopefully, this will lead to the return of foreign investors who have shunned the UK since the Brexit vote in 2016.

Investors can either buy individual shares or obtain broader exposure via funds, investment trusts or exchange-traded funds. This article offers some investment ideas and explains what to consider with the large, mid and small cap parts of the market.

LARGE CAPS

The FTSE 100 is an index of the biggest companies on the London Stock Exchange, dominated by pharmaceuticals, oil producers, banks, miners, consumer brand companies and tobacco manufacturers.

The one thing that unites these sectors (excluding consumer brands) is cheap valuations. The reasons behind many of these low price to earnings ratios is two-fold. First, oil companies, miners and banks are highly cyclical industries and have unpredictable earnings. They typically trade on low price to earnings ratios as a result.

Second, oil companies and tobacco producers sell products deemed unfriendly in the modern world from an ESG (environmental, social and governance) perspective. Many investors will not touch these stocks full stop, hence they carry a market discount.

The FTSE 100 has lagged the S&P 500 index in the US for more than a decade but finally came out of its shell in 2022 when there was a market rotation towards value stocks, many of which can be found on the UK stock market.

Investors were less willing to pay high multiples of earnings to access growth companies in a rising interest rate environment, so value stocks shone in 2022. The FTSE 100 with its multitude of lower growth, but profitable and cash-generative firms suddenly became in vogue.

Last October, investors developed a bigger appetite for risk, with previously sold-off areas such as small and medium-sized companies and US stocks beginning to bounce back. Interestingly, the FTSE 100 did not go into reverse; instead, it has continued to push ahead. That tells you we are not simply seeing a rotation back to the areas which previously did well before the big sell-off that started in late 2021.

We may only see a couple more interest rate rises this year but there are not expectations for rates to suddenly come down at a rapid pace, so a higher cost of borrowing is something that consumers and businesses will have to stomach. That suggests value stocks could continue to do better than growth stocks for the foreseeable future.

Inflation is also proving to be stickier than previously anticipated, despite key components such as energy coming down in price. Therefore, there is a good argument to suggest that large cap UK stocks will remain in demand.

‘A recession may not a big surprise now, at least from a share price perspective, and if we get an alternative outcome – such as stagflation, inflation and stickier-than-expected interest rates – the UK equity market’s charms may become more apparent,’ says Russ Mould, investment director at AJ Bell.

‘There is the potential for upside to earnings estimates, especially as the slant of earnings towards oils, miners and banks means the FTSE 100 may be one of the indices that is better suited to an inflationary or stagflationary out-turn which could mean interest rates stay a bit higher for a bit longer than expected and that the yield curve turns out steeper than expected.’

---

---

---

THE SECTORS THAT MATTER

It’s important to think about the sectors that dominate the index as these will be the drivers to help the FTSE 100 reach even higher levels.

Oil producers: Investors have realised these companies are still making significant amounts of money and dividends are growing again. Demand for oil remains robust despite a global shift towards renewable energy and companies like BP (BP.) have realised the transition away from fossil fuels is going to take longer than previously expected. Valuations remain cheap.

Miners: A lack of investment in new projects over the past decade provides support for commodity prices as supplies are getting tighter across metals and minerals.

The reopening of China’s economy provides a tailwind for commodities demand and there is a structural growth driver from decarbonisation. The transition to renewable energy and a shift from internal combustion to electric vehicles require significant amounts of metals and materials.

The mining sector is sensitive to economic news, so buying shares when the outlook is mediocre to gloomy is better than buying when everything seems rosy as you should get a better entry point.

Banks: We have returned to a more normal interest rate environment, and one where banks should be able to make better earnings than the past decade or so of low rates.

Longer term, the banking sector is not an attractive place to invest due to regulatory pressures and elevated levels of competition. But short term it could be a source of positive returns.

Banks are better capitalised as we enter a potential economic downturn. That said, Barclays’ (BARC) poorly received results on 15 February show it is not all plain sailing.

‘By the very nature of markets, there will be some so called “Hot Money” involved,’ says Rob James, a fund manager at Premier Miton. ‘Banks that have missed forecasts, even marginally, have seen sharp (downward) share price movements as the hot money leaves. But to me, this is noise. Interest rates are not returning to the zero band.

‘Sure, there are some headwinds to consider. Inflation is affecting everyone, so costs will have to rise. Higher rates will inevitably lead to higher bad debts. But the juggernaut of interest income has a powerful engine, and will reward shareholders through significant capital returns, be that in the form of dividends or share buybacks, the latter of which boost earnings per share for those that remain invested.’

Tobacco: Stocks remain cheap because investors either do not want exposure to this sector for ethical reasons or they question the long-term growth in a world when regulation is tightening, more people are health conscious and there is a structural shift from tobacco to vaping.

However, tobacco companies have continued to churn out the profits and cash which fund large dividends and share buybacks. If lacklustre economic conditions continue for the rest of 2023, defensive names such as tobacco stocks could be in fashion again.

Consumer goods: Owners of prized brands have been pushing up prices but there are concerns that if they go up too much then consumers will look for cheaper alternatives. Despite this risk, Unilever (ULVR) and Reckitt (RKT) are both undergoing management changes which the market hopes will result in a sharper focus and hopefully stronger returns in time.

Beverages: Diageo (DGE) is the only stock in this sector that really matters to the FTSE 100. It has benefited from the reopening of the hospitality industry post-Covid, more people travelling (as it shifts a fair number of whiskey bottles via airport shops), and the shift towards premiumisation with regards to alcohol choices.

Pharmaceuticals: GSK (GSK) is one of two big players in this sector within the FTSE 100 and trades at a 20% discount to its industry median, providing investors with a value stock opportunity. A string of good news from company is helping to revive its share price.

---

Two ways to play the UK larger company space

Temple Bar (TMPL) 243p

Discount to net asset value: 7.1% – Yield: 3.9% – Ongoing charge: 0.48%

This is a value-focused investment trust well suited to the current market environment. Co-managed by Redwheel’s Ian Lance and Nick Purves, Temple Bar seeks to achieve a greater total return (share price gains and dividends) than the benchmark FTSE All-Share index by investing in UK shares.

Performance has turned round significantly since Redwheel’s appointment as manager in 2020.

Lance and Purves consider a company’s growth prospects and sustainable levels for profit margins and then calculate an intrinsic value for the business, looking to invest when the shares trade below this intrinsic value.

The onus is on larger companies selling cheaply which have strong enough balance sheets to survive any short-term problems.

The top 10 as of 31 December included retail bellwether Marks & Spencer (MKS) and broadcaster ITV (ITV) as well as energy giants BP and Shell (SHEL), British Gas owner Centrica (CNA), education publishing group Pearson (PSON) and banking group NatWest (NWG).

---

---

City of London Investment Trust (CTY) 425.5p 

Premium to NAV: 1.8% – Yield: 4.7% – Ongoing charge: 0.37%

Investors seeking a conservatively-managed income fund offering exposure to the ‘best ideas’ of the FTSE 100 and an attractive 4.7% yield should buy shares in City of London (CTY).

Managed by Job Curtis since 1991, City of London is renowned for its 56-year record of unbroken annual dividend increases.

Targeting long-term income and capital growth from high-quality large caps with strong balance sheets, City of London is a happy holder of so-called ‘sin stocks’ including cigarette makers British American Tobacco (BATS) and Imperial Brands (IMB), defence contractor BAE Systems (BA.) and alcoholic drinks giant Diageo.

It also invests in the likes of consumer goods giant Unilever and information services group RELX (REL).

---

---

FTSE 250

The FTSE 250 features the next biggest companies on the London Stock Exchange after those in the FTSE 100.

Whereas the FTSE 100 increased by 1% in value in 2022, the FTSE 250 slumped by 20% as the mid-cap index has a greater weighting to industries that might suffer should there be an economic slowdown. This includes areas such as retail, travel, leisure and industrials.

The flipside of a sharp correction in the value of the index means mid-caps are now trading on more attractive valuations.

‘The market has been anticipating that earnings would come under pressure,’ says Richard Bullas, manager of the FTF Martin Currie UK Mid Cap Fund (B7BXT54). ‘We have had six to 12 months of downgrades to earnings forecasts. While we are still seeing downgrades, we think we are past the worst. That makes us more optimistic.’

Yes, mid-caps have started to bounce back from the late 2022 lows, but there is still further to go before they recover all the lost territory.

---

---

For example, Halfords (HFD) fell 64% from a starting point of 345p in January 2022 to a low of 125p in August. A 75% share price recovery since last summer sounds very impressive, but that only takes the stock back to 218p. It needs to rise a further 58% before returning to the 1 January 2022 share price level.

Admittedly there is no guarantee any of these shares will return to their previous highs, particularly if earnings expectations have fallen.
Yet there is a feeling that earnings forecasts for mid-caps in general might start to go up from
here, because so much potential negativity has already been priced in and many experts believe we will not get such a severe recession as previously thought.

‘We can see a manageable downturn. We have not had mass jobs layoffs and unemployment remains low,’ notes Bullas.

If the optimists are wrong and we get a nasty downturn, the FTSE 250 does not have the type of defensive stocks where investors can hide. Instead, we would feasibly see another sell-off but that is merely an opportunity to buy more shares in good companies at a cheaper price, in the view of Bullas.

Richard Champion, deputy chief investment officer at Canaccord Wealth Management, says many mid-caps last year suffered from supply chain problems and rising costs, putting a squeeze on margins. He believes these issues have now rectified as shipping costs fall, so headwinds are now tailwinds for earnings.

---

---

Two ways to play the UK mid-cap company space

Schroder UK Mid Cap Fund (SCP) 603p

Discount to NAV: 9.7% – Yield: 3.2% – Ongoing charge: 0.89%

The share price rebound at Schroder UK Mid Cap Fund (SCP) should have further to run should interest in British shares be rekindled in 2023, hopefully narrowing the 9.7% discount to net asset value on the UK All Companies sector’s best one and five-year share price total return performer, according to AIC data.

Managed by Jean Roche and Andy Brough, Schroder UK Mid Cap aims to deliver a total return in excess of the FTSE 250 (ex-investment companies) index.

The managers refer to the FTSE 250 as the ‘Heineken index’ given its potential to ‘refresh’ portfolios in a way other parts of the UK stock market cannot.

The fund’s three leading sector allocations are to industrials, consumer discretionary and financials, while top portfolio positions span global autos distributor Inchcape (INCH), fantasy miniatures maker Games Workshop (GAW), homewares retailer Dunelm (DNLM) and multi-utility supplier Telecom Plus (TEP).

---

---

BlackRock Throgmorton Trust (THRG) 636p 

Discount to NAV: 2.7% – Dividend yield: 1.7% – Ongoing charge: 0.55%

Should we see a significant decline in inflation and investors begin to peer past the peak in interest rates, this could benefit funds focused on UK small and mid-caps and would augur well for BlackRock Throgmorton (THRG).

Disappointingly, the Dan Whitestone-steered fund’s net asset value fell by 31% and underperformed the Numis Smaller Companies plus AIM ex-IC index in the year to November 2022 as Whitestone’s growth style fell out of favour as investors focused on energy, lower growth value and defensive stocks.

Yet despite the tough backdrop, Whitestone is sticking to his tried-and-tested focus on high quality, financially strong, highly profitable and cash generative growth companies that can weather the storm and has been rewarded by a recent pick-up in performance.

BlackRock Throgmorton, which has delivered strong 10-year annualised total returns of 13.4%, offers exposure to mid-cap names such as WH Smith (SMWH) and specialist distributor Diploma (DPLM) as well as interesting small cap stocks.

---

---

SMALL CAPS

The UK small cap space is home to interesting companies, many of which are not on the radar of mainstream investors. This is where using a fund manager really comes into play as they have the time and expertise to hunt out good opportunities.

Champion at Canaccord Genuity Wealth Management suggests one approach is to have a blended portfolio of small and mid-cap stocks. ‘Some may double or triple in price, which is enough to allow you to make some mistakes elsewhere in the portfolio,’ he adds.

Liberum believes small and mid-caps will outperform large caps when we are in a recession. ‘Earnings are just one part of the story, while discount rates (i.e., long-term bond yields) are the other. Share price reactions are some 10 times more sensitive to changes in discount rates than to changes in earnings. Thus, especially towards the end of a recession, small and mid-cap stocks typically outperform large caps as bond yields decline.’

The accompanying bar chart below shows the performance of UK small and mid-caps versus large caps in the last two quarters of a recession and the first two quarters after a recession. ‘The FTSE 100 in these 12-month periods was up slightly, while small and mid-cap stocks showed double-digit returns. Pretty much exactly what we expect for Q2 2023 to Q2 2024,’ says Liberum.

---

---

Two ways to play the UK small cap company space

Aberforth Smaller Companies (ASL) £13.56

Discount to NAV: 11% – Yield: 3.5% – Ongoing charge: 0.8%

This investment trusts looks for smaller companies trading below intrinsic value while also managing a portfolio with the ability to deliver a growing stream of dividends. The trust’s value discipline leads the managers to stocks with higher-than-average yields and the portfolio has generated respectable 10-year annualised total returns of 9.2%.

An 11% discount to net asset value presents a compelling entry point for new investors while a 3.5% yield offers some downside protection.

Resurgent demand for UK equities generally should prove positive for this diversified portfolio of 80 stocks at last count, among their number greeting cards-to-gifts purveyor Card Factory (CARD), business publishing and training firm Wilmington (WIL), recruiter Robert Walters (RWA) and van rental outfit Redde Northgate (REDD).

---

---

FTF Martin Currie UK Smaller Companies Acc (F7FFF70) 295p

Yield: 1.2% – Ongoing CHARGES: 0.8%

For those after a growth companies-focused portfolio with proven pedigree, FTF Martin Currie UK Smaller Companies (B7FFF70) fits the bill. Managed by Franklin Templeton’s Dan Green with input from Richard Bullas, the £196 million fund focuses on quality companies that are reasonably valued on metrics such as enterprise value to earnings before interest, tax and amortisation (EV to EBITA), price to book and free cash flow yield.

The managers take a longer-term view of opportunities in the small cap space and they look to add value by capitalising on market inefficiencies that can arise among under-researched small cap stocks.

Strategic themes include digital economy, decarbonisation and consumer brands and turnover in the 40 to 50 stock portfolio is generally low, emphasising the Franklin Templeton team’s consistent longer-term approach.

The fund, which has generated 10-year annualised total returns of 9.8%, has positions in the likes of financial solutions company Alpha Group (ALPH:AIM) and infrastructure-to-private equity fund manager Foresight (FSG), as well as video games publisher and developer Tinybuild (TBLD:AIM), remote people monitoring technology business Big Technologies (BIG:AIM) and sweet treats specialist Hotel Chocolat (HOTC:AIM).

---

---

DISCLAIMER: AJ Bell owns Shares magazine. The authors (Daniel Coatsworth, James Crux) and editor of this article (Tom Sieber) own shares in AJ Bell.

‹ Previous2023-02-23Next ›