Better times ahead for the unloved UK?

Inflation is improving and economic forecasts are rising for the UK economy
Sentiment remains weak for the UK market, with significant outflows
Many UK companies continue to deliver operational performance ahead of expectations

There are more promising signs emerging on the UK economy, with inflation finally falling and the International Monetary Fund (IMF) predicting that it will side-step a recession in 2023. Yet the UK market remains stubbornly unloved, with investors continuing to exit, even amid cheap valuations and sound earnings prospects. What could turn the tide for sentiment in the UK?

In May, the UK All Companies sector saw £916 million in outflows. The UK All Companies, UK Equity Income and UK Smaller Companies sector accounted for 86% of the overall outflows from equity funds over the month, capping a trend that has become increasingly persistent in recent months. It shows that despite better news on the UK economy, the UK market continues to be out of favour with investors.

It's not just the economy that is stronger than expected, many UK companies continue to deliver operational performance ahead of expectations. Abby Glennie, manager of abrdn UK Smaller Companies Growth Trust, says the direction of earnings has historically been a good indicator of market levels: “We saw a turn in earnings revisions at the end of last year. This is usually a good sign.”

“In the UK small and mid cap space where we operate, we continue to see good reporting out of the companies we hold, delivering in line or ahead of expectations. There may be some economic question marks, but we hope to see further upgrades.”

This mismatch between share price performance and operational performance has left the UK market looking cheap relative to its own history, and to its international peers. Rebecca Maclean, co-manager of Dunedin Income Growth Investment Trust, says: “The UK certainly looks cheap compared to the rest of the world, but it is also obviously cheap compared to its own history as well. Its dividend yield is twice that of the US market.”

“We are increasingly seeing valuation anomalies, and a disconnect between what we hear from management teams and what the market is saying about companies in terms of valuations. It is an interesting time to look at this market afresh.”

Innovative companies

The UK market continues to struggle with a few myths. Notably, that it is all about a handful of cyclical, old economy mining and energy names. Maclean says that the mid cap space in particular is far more vibrant than it is given credit for, with a raft of innovative businesses, demonstrating technology leadership.

Rebecca says that the sell-off in UK stock markets has created opportunities to buy good quality dividend-paying companies at lower prices. She points to Games Workshop, which derated significantly in 2022, alongside the high technology tools manufacturer Oxford Instruments and the accounting software provider Sage, which offer attractive growth prospects. These companies are held in the Dunedin Income Growth Investment Trust.

Glennie highlights a number of recent purchases in the abrdn UK Smaller Companies Growth Trust portfolio that demonstrate this innovation: Alpha Group, for example, helps companies to manage their FX exposure, while also providing alternative banking solutions and Hill & Smith is exposed to US infrastructure development.

Iain Pyle, manager of Shires Income, is also taking advantage of this derating of good quality growth companies: “Given the rise in discount rates, we have been buying into strong growth companies with compelling valuations. There has also been severe weakness in UK cyclicals. While there is some near-term earnings volatility, a lot of that volatility is reflected in the price.” With this in mind, he has recently been buying National Grid, which is playing a vital role in the energy transition.

A sentiment problem

If the UK market is cheap, earnings are improving and there are compelling growth opportunities, why isn’t it getting more attention? It is tough to predict when a market will turn, and the UK has been out of favour for some time. Nevertheless, it is already pricing in a difficult economic scenario that may not transpire. The economic forecasts have been improving and eventually, investors may catch up with reality.

The shift in the interest rate environment might make a difference. Pyle says: “The S&P 500 delivered 4x more value in the past 15 years than in the previous 100. This was driven by a handful of growth stocks and long duration assets. It is highly unlikely that we will get the same cuts in bond yields from here. With this in mind, there is no reason to believe the next 15 years will be like the last.” This would favour a different type of stock, refocus investors on fundamentals, and could be a better environment for the UK market.

In particular, it should focus investor attention on dividends and this has long been a key selling point for the UK market. Its dividend yield continues to look attractive relative to other major markets and it is possible to find plenty of companies delivering compelling, above-inflation dividend growth. This may get it noticed in the longer-term. Glennie points out that even after difficult periods, markets can recover very quickly: “The time to reach new market highs has often not been very long, from 12 months to two years.”

While it is difficult to time a change in sentiment, all the conditions are in place for a reappraisal of UK markets from investors. There are still economic challenges, which argues for a focus on quality companies, but opportunities are increasingly abundant. The UK market may finally be coming in from the cold.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.