Fast reading
- The news flow around the UK’s economy and its financial markets has been mostly negative for almost a decade.
- It has contributed to poor market sentiment which has been reflected in declining allocations to UK equities and cheap valuations.
- However, as the outlook for the country’s economy improves, we believe the current environment offers an attractive entry point for investors to increase exposure to UK small-cap companies.
The UK economy expanded by 0.6% in the first quarter of 20241, lifting it out of the very shallow recession reported in H2 2023. The cut to National Insurance rates in January, lower mortgage costs and, most significantly, a 2-3% rise in real wages, has led to improved consumer confidence.
Similarly, strengthening domestic demand along with rising expectations that the Bank of England (BoE) will cut interest rates later this year have boosted sentiment and resulted in an expansion in business investment.
We believe this improving outlook will provide a strong tailwind for UK small-cap companies. These companies earn a greater proportion of their earnings from the domestic economy than their large-cap peers, and have higher weightings to cyclical sectors such as industrials and consumer discretionary. In previous cycles we have seen robust outperformance of UK small-cap companies over large-cap in periods of recovery and economic expansion (see Figure 1).
Figure 1: Performance of UK equities since 2000
Reforms provide a boost
However, over and above the cyclical improvement in the economy, UK equities stand to benefit from attempts to shake the economy out of the stagnation that has held it back since the 2008-09 Global Financial Crisis (GFC).
In the recent election campaign, the Labour Party campaigned on the need to prioritise economic growth. After winning by a landslide in July’s vote, the new government plans to introduce a raft of new policies, including an overhaul of the planning system, a shake-up of industrial strategy, and wants to improve the relationship with the EU.
While more needs to be done to encourage investment and boost the supply-side of the economy, there has been a noticeable shift in tone about the need for structural reforms to boost economic performance.
In this regard, plans to revitalise UK capital markets should provide a welcome shot in the arm for both UK equities and the wider economy. Meanwhile, efforts to raise savings rates, investments and reform the pensions system, have the potential to generate more risk-taking capital which is essential to help create dynamic new businesses.
Following recent listing reforms set out by the Financial Conduct Authority (FCA), there is the hope that more of these companies will opt to IPO in London, as opposed to remaining private or listing elsewhere.
We believe that the next few years will see measures introduced to promote a more dynamic economy, and encourage risk-taking capital and flows into UK equity markets.
A number of pension reform proposals seek to encourage a more dynamic allocation of assets by UK pension funds, which can be very conservative in their approach. The combination of historic legislative and regulatory measures that prompted the wholesale switch out of equities and promoted liability matching to reduce volatility has led to the need for heightened contributions from employers to reduce pension deficits, poor returns for pensioners and has limited the scope for investment by companies.
For example, one proposed measure seeks to encourage companies to build the surpluses in their defined benefit pension schemes rather than seek buy-outs at the first opportunity, with the surpluses achieved used to fund raised levels of contributions into their defined contribution schemes and investment expenditure. In combination with the use of fiscal incentives to encourage investment in UK capital markets and building on the Mansion House Compact2 , such measures hold out the prospect of improving the equity market, returns for pensioners and the economy. It is frequently overlooked that the UK has the largest pool of pension and insurance savings assets outside the US – it would only take a small proportion of these assets to alter flows into UK equity markets!
The size of the Labour Party’s parliamentary majority offers the UK some needed stability after a prolonged period of drift and uncertainty, and contrasts with the situation across much of the European mainland. We believe that the next few years will see measures introduced to promote a more dynamic economy, and encourage risk-taking capital and flows into UK equity markets. It should help create a virtuous circle of capital inflows fuelling economic growth, and help to provide an extremely positive outlook for investment returns alongside current valuation levels.
The UK’s poor economic record since the GFC, compounded by uncertainty caused by Brexit, and more recently, the cost-of-living crisis, has led to a marked derating of UK equities against other developed markets (see Figure 2).
Across the stock market, UK companies make profits worth just under 10% of their value every year3. To put this in context, this is roughly double the equivalent measure for the S&P 500 and substantially greater than the approx. 4% yield on 10-year UK gilts. However, the persistent bad news surrounding the UK has led to a number of shares being ‘thrown out with the bathwater’.
Figure 2: Derating of UK equities vs. other developed markets
As an example of the value on offer and an illustration of our investment approach, we felt at the start of this year that investors had ‘thrown in the towel’ on British electricals retailer Currys. A series of profit warnings and disappointing results had led to the collapse in the share price and had created a mismatch between the share price and our estimate of the fundamental value of the business. We invested in the shares following meetings with management and the release of its trading update for the Christmas period, which gave us confidence in the turnaround of the business. A failed bid approach and three earnings upgrades later and the shares are trading up 57% year-to-date5. We look forward to further significant share price appreciation from here as evidence grows of improvements in trading.
UK equities: classic value trap or mispriced opportunity?
We are optimistic about the outlook for returns from UK small-cap companies as economic prospects improve, and believe that our approach is well suited to the likely investment environment over the coming years. Interest rates will fall, but not back to previous lows (which propelled growth stocks over the past decade). Our stock picking approach for the Federated Hermes UK Smaller Companies Strategy explicitly sets out to take advantage of value opportunities from the significant mispricing across UK small-cap companies, and should continue to perform strongly as interest returns to the asset class.
For further information on our UK Smaller Companies Strategy, please contact Douglas Anderson, Head of Consultant Relations, Dan Churchouse, Head of Business Development for the UK & Ireland, or Clive Selman, International Head of Sales.
Share:
The above does not represent all of the securities held in the portfolio and it should not be assumed that the above securities were or will be profitable. This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
1 Office for National Statistics, as at May 2024.
2 The Mansion House Compact is an industry-led voluntary expression of intent to take meaningful action to secure better outcomes for UK savers through increased investment in unlisted equities.
3 Bloomberg.
4 Ibid.
