Areas of the UK stock market that stand out

Guy Anderson, manager of Mercantile Ord (LSE:MRC) Investment Trust, tells interactive investor’s Kyle Caldwell why housebuilders and consumer stocks are among the best opportunities within UK mid- and small-caps. 

He also gives his views on when sentiment will turn more positive towards the UK market, shares his top reason to be optimistic about investing in UK equities, and explains that he's running gearing levels at a near 12-year high to take advantage of valuation opportunities he's seeing.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider Interview. I'm Kyle Caldwell, and today I have with me Guy Anderson, fund manager of Mercantile Investment Trust. Guy, thanks for coming in today.

Guy Anderson, manager of Mercantile Investment Trust: Thank you for having me.

Kyle Caldwell: So, Guy, for a long time now the UK market has been unloved. Both funds and investment trusts have been out of favour with investors pretty much since the Brexit vote. What needs to happen for sentiment to turn more positive?

Guy Anderson: That's a very good question. And as you know, we've seen that clear flow of outflows since the Brexit vote, and I think it's not unreasonable to suggest that Brexit, whether it was a good or bad thing, injected a lot of uncertainty into the UK.

One thing we know is that markets don't like uncertainty, and we've had a number of fluctuation since then. We've had periods where things were starting to look a bit better for the UK and then, of course, we've had to manage the pandemic and the Russian invasion of Ukraine, etc.

What we think looking forwards is that if we are entering a period of greater stability, that can allow the underlying strong fundamentals of the businesses in which we're investing - and other investors in the UK are investing - to shine through.

And that will hopefully present a better playing field and therefore attract more investors back to the UK. Of course, alongside this, we have to think about the potential changes that are coming as a result of a change of government in the UK. And, of course, we're on a bit of a watching brief on that front at this point.

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Kyle Caldwell: We're towards the end of the year, so I'm going to ask you an outlook question. For 2025, could you name your top reasons to be optimistic for the UK market? And a reason for investors to be fearful?

Guy Anderson: Sure. For me, it always comes down to the individual stock opportunities that we're seeing in the portfolio. And in aggregate, we are currently finding more companies that we want to buy than those that we want to sell.

I think that is often the single best indicator that things are improving rather than deteriorating. I could, of course, step back and say from a top-down perspective, why should we be positive?

The reasons, I think, are fairly simple. It's that the UK is going through an economic upgrade cycle. We've had positive surprises to GDP growth and yet that is not reflected in the valuation of the UK market, which is clearly trading at a substantial discount to many international markets and, in particular, mid and small-caps, the part of market in which I'm investing, those are more domestic and more economically cyclical. So, if the outlook there is improving, that should have a better impact on those companies than the overall market.

Kyle Caldwell: What would you say in terms of a negative for the UK market? Is one possible reason, in terms of fund flows, that investors will continue to go into global and US index funds due to the fact that seven technology companies are performing so strongly as a collective?

Guy Anderson: I think it's very difficult for investors to fight the tide, and if we see one market that's consistently doing well, it's quite difficult to sell those holdings, psychologically, it's quite difficult to sell that and then buy something that hasn't done as well.

But I think what we can see is, if we have a period of greater stability in the UK, hopefully that can allow the positives of the UK to shine. Really, you only need a small delta in perception to generate a big change in the outlook.

One of the benefits of running Mercantile, of course, is we have that permanent capital. And so, while it's really challenging to manage a strategy when there are lots of flows going in and out, for us at least, we can take genuine long-term investment decisions knowing that we're not going to have to sell an investment tomorrow just because of an outflow.

Kyle Caldwell: We had a general election in the UK a couple of months ago. One sector I've seen some fund managers talk up is UK housebuilders, due to the fact that the Labour Party are committed to increasing the supply of new houses. Is this an area of focus at all?

Guy Anderson: It is for us. Housebuilders as a sub-sector is the second-largest overweight in the portfolio. It represents about 4% in terms of the overweight.

It is an area that we increased last year, in the summer of 2023, at a point where there were obviously quite a lot of fears about the outlook for house prices and interest rates were on the march up, and that was a great opportunity for us because we were able to add to our pre-existing position in Bellway (LSE:BWY), for example, at a near 40% discount to its net asset value. We thought that was a brilliant opportunity and as a result added quite substantially to our holding there.

When we think about the Labour policy for this economic cycle, they obviously have a target to build 1.5 million homes during this Parliament, so 300,000 homes a year. That is roughly, on an annual basis, 10% higher than we achieved in the previous peak back in 2019-ish. So, that is quite a material step up.

And also, if we think about the current run rate of annual production of houses in the UK, this year, which is probably the nadir in the cycle, probably as a nation we're building around 180,000 homes. So, that is a massive uplift from here.

I don't think we've yet seen any actual improvements on the ground, but the rhetoric from the Labour Party is clear that they want to free up the supply so that this can happen. We will watch and observe what they do rather than what they say in terms of facilitating that.

But I think for the housebuilders to be an interesting opportunity, we don't need to get up to that 300,000 level. We just need to see the cycle recover and hopefully move back at least towards that sort of 250,000/260,000 level that we've seen before.

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Kyle Caldwell: In terms of sectors, consumer discretionary is your top sector allocation. Could you explain why and provide some stock examples?

Guy Anderson: Sure. So, the portfolio is built on bottom-up stock selection and it's very much about the individual opportunities that we find. But when we look from the top down, we see an improving landscape for the domestic consumer-facing stocks.

We're in an economy in the UK where we've had real wage growth for over 18 months. We've got improving consumer confidence, notwithstanding the recent setback around the Budget, but we have generally improving consumer confidence. So, the top-level thesis is that we have the average consumer that both has more money available to spend and a higher propensity to spend, so that should lead to an improvement in consumption. I think that's a reasonably favourable backdrop.

When we look at the individual companies we hold, we hold a number of stocks where those companies' prospects get better based on an improving macro, but where ultimately a lot of that growth is driven by internal actions and market share gains. So, the investment theses are not dependent on that positive macro environment.

The largest example would be a holding in Dunelm Group (LSE:DNLM), which is the homewares retailer, which has really grown tremendously over the last 40-plus years now. That has been a case of gradual market share gains, taking share from some of the incumbents, many of which have had some structural problems, so if we think about department stores as an obvious example, and Dunelm continuing to take market share gains, and we see a further runway for that to continue.

To put it in context, I think it's something like 90% of that growth over the last 10 years has been because of market share gains and only 10% because of the market growth. So, I think that's a great example.

We've also got a pretty substantial investment in WH Smith (LSE:SMWH). So, WH Smith many people will think of as a high street retailer in the UK. The reality is it's really a travel retailer. One of the positives about travel retail is you have effectively a closed consumer, or target consumer, so you have better economics because you have better pricing within a travel hub. And that's the part of the business that they have been growing over time and generating pretty nice returns from.

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Kyle Caldwell: Investment trusts have the ability to gear, or borrow to invest. Due to the fact that you're finding lots of opportunities in UK mid-caps and UK small-caps, have you been increasing gearing levels?

Guy Anderson: Yes, we have. Mercantile has the ability to go from 10% net cash to 20% a year. That's the sort of wider range that we could operate in. Where we're sitting today, we're 15% geared, which is almost the highest we have been over the last 12 years or so, the highest being around 16%, which we reached earlier this year. So, gearing is clearly elevated.

One of the things that I tend to say is, it's more interesting, hopefully, to observe what we do versus what we say, and clearly running with that level of elevated gearing must demonstrate the conviction that we have in the portfolio today.

Kyle Caldwell: Finally, the question we ask all fund managers, do you have skin in the game?

Guy Anderson: Yes, absolutely. So, barring the family home, my investment, as well as my wife's investment and my children's investment in Mercantile, is by far our largest financial asset.

Kyle Caldwell: That's great to hear, Guy, and thank you very much for your time.

Guy Anderson: Great, thank you Kyle.

Kyle Caldwell: That's it for the latest episode of our Insider Interview series. Let us know what you think. You can comment, like, and do hit that subscribe button for more videos. I'll see you again next time.