‘Best time to buy British shares since the global financial crisis’

R&M UK Recovery manager Hugh Sergeant explains why tax cuts from new prime minister Liz Truss will spur business growth in Britain. Combined with low valuations for UK shares, he thinks it is the best time to be buying stocks since the depth of the 2008 global financial crisis. Sergeant also reveals why he likes oil companies, the foreign shares he owns in his fund, and which UK stocks he is most excited about.

R&M UK Recovery is a member of interactive investor's Super 60 list of recommended portfolios.

Sam Benstead, deputy collectives editor at interactive investor: Hello and welcome to the latest Insider Interview. I am here with Hugh Sergeant, manager of the Super 60rated ES R&M UK Recovery Fund. Hugh, thank you very much for coming into the studio.

Hugh Sergeant, manager of the R&M UK Recovery fund: Thanks for inviting me, Sam.

Sam Benstead: There’s a lot happening now in the UK, we’ve got inflation near double digits, we’ve got a new prime minister, we’ve maybe got a recession coming. So how does this affect the way that you invest and are you finding lots of opportunities?

• Explore: ii Super 60 Investments |  Transferring an Investment Account | Free regular investing

Hugh Sergeant: I mean, it is a very uncertain time and it looks likely that we're going into a period of potential recession for a few quarters, but this uncertainty, from my perspective as an investor, you know, does create opportunities. When everything is going swimmingly, it is often reflected in high valuations. When things are difficult, when the economic background, is difficult and geopolitical elements are difficult, which is clearly where we are at the moment, it's obviously difficult for consumers because of the pressure from the cost-of-living crisis, but that difficulty, that uncertainty, does create opportunities, and from my perspective, the opportunities in the UK equity market and [broadly], I mean UK recovery is very focused on UK equities, but we do have the opportunity to invest up to 20% of the portfolio outside the UK, and there are opportunities outside the UK.

So, the opportunity set is as attractive as I’ve seen it. Probably a comparable period would be the beginning of 2009 following the Global Financial Crisis. But I think we are in a less uncertain period today than we were during the GFC. But the opportunity set from a stock-picking perspective, the low valuations now, are as attractive as then.

We do see the change of leadership within the Conservative party as an opportunity to reset the agenda. I don't want to go too much into politics, but I would see the new prime minister Liz Truss as a recovery prime minister with the opportunity to reset the agenda, and it's clearly more supportive of business, more supportive of the City, supportive of deregulation, areas that I think will support stronger growth over the medium term. So, we do see that as a potential catalyst for other investors to get a little bit more interested in UK equities.

Sam Benstead: And what types of stocks are going to do well in this environment? You said it was a great opportunity, but how are you positioning the portfolio?

Hugh Sergeant: The portfolio has evolved over the last year and I would say we're going on the front foot as we speak. UK domestic stocks have been really hard hit and they've taken another lurch downwards over the last couple of months during this period of significant uncertainty.

As a result of that, they're really on rock-bottom valuations. A good example would be Capital & Counties Properties (LSE:CAPC), which is a real estate business that owns 50% of the real estate in Covent Garden. It’s an amazing location and fantastic strategic value of interest, not just to UK investors, but investors all around the world who like London and London property. This company has an NAV of well over £2, and the shares are currently trading at £1.15 so about half of NAV. They're going through the process of merging with Shaftesbury (LSE:SHB) Shaftesbury own a big chunk of Soho and Carnaby Street, so the combination is just going to be an amazing combination of really attractive real estate, which will grow significantly in value over the medium term. It has its short-term issues, short-term worries associated with the pressure on the consumer, and that's why the shares have been weak and are on such a low valuation. But to be able to buy some prime real estate in London at half of book value is a great example of the opportunity set today and a great example of how we think as value and recovery investors.

• How to invest for difficult times
• When markets fall heavily, here's what to avoid doing 

Sam Benstead: Interest rates are going up. Markets expect maybe 4% interest rates at one point next year. Are there any stocks that profit directly from this in your portfolio?

Hugh Sergeant: We've had the view for a number of years as interest rates were going lower and lower, and bond yields were going lower and lower, that it was going to be unsustainable. It reflected the post-Global Financial Crisis deflationary era, and we've always felt that at some point we'd move back to a more normal reflationary environment where such low interest rates, such low bond yields wouldn't be sustained, and we're positioned for that next stage; the more reflationary, somewhat higher interest rates, somewhat higher bond yield environment.

Do we think value stocks do a lot better in that type of environment? Other investors would be more attracted to the shorter duration, immediate profits available from value-type stocks, rather than putting higher and higher multiples on more growthy stocks, which you can do when interest rates and bond yields are falling. So, we like that environment. It benefits things like banks, for example. They're seeing their profits being [upgraded], expectations being upgraded because they can make a much better margin as interest rates move up, their lending margin improves. But what we're not positioned for is interest rates having to go up to such a high level that they create a recession. That's typically not the best environment for value and recovery managers, and the cyclical stocks that are exposed to those worries about the economy turning down have been significantly beaten up.

So, we're beneficiaries of the medium-term move to higher reflation, higher interest rate environment, but suffering in the short term from the value and recovery stocks that are negatively exposed to the cycle. The great thing about those stocks is they're as cheap as they're likely to get, and even though their profits will be under a bit of pressure over the next year, that's reflected in share prices today because they trade so cheaply.

Hugh Sergeant: So, we think that at some point confidence will bottom out from such low levels, and we're positioning the value and recovery strategy, UK recovery, to really benefit from that. Don't know exactly the timing, but it's right to reposition the portfolio for that over the next three to six months.

Sam Benstead: One of the other things you invest in are structural growth companies that are suddenly cheap. Are you finding any opportunities there now?

Yes. This is a good example of where we can find opportunities outside the UK. So, we like the digital platform companies that have been significantly derated over the last year to  18 months. Examples would be some of the social media companies, or search engines. So, in China we like Baidu (NASDAQ:BIDU) and Alibaba (NYSE:BABA), in the US we like Meta Platforms (NASDAQ:META). These are all obviously very large, mega-cap stocks, but they have been very aggressively derated over the last year to 18 months, and now are available on really attractive valuations, so the free cash flow yields for Baidu, if you strip out the equity, the cash on the balance sheet, its free cash flow yield is double digit.

For Meta, it’s running at about 7% at the moment, and they should be able to return to growth. The market's worried about the cyclical downturn in their key source of revenue, which is advertising. Advertising is cyclical, so will go through a downturn, but that's already, we think, reflected in valuations.

Sam Benstead: Shell (LSE:SHEL) and BP (LSE:BP.) are your largest investments, so how long has that been the case and why is that the case?

Hugh Sergeant: Good question. Just stepping back in terms of portfolio construction, the way we think about that for the UK recovery portfolio is that there are some mega-cap stocks in the UK market, and we will upweight those stocks in terms of portfolio construction within the recovery, and clearly Shell and BP are mega-cap stocks, so we've got bigger positions in those than we would have in a high-conviction, small and mid-cap stock.

They've been classic recovery stocks for the last two years. It seems like a long time ago, but the oil price, Brent, went negative for a short period of time during the first wave of Covid, and so all the oil stocks were particularly beaten up at that point, so they represent a classic recovery stock. Clearly, we also have had the sustainability conversation going on in the background at the same time, which led to really low valuations, so we were quite aggressively buying the energy stocks at that point and actually added to them over the last year.

Where we are with Shell and BP at the moment is just running our positions, not adding more capital at the moment. They have performed well and provide a lot of stability for the portfolio during these uncertain times because they're clearly very profitable today. There's still opportunities at the small and mid-cap end within the energy space, so we do particularly like Harbour Energy (LSE:HBR) and EnQuest (LSE:ENQ), which are two leading independents in the North Sea, which we think are going to be supported, much more supported, by the new prime minister than previous governments, which essentially saw the North Sea as a source of cash and tax. In this environment of energy security, I think there is going to be a lot more support for generating our own oil and gas from the North Sea. And now also both companies are in a position to place a decent amount of their cash flow in more sustainable areas of energy production.

• Seven biases that could be hitting your investment returns
• How to invest during a recession: top tips and tactics

Sam Benstead: Your biggest underweight positions are AstraZeneca (LSE:AZN) and Diageo (LSE:DGE) Why is that? Are they simply too expensive to include in the portfolio?

Hugh Sergeant: We've had exposure to both of those stocks over the last few years, but have sold out. They're both stocks that do well in an uncertain world, so they have relatively secure, certain streams of profits and cash flow. As a result, other investors have been comfortable investing in them and pushing up their share prices, so the valuations have become quite full from our perspective, so we see much more opportunities elsewhere. As you suggested, we do see them as expensive, both AstraZeneca and Diageo. With Diageo, we think the spirits market has benefited a lot over the last few years for various reasons, but it was a beneficiary of lockdown, Covid, etc, and we think some of those benefits are going to wear off, and therefore they're not going to be delivering the kind of growth that they've seen over the last two to three years, and with quite a full valuation, we think that will lead to a derating of the shares.

Sam Benstead: You manage this fund and two others. Are you stretched a bit thin? How can you give each fund the attention that it deserves?

Hugh Sergeant: That's a fair question. Over the last couple of years, as we've invested in the team at River and Mercantile, I've consolidated the funds that I run, so I'm essentially point on three strategies, so two in the UK, UK recovery and UK High Alpha, and they have a lot of overlap. The High Alpha Strategy is just more benchmark aware, and then the Global Recovery Strategy, which does the same thing as UK Recovery, but globally, so is looking for value recovery, multi-cap and out-of-favour growth platforms. So, it's very much focused on my value and recovery niche, that's why I can do a number of portfolios. And we've got a great team, and I've not mentioned it, but we have a significant quantitative element to what we do, so we've got a great quants platform, which is, as you know, a systematic way of identifying new ideas and monitoring our portfolios, so we've got that big quants piece to help in terms of coverage.

Sam Benstead: Finally, the question we ask all our guests, do you personally invest in the fund?

Hugh Sergeant: Yes, I've always believed in investing in the funds that I run, and have a significant amount of my wealth in UK recovery. A seven-figure sum invested in UK recovery.

Sam Benstead: Hugh, thanks very much for coming into the studio.

Hugh Sergeant: Thanks, Sam. Thanks for your time and all your great questions.

Sam Benstead: That's all we have time for. You can check out more fund manager interviews on our YouTube channel where you can like, comment and subscribe.