Funds and trusts to play next stage of UK market recovery

There have been several words used to describe the UK stock market in recent years such as the diplomatic “derated” to the brutally honest “unlovable”.

Alex Watts, investment data analyst at interactive investor, uses the phrase “much out of favour” to describe the “past five years of notable underperformance for the UK market” compared with other markets such as the US powered higher by its tech titans.

The impact of Brexit, political instability including the three prime ministers in one year in 2022, the Covid pandemic, the infamous Trussonomics budget and a struggling economy have all played their part in investors remaining on the UK sidelines.

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Watts points out: “Domestic sentiment has been poor and UK equity funds have seen net outflows month on month since 2020 with pension funds and institutions divesting in droves. UK equity valuations have reached historic lows and the small to mid-end of the market has suffered especially from the void of liquidity.”

UK market is rallying

But times may be changing with the FTSE 100 - which closed at a record 8,445 on 15 May - and FTSE All-Share index reaching newfound highs over the past three months.

“The FTSE All-Share returned near 10% (over three months to the end of May), exceeding developed market indices by some 7%, as well as most other regional markets catching many investors’ attention,” Watts said. He adds this rally potentially “marks a sea change for the UK equity market”.

Watts pointed to drivers such as more positive UK economic news, falling inflation and improved business confidence. He also noted: “Dividends across the UK markets appear to have so far shown reasonable levels of growth throughout early 2024, showing a resilience of earnings. Lastly, a pick-up in M&A bids has shown that the base valuations across the public market are deemed attractive and cheap by private equity investors.”

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Jack Roberts, investment analyst at IBOSS, part of Kingswood Group, also points to factors such as hopes of lower interest rates and continuing wage growth positively impacting investor sentiment.

Some investors may fear that the rally is only a short-term phenomenon with the FTSE 100 now falling off those highs, but Roberts encourages them to look further back than the last three months for encouragement.

“The UK stock market continues to suffer from a poor public relations image. Amid the ongoing discourse around American exceptionalism, it may come as a surprise that, since 1 December 2021, the UK market, as measured by the MSCI, has outperformed North America by 5.6% in sterling terms, as of early June 2024,” he said.

UK shares remain cheap

Investors may also be looking more at another long-term trend – the “cheapness” of UK stock markets. Dan Boardman-Weston, chief executive of BRI Wealth Management, says that investors have “finally woken up to how cheap UK equites are on an absolute basis and relative basis to their history and other markets”. He added plainly: “There is the realisation that they are cheap and not that bad, so they can get a bargain.”

David Lewis, a fund manager of Jupiter Asset Management’s Merlin range, which invests in other funds, is already a longer-term supporter of UK markets partly down to valuations. “The UK FTSE All-Share is on 12x earnings, whereas the Euro STOXX is around 14x, Japan’s Topix is around 16.5x and the US is in the early 20s,” he explained.

He adds: “The UK is pretty cheap on a global basis. It has been unloved for quite some time. But we have seen value.”

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Lewis said Merlin are big believers in active fund managing in the UK across mainly large and mid-caps. One fund favoured is the Man GLG Income fund, which has a value investing style and a current yield of 5%.

In terms of growth, Lewis sees opportunities in consumer staples with UK markets boasting world-leading firms across healthcare and pharmaceuticals.

Where pros are looking to capitalise on cheap UK

Indeed, in terms of finding opportunities in this rally it appears that active management and a value orientated perspective is the route to take.

Simon Gergel, fund manager of Merchants Trust Ord (LSE:MRCH), notes the dispersion of valuations is still very large between the biggest and smallest stocks. He points out the biggest companies housed in the FTSE 100 tend to be “high-quality growth companies that are liked globally and tend to be on pretty high premium ratings”, whereas the smaller-sized domestic stocks are “the cheap end of the market which is very cheap!” He adds: “You want to fish in this more value end to take advantage.”

Gergel says Allianz has seen a lot of opportunities in the mid-cap space recently through adding healthcare real estate group Assura (LSE:AGR) and student accommodation group UNITE Group (LSE:UTG). “Real estate is out of favour, but these are sectors which benefit from high-quality tenants. Buying cheaper equities like these is where you see the opportunity is a good strategy rather than just holding a passive fund.”

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David Smith, portfolio manager at the Henderson High Income Ord (LSE:HHI) Trust has in the last six months moved towards mid-cap consumer-based cyclicals. He says: “The furnishings group Dunelm Group (LSE:DNLM) is one example. It is trading on a very attractive multiple and we think that the outlook for the consumer is getting better.

“British Land Co (LSE:BLND), trading a significant discount to its net asset value (NAV), is another as we believe property values can improve as rates come down. It really is about value – picking up stocks which scream good value on price to earnings.”

Look beyond FTSE 100 for better value opportunities

Boardman-Weston agrees with a focus on mid to small-cap stocks. “I’d be playing cyclicals in this market benefiting from the uptick in the economy and inflation coming down,” he said “Banks and some of the financial look attractive as do the housebuilders, REITS and industrial stocks. UK investment trusts in general are attractive sitting on a discount to their net asset value.” He picks out Mercantile (LSE:MRC), Aurora (LSE:ARR) and Urban Logistics REIT Ord (LSE:SHED). He is cautious on retail but said he is tentatively looking at WH Smith (LSE:SMWH) given its cheap valuation and exciting growth plan.

Watts picks out the Fidelity Special Values (LSE:FSV) Trust for investors seeking a contrarian approach to picking companies right across the entire market-cap spectrum. It seeks UK stocks, allowing a 20% overseas allocation, which are currently undervalued by the market, typically holding for three years.

Watts explained that undervalued businesses that are operationally and financially sound may be the strongest beneficiaries of a re-rating of the broader UK market. He adds: “While UK stocks are cheap on aggregate versus other regions, the fund’s manager Alex Wright perceives the greatest degree of mispricing and value opportunity across small and mid-caps. Investors may view the trust as an opportunity to gain cheap access to the wide breadth of the UK market and could be well positioned for a continuation of the turn in sentiment for domestic businesses, which may fuel a rerating of the small/mid-market.”

Watts also likes the JPM UK Equity Core fund as a good core option for risk-conscious investors. The approach is quantitatively driven, and identifies companies with attractive quality, value and/or momentum attributes. “It’s a very benchmark-aware approach, having only marginal stock and sector overweight and underweight positions,” he said. “Given its low active share, investors should not expect returns that deviate too greatly from the benchmark index. However, over time the process has succeeded in generating a small amount of outperformance.”

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For those who prefer to obtain broadly the return of the UK stock market, a low-cost passive fund option on interactive investor’s Super 60 list is Vanguard FTSE UK Equity Income Index. This fund tracks the FTSE UK Equity Income Index, which comprises around 100 UK stocks that are characterised by higher-than-average dividend yields and is based on the FTSE 350 (large and mid-cap companies)

Roberts highlighted the Artemis UK Select fund investing across all market caps and styles and the Polar Capital UK Value Opportunities Fund, which also adopts a multi-cap approach with a strategy that emphasises finding undervalued stocks that have significant potential for growth. “Polar Capital is heavily weighted towards materials, industrials, financial services, and consumer cyclicals, sectors that are expected to benefit from the economic rebound and ongoing market dynamics,” Roberts said.

He believes there is potential room for further growth in the UK market. “The undervaluation, coupled with robust fundamentals in key sectors, suggests there is ample room for appreciation,” Roberts said.

Gergel agreed stating that there is “growing scepticism about the portrayal of the UK as an unequivocal negative outlier”. Now that’s a phrase to rally around.