How we are playing the ‘unloved’ UK market

The UK equity market has been out of favour for a number of years, with billions of pounds exiting funds that invest in the region.

Our collectives editor Kyle Caldwell asks Rebecca Maclean, co-fund manager of the Dunedin Income Growth Ord (LSE:DIG) Investment trust, what needs to happen for investor sentiment to improve.

Maclean picks out a stock that is being overlooked due to it being UK listed, names a recent new holding, and explains how she is approaching the prospect of interest rate cuts.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio I’m joined by Rebecca Maclean, co-fund manager of the Dunedin Income Growth Investment trust. Rebecca, thank you for your time today. 

Rebecca Maclean, co-fund manager of Dunedin Income Growth Investment trust: It’s a pleasure to be here. 

Kyle Caldwell: The investment trust predominantly invests in the UK, but there’s also some exposure to overseas of which you can hold up to 25%. So, where do you find the best opportunities at the moment from a valuation perspective? Here in the UK or overseas? 

Rebecca Maclean: Well, the UK market is unloved. And it’s been said many times that the UK market is looking cheap from an earnings perspective, and from a dividend perspective it sits on about 10 times P/E, a 4% dividend yield. This is attractive versus history, and it’s attractive versus other markets. If you look at the US market, for example, the index is on 18x, and about 1.5% dividend yield. And the markets are made up of different types of companies. So, you do need to correct for the differences.

For example, the technology weighting in the UK is much lower than in the US. But even when you do adjust on a sector basis, the underlying valuations are at a discount in the UK versus overseas. There’s very little optimism priced into the UK market. So, when it comes to picking companies for the portfolio, we’re seeing lots of opportunities to invest in great companies which are just being overlooked because they’re listed in the UK. 

For example, a company like RELX (LSE:REL), which is an information data analytics firm and makes decision-making tools for its customers. It’s a fabulous company focused on organic growth. It’s really providing value to its customers. For example, a lawyer using their tools is going to be able to make decisions about the judges they should be consulting or the strategy that they should be looking to execute on a case by using the data and tools RELX has developed for them. 

And RELX’s growing very well. Consistently the growth has accelerated. But meanwhile the multiple that the market has placed on RELX is at a material discount to its US peers. So we see that as an opportunity. I think there really is an opportunity to invest in very high-quality resilient businesses, which are innovative and growing in the UK, at discounted valuations. So we're optimistic about that pipeline.

Kyle Caldwell: It’s a concentrated portfolio and there are currently 36 companies. Which were the latest names to enter the portfolio? 

Rebecca Maclean: It is a concentrated portfolio, so we do select our best ideas for the trust. The last company to be introduced to the portfolio was National Grid (LSE:NG.). We like the space. It is an infrastructure, electricity, networking business that operates in the UK and in the US. We also hold SSE (LSE:SSE), which is in a similar sector. 

We think the underlying fundamentals for the sector are more positive than they have been in the past. There’s a huge amount of investment required to update the grid and the electricity network in the UK and in the US to allow this transition towards renewable energy because of the differences in terms of where the electricity is generated. In the UK, much of the wind energy is generated in Scotland, so there’s a huge amount of investment required to get the electricity to where it needs to be, which is predominantly in the South.

So what this means is that there’s sort of underlying support because of the investment required in the assets, which is going to support National Grid’s asset base and, in turn, the earnings generation of the business. So that should support future earnings growth and then also dividend growth. 

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Kyle Caldwell: And when you identify a new opportunity such as National Grid, is it a case of selling down existing holdings or taking one out? Is it a one in, one out policy given it’s such a concentrated approach? 

Rebecca Maclean: Well, there’s a healthy amount of competition for capital. Every time we’re considering a new company, when we’re looking at our watch list of 20 companies that are on the sidelines [and] that we’ve been monitoring for some time to take that decision to enter, we’re going to be weighing up the outlook in terms of the prospective returns of that company to the rest of the portfolio, and we’re also thinking about the risk characteristics and what that will bring to the portfolio.

In the example of National Grid, we did have a large position in SSE. We partly funded the new introduction of National Grid by reducing SSE, which did add to the theme, but it was helpful in terms of managing some of the risk characteristics, [and] National Grid has a superior dividend yield, so it’s helpful from an income perspective too. So, we’re weighing up those different factors when we make that decision about what to introduce to the portfolio. 

Kyle Caldwell: As you mentioned earlier, the UK stock market is very unloved. What needs to happen for that to change and for investor sentiment to improve? 

Rebecca Maclean: There are a number of things. It’s been a very challenging environment for the UK, for UK investors. There has been persistent outflows from the asset class as investors have looked to deallocate from the UK, and looked to invest globally, or in the US. So that’s been a real headwind for UK companies, particularly mid-cap and smaller companies because of the liquidity challenges which that brings.

So I think one factor would be a change in the underlying flow picture. It would be very supportive for UK equities if [we] start to see that tip back into inflows, which we have not seen for a number of quarters now.

But there are some underlying fundamentals in terms of interest rates and inflation metrics, which have been a headwind to risk assets including UK equities. We’re starting to see them actually turn and be more supportive. Some of those headwinds should start to decrease. We are seeing inflation coming down, it’s easing. We’re seeing what looks like peak interest rates and that should be supportive too. I think that will be helpful.

The underlying health of the economy, too, is going to be something which markets are going to be watching. So I’d say the market in the UK is already priced for recession, and that’s the expectation. But what we’re starting to see now is consumer confidence pick up, real wage growth, and some of these headwinds in terms of inflation coming down and interest rates, that should be supportive of the underlying economic environment. And so, in turn, just the market for the companies in which they’re operating in. 

Kyle Caldwell: As you mentioned, the interest rate cycle may well have peaked, and some commentators think that there may be some interest rate cuts on the cards in the UK this year. In terms of managing the portfolio and making investment decisions, how much of an influence do interest rates have if interest rates are cut? Are there certain areas of the portfolio that will benefit from that? 

Rebecca Maclean: Yes, we’re seeing inflation come down and the expectation is that we are close to peak rates now. Certainly our internal economists are forecasting interest rates in the UK to come down this year.

I think this is going to be supportive for equity markets in terms of how that plays out in the portfolio. There are a number of ways that you will see that. There are some sectors which are very interest-rate sensitive. For example, we hold Taylor Wimpey (LSE:TW.), which is a housebuilding company. The housebuilding sector has seen a material downturn in volumes. So, the volume is down probably 30% from when interest rates started to increase, but pricing has remained resilient.

Taylor Wimpey has been able to maintain its dividend throughout this downturn because it had a strong cash position to start with, and a strong land bank, so it has been able to sit and wait. But a company like Taylor Wimpey, it’s going to be the volumes and the sales rates that’s going to be driven by interest rates and, in turn, mortgage prices. Indeed, we are seeing mortgage prices starting to tick down now, and early indications from companies at the start of the year are that those sales rates are just about to tick up too. So, I don’t think it’s going to be a quick rebound, but that’s a sector which is very sensitive to interest rates.

The other way that you see it in the portfolio is around the valuations which are placed on companies. If we’re thinking about multiples being a function of discounted cash flows, then that discount rate is going to be influential in the valuation that you then put on companies, particularly growth companies. If I look at a company such as Softcat (LSE:SCT), which we own in the trust, this is a UK, value-added reseller of IT equipment, hardware and software to small companies, and also to government. That company is benefiting from the underlying growth in demand for technology, which we’re seeing is becoming much less discretionary than it has been in the past.

The new trends around such as AI and big data, which companies need to keep investing in if they’re going to remain competitive. So, this is a growth market. We expect the company to continue to grow, and it should be in a strong position given its culture, customer relationships and breadth of offering. We’re supportive of that future growth. But you will start to see the way that you value a business like that change as discount rates come down. I mean, that’s not the investment case, it’s not sort of predicated on lower interest rates, but a growth company like that would see it shares supported by low interest rates. 

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Kyle Caldwell: Investment trusts have the ability to borrow to invest, known as gearing. What are current gearing levels on the investment trusts you manage? 

Rebecca Maclean: The current gearing is 9%. It hasn’t fluctuated too much. We’re not really looking to time the market, but there is flexibility in order to increase that, the gearing, if we felt that was appropriate. But yes, it’s been pretty consistent at 9%. And it’s helpful from a trust perspective in terms of enhancing some of the returns and the income as well from the portfolio by having that gearing. So yes, we do run it. I don’t think it’s [a] particularly aggressive level, but it is something which is helpful and we see as supportive for the trust.

Kyle Caldwell: And, finally, do you have skin in the game? 

Rebecca Maclean: I do, I own the trust. I also bought shares for my two young daughters. The reason being, as we said, I think it’s a great time to be investing in UK companies and Europe. But this is a way of having exposure to a diverse set of quality companies, which we think can deliver attractive returns over the long term. And then on top of that, the trust is trading at a high single-digit discount to nav too. So there’s a double discount. So, it feels like a good place to be investing with that long time horizon. 

Kyle Caldwell: Rebecca, appreciate your time. Thank you for coming in. 

Rebecca Maclean: Thank you for having me. 

Kyle Caldwell: That’s it for our latest Insider Interview. Please let us know what you think. You can comment, like and subscribe and hopefully I’ll see you again next time.