Opportunities and risks for UK stock market in 2025

Laura Foll, fund manager of Lowland Ord (LSE:LWI) Investment Company, tells interactive investor’s Kyle Caldwell why valuations put the odds in favour of investors sizing up the prospects for the UK stock market.

Foll also offers some reasons for caution – a difficult-to-call macroeconomic backdrop and the potential decline of special dividends due to an increased focus on share buybacks.

She also names two new holdings in 2024, explains how she approaches interest rates, and how she examines a dividend to assess its sustainability.

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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 in the studio I have with me Laura Foll, manager of Lowland Investment Company. Laura, good to see you today.

Laura Foll, fund manager of Lowland Investment Company: Thanks for having me.

Kyle Caldwell: We're recording this video towards the end of 2024. It's been a very eventful year. Could you give an overview of portfolio activity in 2024? Could you name some of your newest holdings?

Laura Foll: Sure. So it's been quite a high-activity period for Lowland this year, and the reason for that is that we've had six or seven takeovers this year across all sorts of different sizes of companies. So, things like International Distribution Services (LSE:IDS), which is Royal Mail, got taken over. At the smaller-company end, Alpha Financial Markets Consulting, which is a consultancy business, got taken over, so we needed to find a replacement for those holdings.

So, some of the holdings, if you want to describe it like this, which were kind of in the hopper, have now moved into the fund.

To give you a couple of examples across different sizes, we've a new holding in Sainsbury (J) (LSE:SBRY)'s. We already held Tesco (LSE:TSCO). We think that the listed companies within the market are in a stronger position balance-sheet wise than some of the private companies, Morrisons and Asda specifically.

The first thing is they have a scale advantage, Tesco and Sainsbury's, but also that strength of balance sheet means that they can keep investing in their price competitiveness, and you get to what we think might be a virtuous cycle where they take market share, they invest more in price, etc, and at the same time they both pay a decent dividend yield.

So, we now have both Tesco and Sainsbury's and at the smaller-company end, we've bought new holdings in. A couple of examples, something like FRP Advisory Group Ordinary Shares (LSE:FRP), which is a UK administrator restructuring business where if companies are going into administration, liquidation, they will come in with their administrators on a charge-by-the-hour basis.

So, it's very much a people business. You would expect there not to be a huge amount of operating leverage for that reason because you have the people and they're literally charging by the hour. But that type of business is doing better now that we have more normal interest rates.

In the decade or so post the financial crisis, when interest rates were very low and not many businesses were going into administration, they had a tougher time, but now that we've got 5% interest rates, unfortunately there are more businesses that are running into trouble and this type of business is well-placed for that.

So, I just feel it's a bit of a hedge for some of the other companies in the portfolio that are maybe more tied into the economic cycle. So, that's a new holding that we've got this listed on AIM.

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Kyle Caldwell: How much time do you spend thinking about interest rates? How do they influence your investment decision-making?

Laura Foll: Not a lot of time because I think time spent like that, [means] you will inevitably get it wrong.

If you think about how much our expectations of interest rates have changed just in the last month or so since the Budget and over the summer, the very entrenched expectation was that rates are coming down and they're coming down relatively fast, but at a decent clip.

And now, here we are filming this, as you say, towards the end of the year, and we've had the Budget, we've had the national insurance (NI) increases, and the thinking now is, OK, well, the Sainsbury's that I mentioned, they all have to pass that on, that national insurance hit, so we're probably talking about inflation being extended into 2025, possibly beyond. And suddenly interest rates don't look like they're coming down in the way that people thought over the summer.

So, I think you could spend all the time in the world thinking about what interest rates might be next month, next year and easily get it wrong. I find it much easier to spend my time thinking about, OK, well, can FRP grow their earnings if interest rates are 4%? Yes, I think so. Can they grow them if interest rates are 5%? Yes, I think so.

And I would say the same with Sainsbury's. I find it so much easier to concentrate on individual companies rather than trying to make that kind of call. There are people that are very good, I'm sure, at making that kind of call, but I don't think it's me.

Kyle Caldwell: Now, while you've mentioned that you prefer to focus on the fundamentals, I'm going to ask you a more macro question. Heading into 2025, what would you say is the main risk for the UK stock market and what would you say is the main opportunity if you were trying to convince someone to invest in the UK?

Laura Foll: Let me start with what's good about the UK market, then. That's the easier question.

I think the valuation argument for the UK still very much holds. If you look over time, the correlation between your starting price to earnings (P/E) and your return - a decent amount of time later, say 10 years later - is very high.

So, starting valuation historically, not to say it will always hold, but historically, effectively stacks the odds in your favour in terms of the real total return that you're likely to make a decent amount of time later. So, I think the valuation argument still stacks up.

What worries me [is] I think we're in a very difficult-to-call economic backdrop. If we think about what we were just talking about in terms of inflation and interest rates, if we think about Trump and tariffs, I genuinely don't feel I know what the macroeconomic backdrop is going to be.

Over the summer, people, probably me included, got a bit entrenched in thinking the consumer will be having a good time. Real wages are good, interest rates are coming down and I think that's a more uncertain backdrop now. So, I think we just need to be very conscious of the balance of the overall portfolio and making sure that we own businesses that can thrive in different types of economic backdrop. [Businesses] that have management teams that are experienced enough to deal with that, and the balance sheets to get through whatever is thrown their way.

Because I think, like you said, this year has been an eventful year and 2025 could easily be no different. So, we just need to make sure we have a portfolio that's balanced for that.

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Kyle Caldwell: Lowland aims to deliver both capital growth and income. Could you explain how you delve into a dividend to try and ensure that it's sustainable? And could you also talk us through whether there are any sectors that you invest in that you think are more dependable dividend payers than others?

Laura Foll: Yeah, that's a good question. So, in terms of what I'm looking for, I'm looking for dividends that are comfortably covered by both earnings and free cash flow, and balance sheets that aren't starting from a stretched position.

So, if a dividend is higher than, say, earnings or free cash flow, that's a red flag for me. That's not to say we won't completely rule out that type of company, but we've got to always bear in mind that that would be a risk if we saw that. So, those are the main things that we think about.

In terms of the outlook for dividend growth, the UK's starting from a more sustainable payout ratio these days because the types of companies that maybe back themselves into a bit of a corner with their dividend, often cut them during Covid, so you're starting more from a blank sheet of paper in terms of where company dividends are.

But just to strike a bit of a note of caution. I think UK companies, UK boards, because UK equities are at a discount to overseas markets, are increasingly trying to pull levers that they can control by doing share buybacks rather than special dividends. So, a trend that we're definitely seeing is special dividends declining because companies, where they do have excess capital are diverting that towards a buyback.

So, that's not me sounding an alarm bell for ordinary dividend payers in the UK. I think we can probably expect maybe low single-digit increases next year, but I'm not expecting the level of special dividends going forwards that we had in the past unless that UK equity discount corrects itself.

Kyle Caldwell: What are the implications of share buybacks? Can they boost the share price?

Laura Foll: What we're seeing is that they do manage to boost the share price, but for only as long as the share buyback is ongoing.

And this is only anecdotal from what I see, [but] increasingly, it's smaller companies doing buybacks as well, [and] you will see a positive benefit to the share price. But say they've announced a 10 million buyback and they get to the end of it, then the share price lurches downwards because, to the point we were discussing earlier, flows in the UK equity market remain tough.

So, as soon as you take away that natural buyer of the shares, i.e. the company themselves, there's often not someone who can step in once that comes to an end.

Kyle Caldwell: As you just mentioned, many investors are still sitting on the sidelines. We've seen since the Brexit vote outflows for UK equity funds pretty much month on month, and we've seen a lot of money go into index funds and ETFs, particularly those that are investing in the US and global markets. Could you make the case for active management for the UK market?

Laura Foll: Sure, and I'd like to think I can. So, the UK market, and the UK market is not alone in this by the way at all, is becoming increasingly concentrated among a handful of companies.

If you look at the UK, the FTSE All-Share, for example, which is what Lowland is benchmarked against, 85% of that FTSE All-Share index is now in the FTSE 100, and of that, the biggest 20 companies in the UK are now 55% of that index.

So, if people are buying a FTSE All-Share tracker fund, say ETF, and thinking, 'I've got a diversified fund there, I bought the whole index', in reality, their exposure is pretty concentrated to a handful of very large companies. Think the AstraZeneca (LSE:AZN)s of the world, the Shell (LSE:SHEL)s of the world.

Whereas if you want to diversify away from that, you really need to think about small and medium-sized companies as well, and they are much harder to get exposure to in a passive vehicle. We really need to go to an active vehicle to get exposure to that smaller company.

So, if you want to get exposure to the £100 million market-cap company that might become a billion over time, it's really an active manager that will be most likely to do that for you rather than a passive vehicle.

When I talk to friends and relatives about how they do their investments, they often hold tracker funds, and there's obviously a place for that, but we just need to be aware of how concentrated they're becoming in a couple of very large companies.

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Kyle Caldwell: My final question is our usual 'skin in the game' question. Do you personally invest in Lowland?

Laura Foll: I do, and both me and James Henderson, we run the fund together, always put in the annual report, not just of Lowland, but the other trusts we run as well, so Law Debenture Corporation Ord (LSE:LWDB) and Henderson Opportunities Ord (LSE:HOT), exactly how many shares we hold in each of the trusts. We don't have to do that, we just think it's important for people to know. So, anyone can go into the report and see how much, if they want to, I own.

Kyle Caldwell: Laura, thanks for your time today.

Laura Foll: Thanks very much.

Kyle Caldwell: So, that's it for our latest Insider Interview. Hope you've enjoyed it. You can let us know what you think. You can comment, and do hit that subscribe button for more videos in future. And hopefully I'll see you again next time.