The shares and sectors we are backing under Labour

RGI UK Recovery manager Hugh Sergeant tells ii’s Sam Benstead why the UK market’s still cheap, even after a strong recovery. He reveals where he’s finding the best opportunities today, including in smaller companies, and explains why the new Labour government is bullish for the stock market.

The fund is one of ii’s Super 60 list of recommended funds.

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Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Hugh Sergeant, manager of the RGI UK Recovery Fund. Hugh, thank you very much for coming in.

Hugh Sergeant, RGI UK Recovery manager: Morning, Sam. Good to see you and thank you for inviting me.

Sam Benstead: We’ve seen a recovery in UK shares. You look for cheap companies - are there still lots of valuation opportunities in the UK market?

Hugh Sergeant: There are, Sam. I mean, from a risk-adjusted perspective, I’m still really banging the table because I think there’s less downside than a couple of years ago. I think the economic background, the recovery phase of the cycle, the change of government is clearly supportive of the economic background. So, there’s less element of uncertainty.

Meanwhile, valuations are still really attractive. So, if you look at the overall, the UK market’s trading on 10 to 11 times earnings, which in absolute terms remains attractive. If you look at it from a relative perspective versus, say, the global benchmark, quite a few of the longer-term value indicators like price-to-book or price-to-sales, the UK trades 50% cheap versus that global benchmark.

Then, if you drill down into individual companies, you can still find lots on single-digit earnings multiples. Some of them may be our classic recovery shares, where you need to look through the next couple of years to the profitability they can make in a couple of years’ time. If you do that, then they might be trading on four or five times earnings multiples.

So, the valuations remain very supportive and, as I mentioned, the economic fundamentals are improving. So, that combination from a risk-adjusted perspective, means that I remain high conviction about the opportunities in the UK market.

Sam Benstead: And where are you finding exciting opportunities today? Are there more opportunities in the larger company space or perhaps the smaller or micro-cap space as well?

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Hugh Sergeant: I think the latter. I think the small and mid-cap space is particularly exciting at the moment for a couple of reasons.

The first is that traditionally they get de-rated during a period of economic uncertainty, and that’s what’s happened over the last couple of years. They actually came out of the Covid crisis on quite a bull market and then, as interest rates started going up and economic uncertainty re-emerged, they went into quite a severe de-rating.

That was combined with what I describe as a buyers’ strike. So, because there hasn’t been much capital generally applied to UK equities at the more illiquid end, that’s had an exaggerated impact. So, few buyers, quite a few forced sellers, and illiquidity creating significant opportunities in small and mid-caps.

So, our preferred areas are small and mid-cap. It’s the traditional value part of the market, which clearly includes large-cap, and examples I’ve already mentioned would be things like Lloyds Banking Group (LSE:LLOY), Prudential (LSE:PRU), which is de-rated because of its exposure to China, and then the classic companies that benefit from an improving economic background, so it’s consumer cyclicals, housebuilders, real estate, the advertising sectors. So, that’s classically cyclicals, and includes a large number of high-conviction recovery stocks.

I would, I suppose, point to some of the traditional broadcasters that are actually very valuable for the English language content they produce. So, an ITV (LSE:ITV) or a smaller play, STV, would be areas to highlight.

Sam Benstead: We now have a new government. Labour is in charge. What opportunities does this present for you as an investor?

Hugh Sergeant: In general, I think it’s bullish. Two reasons for that. The first is we’ve had a period of uncertainty the last six or seven years. I suppose post-Brexit that itself created uncertainty and then the rotation that we saw in terms of leadership of the Conservative Party and therefore the government created an uncertainty. Now, the new government clearly have a significant majority, and they’ve got a Cabinet that have been doing their jobs shadowing, for many of them, for many years.

So, I think that just allows a much higher degree of certainty and that will allow other investors that have discounted the UK market because of the perceived turmoil to re-engage with our market.

The second aspect would be the policies of the government, which are clearly going to be tested over the next couple of years in terms of actual implementation. But the general direction is one of focusing on growth, which I think is the right aspect, because you can only pay for things like the NHS by delivering more substantial economic growth, and they realise that.

So, they’re looking at all the tools available to them to try and generate more growth. And I think that’s the right aspect and also will allow investors to re-engage.

And then they’re probably coming into power at a time when the economy was naturally picking up anyway. We’ve seen GDP estimates revised upwards. Interest rates will be cut, so that I think there should be a bit of a following win. So all that, it’s a kind of combination, will allow this government to be associated with attractive returns for UK equities and a more supportive economic background.

Sam Benstead: And what sectors do you think will benefit the most from this new government?

Hugh Sergeant: Obviously there’s some areas that they’re particularly focused on which would be beneficiaries, and are also participants in our overall view that we’re going to go into a period of greater economic strength, in particular on the domestic side of things. So, I suppose, classically, everyone’s talking about the builders and we would agree with that, housebuilders.

MJ Gleeson (LSE:GLE) would be a classic kind of beneficiary of the building cycle in improving volumes increasing, because volumes are depressed in that industry at the moment.

Another good example would be Henry Boot (LSE:BOOT), which is more focused on the planning side of things. So, working land through from landowners and getting planning permission for housing or other forms of construction. Clearly the Labour government are focused on reducing the logjams on the planning side and allowing volumes to pick up. So, that should be specifically supportive of the likes of Henry Boot.

And then there’ll be a more general beneficiaries of just an improving economic background and also greater confidence. So, the greater confidence aspect in particular will be supportive of small and mid. I didn’t really drill down into the micro-cap side of things when you asked the question. I do think that is also a particularly interesting part of the market. Tends to get very depressed when the cycle’s against it because they’re so illiquid, but many of them could be beneficiaries of an economic pick-up.

So, we have increased our allocation to micro-cap. It’s now running at - these are stocks that are below £100 million - 6% of the portfolio. A bit like Somero Enterprises Inc Ordinary Shares (LSE:SOM), which came out of the global financial crisis and went up multiple times, we think there’ll be one or two stocks in the micro-cap world that will be able to generate those very powerful returns.

Sam Benstead: You’re underweight some very highly regarded UK companies: RELX (LSE:REL), AstraZeneca (LSE:AZN) and Unilever (LSE:ULVR). Why is this?

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Hugh Sergeant: Well, we’ve always been structurally underweight that part of the market, normally significantly underweight. So, you classify them as quality compounders, typically. But we have allowed ourselves to, somewhat opportunistically, apply capital to those types of stocks when they’re temporarily out of favour.

So, RELX was an example that quite de-rated during Covid because some of its businesses were exposed to industries that suffered during that period, so it became quite cheap and we applied capital to that. Actually, it’s now been quite significantly rerated, so we’ve quite recently exited that position.

AstraZeneca, likewise, about a year ago, did de-rate and we put some capital to work in that.

Unilever is among a number of consumer staples that have actually struggled over the last couple of years. In an inflationary period, they’ve found it difficult to pass on all the cost increases to consumers that typically have been quite price-resistant to staples, have been more wary, and therefore their business fundamentals have deteriorated over the last couple of years.

That’s meant they have been de-rated. Actually, the poor performance of consumer staples, which we have been underweight in, has contributed a relatively strong relative performance.

But we do see opportunities there. Unilever would be a good example. They also have the catalyst of management change and that management focused on: let’s look at where our really strong core operations are, core brands are, and divest of some of the weaker areas, and we think that will allow returns to improve. So, it’s almost a recovery stock, hence having a reasonable amount of capital in Unilever today.

Sam Benstead: I know you prefer value and recovery shares, but are there any typically expensive shares that you own in the portfolio?

Hugh Sergeant: That’s a great question, and it is an area of excitement for me, actually. So, as you say, the portfolio’s always been focused on value and recovery stocks. But we’re a broader church than just buying cheap stocks, and when there are structural growers that are temporarily out of favour, it is a potential hunting ground for us.

That’s definitely the case at the moment in the small and mid-cap part of the market, either it’s companies that have missed short-term growth expectations and been de-rated as a result, or companies that have suffered during the buyers’ strike in the small and mid-cap end of the market.

So, they might have been very popular a few years ago. Small-cap funds attract a lot of capital, pushed up valuations. A lot of that capital has come out, that’s ended up with depressed valuations. So, in terms of the portfolio’s exposure to that part of the market it’s probably definitely at the high end versus the last 15 years.

So, structural growers on really quite attractive valuations as we speak. Examples of that would be Wise Class A (LSE:WISE) in the fintech area. Global data, that speaks for itself, a leader in terms of data manipulation.

Treatt (LSE:TET), which is a smaller play on flavours and fragrances and has a particular niche in more sustainable production of flavours and fragrances.

Molten Ventures Ord (LSE:GROW), which focuses on private equity and venture capital into growth-type stocks. So, those are four examples of companies that [have] quite aggressively derated over the last few years, have attractive medium-term structural growth characteristics, and are an exciting part of the portfolio today.

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Sam Benstead: And finally, the question we ask all our guests, do you personally invest in your portfolio?

Hugh Sergeant: Yes, a good question. I think it’s essential for fund managers to have substantial skin in the game. So, I do have a seven-figure sum invested in the UK recovery strategy. I have continued to apply capital. It’s there to create wealth for investors. We think we’ve been able to deliver that over the years. We’re very confident about being able to deliver that over the next five to 10 years. So, yes.

Sam Benstead: Hugh, thank you very much for coming in.

Hugh Sergeant: Thank you very much for your time and all your insightful questions.

Sam Benstead: And that’s all we’ve got time for today. You can check out more Insider Interviews on our YouTube channel where you can like, comment and subscribe. See you next time.