The sweet spot for finding value in UK stock market

Laura Foll, fund manager of Lowland Ord (LSE:LWI) Investment Company, tells ii’s Kyle Caldwell why she's finding value in a specific area of the UK stock market, names examples of undervalued stocks she's backing to return to form, and explains how the AIM market has reacted to changes announced in the Budget on inheritance tax.

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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, fund 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: To kick off, could you explain the investment objective of Lowland and how you're trying to deliver both capital growth and growth in income?

Laura Foll: Sure. So, as you say, Lowland aims to grow both capital and income over time and beat its benchmark, which is the FTSE All-Share. And the way that we do that, and really the difference versus our UK equity income peers, is that we invest across the breadth of the UK markets.

So, we invest in small, medium and large companies. And the reason that I emphasise that is that there are two ways you can diversify your income as a UK equity income fund. You can either go overseas, which many of our peers have chosen to do, some very successfully, or you can go down the market-cap scale and invest in smaller businesses.

And the reason that we've done that, and we think that's been successful for our shareholders over time, is that these smaller companies are at an earlier stage of their life cycle. And that means that they, hopefully, or what we're looking to find, is companies that have a long pathway of growth ahead of them. So, the route to growing sales, earnings and it's ultimately that earnings growth that drives dividend growth for our shareholders over time.

Kyle Caldwell: So, what's the current split between large-caps, mid-caps and small-caps? And is there a particular one of those areas that you're finding more value opportunities in?

Laura Foll: So, I'll give you some rounded numbers. At the moment, we have low 40% in the FTSE 100, and then the rest is split relatively equally [between] small- and mid-cap.

And where we're finding the best opportunities at the moment, and bear with me because it's slightly nuanced, is the FTSE 80 and below. And what I mean when I say the FTSE 80 is, if you take the FTSE 100, the biggest hundred companies in the UK, the top 20, the biggest 20 companies that are listed on the UK market have done very well over time.

And what's underperformed in the last, say, two to three years, has been anything outside that top 20. So, the FTSE 80 has underperformed, the FTSE 250, the 250 medium-sized companies have underperformed. And AIM in particular has performed very poorly over the last two, three years.

We're finding the best value opportunity is often, not exclusively, but most of the time, outside the top 20 companies in the FTSE 100. So, we're finding we're adding to companies in the FTSE 80, if you want to call it that, the likes of Sainsbury (J) (LSE:SBRY)'s. They are big companies, but they're acting as if they are in the FTSE 250 and below.

So, it's really anything outside that, effectively it is the equivalent of the Magnificent Seven in the UK. That's where we're finding the best opportunities at the moment.

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Kyle Caldwell: We've seen over the past year the performance of the UK market as a whole has picked up. In particular, we've seen some strong share price gains for certain mid-caps and small-caps. However, retail investors continue to shy away from the UK. So, what needs to happen for that to change? Do we need to see a sustained period of the UK market outperforming?

Laura Foll: You're completely right in that the flows have been stubbornly negative from the UK market despite actually better performance. So, the UK equity market on a one-year basis, October to October, is up roughly 16% for the FTSE All-Share, so hopefully investors would be quite happy with that.

So, what's been what's been holding people back? I think the S&P 500, the fact that the US market is still outperforming, is overshadowing, even though 16% is absolutely fine from a total return standpoint. But the S&P 500 and particularly individual stocks in the S&P 500, the likes of NVIDIA Corp (NASDAQ:NVDA), etc, continue to draw people's attention away.

But in the UK market, if we think back to this time last year, we were in recession. We're not in recession anymore. OK, maybe the momentum's slowing, but we had some decent growth in the first half of this year.

The valuations in the UK equity market still look pretty attractive. There are takeovers going on, there are buybacks going on. I think the UK equity market has positive things going for it and the absolute total return has been pretty decent over the past year. It's just that there is this 'Big Brother' in the room, if you like, of the S&P 500 that continues to outperform.

Kyle Caldwell: And in terms of sectors, are there any that particularly stand out for you?

Laura Foll: So, we tend to think more in terms of stocks than individual sectors. We tend not to take that sort of macro bet, if you like, that comes with investing in sectors, but let me give you a feel for some areas that we're finding opportunities in.

Things like the industrial sector, which has performed, with exceptions, generally poorly as people worry about slowing economic growth. Now it's Trump with tariffs. But there are some really good-quality engineers in that sector within the UK, where, if you can have a slightly longer-term time horizon, or there are companies doing individually very good things around taking out costs and improving theirmanufacturing base, etc. So, some of those companies are trading at big valuation discounts because of these shorter-term uncertainties. So, that's an area that we find ourselves drawn to.

Another area that we're looking at more recently would be something like property, so something like Shaftesbury Capital (LSE:SHC) is a newer holding for Lowland and we hold it elsewhere as well. This owns - it's mixed-use property - a lot of the likes of Covent Garden, Carnaby Street. Anyone who lives in London and goes to these places knows that they're always incredibly busy and buzzing, and we think there's still good prospects for rental growth in something like that so, industrial property and pockets of other areas that we're looking at at the moment.

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Kyle Caldwell: As you mentioned earlier, you have some exposure to the AIM market. I think around 15% of Lowland is in AIM. Did any of your holdings benefit from the relief rally following the Budget? Of course, during the Budget, we saw that the inheritance tax sweetener for AIM became a bit less sweet, but there were fears that the inheritance tax break would be completely removed.

Laura Foll: I think the way you described it is completely right in that it was a beat from what were very low expectations by the day of the Budget. The expectation in the market had been exactly as you say, that IHT relief would be completely removed from the AIM markets. On the day, you got a positive response, but it was really only getting back to evens from the beginning of October. That's how weak the market had been going into the Budget.

I think, rationally we might see some companies where there isn't a particular reason for being on AIM, some of the larger companies on AIM, possibly move to the main market where there's a wider investor base. So, we did see that initial pop, if you like, on the day, but it really doesn't touch the surface of how much AIM has underperformed over the longer term.

I mean, the other effect that we saw on the day of the Budget was we hold some companies that invest in the North Sea. So, things like Serica Energy (LSE:SQZ), which is predominantly a gas producer in the North Sea, and we did see a positive benefit on the day because there were some clarification around the ability to use capital expenditure to offset your tax bill. And again, similar to the AIM IHT debate, there had been an overhang on that area of the market and just the clarification of it meant that there was a positive reaction on the day.

Kyle Caldwell: Investment trusts have the ability to gear, borrow to invest. What are the current gearing levels for Lowland at the moment and how do they compare to normal?

Laura Foll: Lowland at the moment has around a 12%-13% level of gearing. That would be very normal for this trust. The only time that we've taken it down materially, and this is before my time, is when James Henderson (co-manager) took it down pretty much to zero before the financial crisis, where he felt that there weren't many valuation opportunities in the market.

But for the most part, our view is that we're not trying to time the market. And so as long as we can find a good level of valuation opportunities, which we definitely feel we can at the moment, we stick with a decent level of gearing absent that very extreme scenario like pre-global financial crisis. So, 12%-13% is pretty normal for us and just reflects the fact that we really are not struggling to find value opportunities.

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.