Two reasons why the UK market could revive

For several years, more money has been withdrawn from UK funds than invested. However, this long-term trend could soon reverse, according to Thomas Moore, manager of abrdn Equity Income Trust Ord (LSE:AEI).

Moore tells interactive investor’s Kyle Caldwell two reasons why the UK market could revive, runs through portfolio activity, and outlines both the opportunities and risks for investing in UK equities in 2025.

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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, Thomas Moore, manager of abrdn Equity Income Investment Trust. Thomas, thank you for coming in today.

Thomas Moore, manager of abrdn Equity Income Investment Trust: Hi Kyle, good to be here.

Kyle Caldwell: So, Thomas, we're recording this interview towards the end of 2024. It's been a very eventful year. Could you give an overview of portfolio activity over the year? What have been your most recent purchases?

Thomas Moore: The first thing to say is that we are spoilt for choice. The valuations are low. Companies are seeing operational progress. But we do need to be mindful about the environment in which we're operating. The environment is choppy. We're seeing lots of macro variables.

The UK Budget during October 2024 caused an upward move in bond yields. That's had an effect. We've also had the election of Donald Trump. That's causing the dollar to rise. So, we're thinking about the company specifics in the context of these macro variables. Where that's pointing me with my portfolio is towards companies where I've got good visibility on earnings growth.

Now I'll give you a couple of examples. So, companies where there's stability like Galliford Try Holdings (LSE:GFRD), the construction company, where they've already generated the vast bulk of their revenues on day one of the financial year because their order book is so, so long, it goes out well over 12 months. So, companies like that with really good visibility on their order book.

But also companies that are actually going to be beneficiaries of 'higher for longer' interest rates. So, NatWest Group (LSE:NWG), for example, will generate a really nice return just by sitting there with all those cheap current account deposits they've got. They reinvest them at these gilt yields, which are now higher because of all this borrowing that the chancellor is doing. Well, that's good news, funnily enough, for NatWest. So, I can find opportunities even in an environment where a lot of people are worried, understandably so, about the macro.

Kyle Caldwell: As we head into 2025, could I ask you to name one reason to be cheerful for the UK stock market?

Thomas Moore: Look, I'm very positive about the ability of good companies generating strong cash flows to re-rate in terms of their valuations. When you start at some of the lowest valuations across the developed world, so if you look at the UK and you compare it with all these other markets, you compare it with the US particularly, you're looking at a P/E ratio (price earnings) of about 12 times for the UK stock market.

Now, the US market is trading on upwards of 20 times earnings. Now obviously sector composition is different, but even if you compare two companies like for like from the same industry, for example, Shell (LSE:SHEL) versus Exxon Mobil Corp (NYSE:XOM), you're going to see a huge difference in the P/E ratio.

So, I'm very optimistic that UK companies are being managed well, can see their valuations re-rate, and we're beginning to see that across our portfolio in the last 12 months, and we think that's got lots more to run.

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Kyle Caldwell: And if I asked you to put your more bearish hat on, what would you say is the main risk for the UK stock market in 2025?

Thomas Moore: OK. Well, let's be realists as well. So, it's important to talk up the risks here to the outlook. I would point to the upward move in bond yields post the UK Budget, plus the national insurance increases as a headwind for UK domestic companies. We are having to be very selective about which UK domestic companies we select.

The reason for that is that investors who are tuning in today can choose to invest their money all over the world and not every economy is doing tax rises and borrowing increases. That is going to have a dampening effect on UK domestic consumption in the short term because people will find that their pay increases are a bit lower. Inflation's a bit higher, their mortgage rates are a bit higher, and all that will dampen down the private sector growth, and that's called crowding out. That's the economist term for what is happening at the moment in the UK.

Now, I think that that's a challenge for investors like me. But the fact that I'm able to select from such a broad range of stocks, I invest across the UK market. I'm looking all the way down to small-caps through the mid-caps, all the way up to the mega-caps. I've got lots of companies I can choose from to make sure that we're able to deliver for our shareholders in that tough environment.

Kyle Caldwell: I wanted to next ask you about interest rates. We've seen a couple of interest rate cuts in 2024. What's your view on interest rates in 2025, and do you think interest rates are potentially going to be higher for longer? And how does this all influence your stock-picking decisions?

Thomas Moore: So, if you look at money markets, what they are pricing in, they're now looking at one or two base rate cuts in the next year. Now, if you compare that with six months ago, back in the middle of 2024, money markets were expecting five or six interest rate cuts. So, that's quite a big difference. And that will dampen down the speed and the magnitude of the economic recovery that we see here in the UK. So, we need to be mindful of that when we're investing.

The good news is there are plenty of companies that can thrive in a higher-for-longer environment. If you think about some of the stocks in my portfolio, there's businesses that benefit from higher rates either because they're generating interest income or because trading activity will be higher.

So, within financials, there are companies like TP ICAP GROUP (LSE:TCAP), which is an inter-dealer broker. They thrive on higher-for-longer interest rates and they love interest-rate volatility. So, that's the business that's trading its socks off at the moment.

So, look, we need to keep going through the portfolio, making sure that we're in the right place. I come in every day to the office with a blank-sheet-of-paper mindset. I want to make sure that the portfolio is positioned correctly for each environment while we're picking those long-term winners.

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Kyle Caldwell: And what's your overall outlook for dividends as we head into 2025? Are there certain sectors that you view dividends as being more dependable than others?

Thomas Moore: Yes, absolutely. Dividend dependability is really important. And by the way, it doesn't mean we have to go low yield. I think it's really important to say, dividend dependability can be the case for higher-yielding stocks. If you look at Imperial Brands (LSE:IMB), I'll give you that example, it's the largest position in the portfolio. For me, if you go back four or five years, the shares were languishing about £12, £13. They're now about double that level.

Now, how has that happened? Because surely all high-yield stocks are value traps, right? That's what the conventional wisdom is, that's what most armchair investors will tell you; 'I wouldn't touch it. The yield's a bit high, it's obviously a value trap'. That was not the case in Imperial Brands. That's why we made it our biggest position, because we believed that the market was being far too pessimistic about the dividend dependability of a rock-solid business like Imperial Brands. Sure enough, the dividend yield was 12%, it's now 6%, and that's because the share price has doubled.

Kyle Caldwell: In terms of investor appetite for the UK; we've seen for several years now there's been consistent outflows for UK equity funds. What needs to happen for that to change?

Thomas Moore: It's a great question and it's been years of investors pulling money out of the UK and they're putting it all over the place. They're putting it into gold, they're putting it into US equities, into fixed income. So, it's been a long-term trend.

Now, I would say there's actually a really natural way for this to sort itself out, which is that companies that are generating lots of cash, the kind of companies I'm investing in in my portfolio, they've got enough cash to pay their dividends. They're also buying back lots of shares. So, the pace at which some of my companies are buying back their shares means there won't be any shares left soon. So, I think that's the first point. Buybacks are really important because that will naturally stabilise the share prices of the UK market. And when that happens, that will in itself attract more buyers because when share prices stabilise, surprise surprise, people are more interested because the momentum is improving.

The second way in which the UK market could revive is M&A. So, a bit like buybacks, if valuations are that low, companies will swarm to the UK and we're certainly seeing that in my portfolio. I've had four bids in the last 12 months in my portfolio; DS Smith (LSE:SMDS), Hargreaves Lansdown (LSE:HL.), Tyman and Centamin.

Across different industries, US companies, private equity, are looking at the valuations on offer here in the UK and they're saying we see an arbitrage. We see our valuations up here, we see UK valuations down here. We see an opportunity. We're going to grasp that opportunity. And so if institutional investors and asset allocators are pulling their money, look, there's a flip side of that, which is that there's going to be more buybacks, there's going to be more M&A and that will underpin share prices.

And as I said, I think that will also help to sustain an improvement in sentiment towards the UK. And you know what? Performance begets performance, flows beget flows. Once people start to become more interested in the UK equity market, it could get its own momentum.

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

Thomas Moore: Yes, my wife and I own abrdn Equity Income Trust as a meaningful part of our personal portfolio. And on top of that, my four children own it in their Junior ISAs, so I've got them to answer to when they turn 18.

As well, I should also mention that my elderly mother owns abrdn Equity Income Trust, and I think what's important about that is an elevated cost of living is important for many investors to have access to that high dividend yield. I know she appreciates it.

And I would also say that I've met many shareholders over the last 12 months, individual investors, who tell me that they appreciate the high dividend yields because that brings in cash that can help them to sustain their daily lives.

So, for me, that's one of the most heartwarming parts of the job is, when I meet people, it's very motivational to hear that what I do can make a difference to them.

Kyle Caldwell: Thomas, thank you for your time today.

Thomas Moore: Thanks, Kyle.

Kyle Caldwell: So, that's it for our latest Insider Interview. We'd love to hear from you. You can comment, do hit that like button and also hit the subscribe button for more videos from fund managers. And hopefully, we'll see you again soon.