UK shares back on trust investors’ radar

Fiona Hamilton finds investment trust managers in confident mood about UK prospects. 

The UK stock market “suddenly offers a compelling combination of political certainty, rule of law, low valuations, pro-business policies and potentially burgeoning economic momentum,” says Duncan MacInnes, joint manager of Ruffer Investment Company (LSE:RICA).

This is quite something coming from a house which puts a high priority on capital preservation, and which has seen its performance suffer in recent years from a relatively low equity weighting. RICA’s overall equity weighting is still only 41%,but whereas the emphasis used to be on Japan and the US, the UK element was doubled in the last quarter of 2019 to 16.7%.

Renewed enthusiasm

Outlining the reasons behind this renewed enthusiasm, MacInnes says that in recent years UK assets have traded on ever wider discounts to other regions, due to uncertainty on fronts ranging from Brexit to the Woodford fund debacle, the relatively small size of the UK market and fears of a far left government. There may still be problems out there, he says, “but as someone once said: ‘You make more money when things go from terrible to OK, than you do when they go from OK to good’.”

More positively, he believes the outlook for the UK economy looks encouraging, with high employment, rising wages and low inflation. There is now a government with a strong majority, which is promising fiscal stimulus in its next budget and which he expects to wrangle some form of Brexit deal. All of this is encouraging UK businesses to start investing after years of holding back.

“Straight after the election the CBI survey of 300 manufacturing firms showed its biggest positive swing since 1958, with a similar picture visible in the widely reported Deloitte CFO survey of large businesses,” MacInnes reports. Meanwhile, he cites recent bids for companies ranging from Sophos (LSE:SOPH) and Greene King (LSE:GNK) to Hansteen (LSE:HSTN) and Entertainment One (LSE:ETO) as evidence of a wall of UK and overseas money that could  chase cut-price UK companies now the outlook is clearer.

Value further down

Andrew Bell, who masterminds the asset allocation of Witan (LSE:WTAN), similarly thinks the UK market currently offers value. He is therefore happy for the trust’s UK weighting to be well above its benchmark. He is wary of UK large companies on the grounds that they are dominated by low-growth sectors such as banks and oil companies; but he thinks there are a lot of interesting companies further down the market, offering an attractive hunting ground for Witan’s two remaining UK-oriented managers, Artemis and Heronsbridge.

Bell says worries about Brexit are still deterring some investors, but companies have another 10 months to come to terms with even a disorderly outcome. Meanwhile, there is not the same political paralysis, and there are hopes of a substantial domestic reflation which should be a fillip to domestic growth. He adds that one of Witan’s global managers used to have 80% in the US and the balance in the UK. Now it has 40% UK, 20% US and 35% Europe. “They added to the holding before and after the election as they feel there is pent-up demand and probably a currency benefit.”

Bell’s belief in the pent-up demand for UK shares ties in with reports that global institutional investors have almost their lowest-ever weighting to the UK, and news of exceptionally strong flows into UK equities in December.

Growing confidence

Lowland Investments (LSE:LWI) picked up strongly in the last quarter of 2019, following several difficult years. Manager James Henderson says its near 60% weighting in mid-sized and small-cap companies benefited from growing confidence that the UK was not heading for recession and that interest rates might come down, followed by post-election expectations of a more decisive and business-friendly government. Henderson is encouraged that projects which had been put on hold are now starting to come through.

“They may only be replacement projects, but that is how a cycle can begin,” he says.

“Motor manufacturers, for instance, have been allocating a bit more to the UK, because it is still a large market. They can’t just walk away and there is a lot to do in terms of the move towards electric cars.”

Despite his longstanding belief that smaller companies can be exceptionally rewarding, he is currently happy to keep the trust’s large-cap weighting at over 40%, largely at the expense of mid-caps which are down to 22%. One reason is that he thinks the economy is likely to remain subdued for a while, which can be challenging for more cyclically oriented smaller companies.

Another is that he expects the recent flight from less liquid stocks to persist for a while, despite the very low valuations further down the market. A third is that he expects the biggest increase in demand for UK stocks to come from UK and European institutions, as they realise their increasingly low allocations have left it looking so cheap.

“If they raised their allocations by just 2% to 3% it would be meaningful, and they are likely to favour larger stocks,” Henderson explains.

As manager of Mercantile (LSE:MRC), Guy Anderson’s remit is to focus on medium to smaller UK companies. Since taking charge three years ago, he has concentrated its portfolio down to 80 holdings, with just 5% in smaller companies. He geared Mercantile for the first time in two years just before the election, and increased it afterwards.

“I am more positive than for some time,” Anderson says. “The risk of a leftwing government has gone, and the government’s majority means it is in a better position to negotiate some form of Brexit.” He points out that the UK market is still at around a 30% discount to the MSCI Developed World index, and although it is always on at least a 15% discount due to its sectoral makeup, the valuation gap could converge now sentiment is improving on the domestic front – which accounts for around half the portfolio’s revenue.

“Employment is at record levels, wages are growing and inflation is stubbornly low, so I expect consumption to improve and investment intentions to pick up.”

While Mercantile’s portfolio remains overweight technology, Anderson has been more positive about high-quality industrials. He has also added to retailers such as Dunelm (LSE:DNLM) and B&M (LSE:BME), and to housebuilders Bellway (LSE:BWY) and Countryside (LSE:CSP).

Takeovers can provide a big boost for mid-cap investors, and Anderson is hoping for an upsurge there too. “There was a pick-up last year, mainly from private equity, but improving confidence means UK or overseas companies may be more willing to consider M&A,” he declares.

Dividends help UK equity income trusts outperform

Note: Table shows highest total returns among UK-focused trusts, ranked over three months to 1 February 2020. Source: FE Analytics

Some reticence

Troy Income & Growth (LSE:TIGT) invests predominantly in large UK quoted companies, and its joint manager Hugo Ure is more reticent than other managers about the outlook. He says the team favours a long-term approach, and seeks to maintain a balanced portfolio that can cope with unexpected events such as coronavirus.

The emphatic Tory victory improved the outlook for more domestically oriented companies, so they were glad they had started boosting their exposure to this sector in late 2018, when it looked exceptionally cheap. However, they took profits on holdings such as Land Securities (LSE:LAND) during the election surge, and while they have added some high-quality mid-cap industrials such as Victrex (LSE:VCT) and Spirax-Sarco (LSE:SPX), they have been happy to run with around 6% cash.

Ure agrees that the global orientation of TIGT’s portfolio means it has benefited in recent years from dollar strength, and this could turn into a headwind if sterling strengthens, However, he thinks the pound will continue to weaken against the dollar over the long term, and overseas markets offer more long-term growth potential than the UK. He is therefore comfortable that the UK accounts for only a third of the portfolio’s revenue.

For the moment, however, like the other managers he thinks the UK stock market offers relative value.

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