Patient investors have had plenty of opportunity to perfect their art in the UK equity market over the past 20 months or so to October 2023, as domestically oriented stocks in particular have remained stubbornly out of fashion.
Guy Anderson, manager of the mid- and smaller-cap focused Mercantile Investment Trust (MRC), is one of the leaders playing the waiting game. Yet he emphasises that the situation is much more complex than the market’s persistent deeply negative sentiment would suggest.
Inflation, of course, is at the heart of the issue. Its dramatic rise through last year and much of this one, accompanied by a string of painful base rate rises from the Bank of England, has been acutely felt by British consumers.
Unsurprisingly, 2022 saw a sharp decline in consumer confidence, with the GfK consumer1 confidence index plummeting to a record low of -49 points in September 2022. Yet wage growth has been robust and employment has stayed resilient despite the UK government’s rapidly tightening monetary policy.
Indeed, as inflation has haltingly declined in 2023, the UK has started to see real growth in wages for the first time in a year and a half. As Anderson explains, that trend has been really important in stimulating consumption. “It’s one of the key reasons why consumer confidence picked up from its nadir at the back end of last year,” he adds.
The UK economy: Surprises on the upside
In fact, the domestic economy has consistently surprised on the upside over the last 12 months. “The UK has a bit of a PR problem, in that the economic narrative is extremely negative - and that’s been reflected in investors’ very low expectations for the future. But so far they have turned out to be more negative than the reality.”
Thus, consensus forecasts for 2024 GDP growth have consistently improved since this time last year, when they hit rock bottom. “The UK has been through a GDP expectations upgrade cycle, which is clearly a positive,” Anderson observes.
The UK economy has consistently been more resilient than anticipated, and at the same time assets are still very lowly rated
Nonetheless, in spite of the improving outlook valuations remain extremely depressed. The UK market now sits at around a 40% discount to other developed markets – roughly double the average discount of the past 50 years.
In effect, the situation is full of potential for significant turnaround. “Yes, we’re in a pretty tough environment – but the UK economy has consistently been more resilient than anticipated, and at the same time assets are still very lowly rated,” says Anderson.
Against that backdrop, The Mercantile’s bottom-up, stock picking approach ensures that the portfolio remains clearly weighted towards companies with certain characteristics.
Thus it targets high-quality businesses (for instance, the average return on invested capital sits at around 15% compared with 10% for the benchmark as at November 2023), where the longer-term outlook is better than the benchmark (as measured, for example, by expected earnings per share), and valuations are attractive.
Strongly placed for recovery
In aggregate, says Anderson, the portfolio is strongly placed for recovery in due course. “These businesses are still generating high-quality earnings, we’re not downgrading expectations for future earnings, and yet they’re attractively valued,” he comments.
The strength of that positioning also means the team is comfortable with its current level of gearing, towards the higher end of its average range over the past decade at around 12%.
“Hopefully, our action in holding this level of gearing is the best indicator of what we really think about the current situation.”
As far as positioning is concerned, there have been few significant changes this year. Unsurprisingly, given the focus on stockpicking, the portfolio sector weightings continue to deviate significantly from those of the benchmark.
“However, it’s not about our top-down view of the outlook for specific sectors,” Anderson stresses. That’s very evident in an examination of The Mercantile’s top 10 overweight holdings, which span a broad range of industries.
The table is topped by investment group 3i, but also features software business Softcat, engineering company IMI, automotive firm Inchcape, retailers WHSmith and Dunelm and housebuilder Bellway.
It’s a diverse mix, but there are some common themes that run through the selection. “Of course, it’s good to focus on areas where there are great prospects for structural growth, but what we really like are those businesses that have more drivers within their control and specific levers that they’re pulling to drive their own growth,” Anderson explains.
Growth of market share is one such driver. It’s exemplified by Softcat, a corporate IT services provider that has benefited not only from companies’ increasing demand for technology but also from its focus on ‘softer’ factors such as employee satisfaction.
“There is a very high correlation in the business between salespeople’s tenure and their gross profit contribution,” says Anderson. In effect, the business’s focus on happy, long-serving staff is instrumental in its ability to increase market share.
He points to IMI plc as another example of the proactive approach to growth that MRC seeks out.
“IMI has been commercialising its business by concentrating on providing solutions that customers actually want, rather than those that engineers think might be useful,” he says. “If you create things that customers want, they tend to pay more for them and growth is stimulated, so that is another theme through the portfolio.”
Catalyst for change
Of course, the UK has been cheap for years; for as long as the UK market remains unloved, MRC’s attractively positioned portfolio capacity to deliver is restricted. So – the million-dollar question – what could trigger a rerating?
For Anderson, one step in the right direction would be an improvement in the UK’s “horrendously negative PR”. That would be helped by a break from the steady stream of “inflation and other exogenous factors that seem to hit us harder than other countries”.
But the real catalyst for change, he believes, will occur when company outcomes are better than the market’s negative expectations for them. Once that happens, expectations should improve, stimulating wider interest in investing in the UK market and setting up a virtuous circle of rising performance and demand. At which point, patient investors should finally see their rewards.
1 Gfk consumer confidence index - ttps://www.gfk.com/about-gfk