Economic Development in Great Britain

Written by Citywire

December, 2020

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Why I’m backing Britain

Domestic stocks have lagged international ones this year. Citywire spoke to several wealth managers and advisers who are backing Britain.

It might be the least loved part of the most unloved market, but the UK mid-caps of the FTSE 250 are piquing the interest of professional investors.

Charles Stanley is increasing allocations, using profits from areas that are more stretched, notably US equities. A medium to high-risk private client now has 10-15% in the FTSE 250, up from 5-7%, as part of an overall allocation to the UK of 35%.

Canaccord Genuity and Quilter Investors are underweight the UK relative to peers and their own internal benchmarks, with allocations of 18% and 17.5%, but overweight small and mid-caps with allocations of 7% and 9%, respectively.

Progeny, the adviser and wealth manager, has been overweight UK mid-caps since it was founded four years ago and has recently increased exposure to companies and sectors it regards as more defensive, many of them in the FTSE 250.

‘I much prefer to invest in companies with predictable cash flows and business models that can offer value throughout the economic cycle,’ said investment manager Craig Melling.

‘With the prolonged uncertainty Covid-19 is causing economies, it’s especially important to have broad exposure. The FTSE 250 has a variety of companies that fit the bill, with a more diverse array of industrials, consumer discretionary and technology companies than the larger company index.’

VALUATION

There is no disputing that UK stocks look cheap. Melling points to the FTSE 250 trading at a 15-20% discount relative to history. Its price-earnings ratio of 11.7x compares to a long-run average of 13/14x.

Devon-based wealth manager Philip J Milton & Co, a staunch value investor, is overweight the UK and has been bargain-hunting among mid-cap shares and investment trusts.

‘On the balance of simple mathematical probability, the UK is too unloved,’ said founder Philip Milton. ‘A big bounce will happen at some point, probably sooner than the neg ferrets think.’

While the FTSE 100 and FTSE 250 are valued similarly on a one-year forward basis, the longer-term picture is more compelling for mid-caps.

‘When you consider analysts’ earnings per share growth estimates for the next few years, the FTSE 250 has considerably higher and sustained growth year-on-year, whereas the large cap index, short of a rebound next year, looks fairly stagnant,’ said Will Dobbs, an investment manager at Charles Stanley.

POLITICS AND THE PANDEMIC

Brexit has constrained the UK stock market, notably the FTSE 250, since the EU referendum in June 2016. Investors have shunned the UK for so long that the impact of a no-deal Brexit may be relatively subdued. It could even revive the market by unlocking the stasis that has built up.

‘A no-deal scenario will impact the real economy over the long term, but in the more immediate term, the perception of the investment community arguably matters more for markets than the impact on businesses. Many don’t care much between a deal or no-deal – they just care for an outcome that provides certainty,’ said Quilter Investors’ portfolio manager Paul Craig. ‘Brexit and Covid-19 are irritations to overcome rather than terminal threats.’

Many FTSE 250 companies will see minimal operational disruption from Brexit. The strength and agility of medium-sized companies to adapt to changing circumstances also stands them in good stead amid the pandemic.

While home to few technology companies relative to overseas markets, like the US, the FTSE 250 encompasses many businesses that provide essential services. ‘We remind our investors that not everything is available on the internet,’ said Milton. ‘We continue to buy food, use electricity, water, telephones and mobile devices, take medicines, clothe ourselves, pay our insurance premia and mortgage instalments, engage our accountants and maintain our properties.’

CURRENCY

Expectations of an EU trade deal being hammered out ahead of the transition period ending on 31 December are so low that even a partial deal would have a decent impact on UK assets and sterling, according to Richard Champion, deputy chief investment officer of Canaccord Genuity Wealth Management.

‘When you look at historical negotiations, there tends to be an impasse for weeks and then finally, at the 11th hour, a decision is made,’ he said.

The likely upshot of that would be a stronger pound, which would benefit the FTSE 250 over the FTSE 100 given their overseas earnings exposures of 50% and 75%, respectively.

‘As uncertainty over our future trading relationship with the EU lifts, one might expect sterling to rise, putting pressure on some of the larger overseas earners,’ said Dobbs. ‘For more domestic companies, this is less of a concern and in fact you can find many companies in the mid-cap index that will benefit from rising sterling.’

INCOME

Though most investors expect a greater proportion of mid-cap total returns to come from capital than income, the importance of dividends is growing. While the rebasing of dividends in the FTSE 100 has been marked and may well prove permanent, that is less likely to be the case for the lower-yielding FTSE 250. It yields around 2%, a reasonable uplift relative to government bonds.

‘Whilst the FTSE 100 yields more than 4%, the income is far more concentrated in fewer companies in highly cyclical sectors, so for investors wanting diversified income, the FTSE 250 offers a sensible place to invest,’ said Dobbs.

Melling at Progeny focuses on companies with growing dividends, while Milton is looking ahead to ‘over-weight dividends when “normal” returns’. ‘Commerce in all forms will survive, make profits and distribute some as dividends to investors,’ he said.

GROWTH POTENTIAL

Champion at Canaccord Genuity likens the FTSE 100 to the ‘Jurassic Park of the investment world – full of dinosaurs’. Oil and gas, energy and commodities are its principle components.

The FTSE 250 is far more dynamic. Companies benefit from the ‘law of large numbers’: ‘It’s easier to multiply a £100 million company by 10 than to grow a £100 billion company into a £1 trillion company,’ said Champion.

Their smaller size also makes them easier to acquire. Acquisitions can signify a payday for investors.

‘We’ve seen an increase in M&A [mergers and acquisitions] activity, which is usually a sign of mispricing and value,’ added Melling. ‘With ample cheap liquidity, record low debt costs, private equity money and gradually recovering business confidence, M&A should continue to recover into 2021.’

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