Three ways of taking advantage of unloved UK equities

The cost of living crisis, the looming threat of recession, and geopolitical problems have dampened investor expectations over recent months. But there are still many innovative UK-listed companies that have continued to deliver bumper profits, despite the challenging backdrop.

Here we take a look at the pros and cons of putting your money into UK equity funds and how some of the fund managers are currently positioned.

What has happened?

It’s certainly been a tough year for UK equities, with soaring inflation, sky high interest rates and unrest around the world all weighing heavily on valuations. The blue-chip FTSE 100 index actually hit an all-time high of more than 8,000 points back in February but is now hovering around the 7,300 mark. Which direction it goes now depends largely on investor sentiment as to how the various global economic and political issues will play out.

Unsurprisingly, this troubled backdrop has persuaded many UK equity investors to withdraw money and put it into less affected sectors.

For example, the amount invested in the IA UK All Companies sector has fallen by a staggering £12.8bn from £151.7bn in January* to £138.9bn in August**, according to Investment Association data. Elsewhere, the IA UK Equity Income sector has fallen by £2.9bn over the same period, while total investment in IA UK Smaller Companies has dropped by £1.9bn.

Reasons to consider

However, these sectors are still comparatively popular. IA UK All Companies, for example, has the second largest assets under management. It’s only beaten by the £171bn in IA Global**.

But are UK-listed companies attractive?

Well, the fact they’ve been out of favour for so long may suggest that a lot of the pessimism has already been priced into the valuations. Active fund managers with the freedom to scour these markets for the best opportunities, therefore, could potentially pick up a bargain.

Here are three ways to play UK equities in a portfolio today.

UK All Companies

This sector is for funds investing at least 80% of their assets in UK equities which have a primary objective of achieving capital growth – and there is no shortage of portfolios.

However, it’s worth noting that not all will be the same. In fact, the investment philosophies and processes of these various funds may vary enormously. Some will focus on established larger businesses, while others will concentrate on those further down the market capitalisation scale. That’s why it’s vital to carry out your own research.

A fund we like in this sector is Schroder Recovery, which is managed by Kevin Murphy and Andrew Lyddon. This is a patient and deep value-driven fund investing in companies valued at less than their true worth and waiting for a correction. 

UK Equity Income

Funds in this area will invest in companies of varying sizes that aim to pay a sustainable and growing income – in the form of dividends – to their shareholders.

There are plenty of great portfolios in this area but one we favour is Artemis Income, a flexible, high conviction portfolio of UK stocks that targets a rising income and capital gain. Typically, the fund holds between 50 and 70 stocks, with a general bias towards large-cap equities. Its 10 largest positions include the likes oil major BP and pharmaceutical giant AstraZeneca****.

Adrian Frost, the fund’s manager, believes the fundamentals of most companies held in the portfolio have held firm in a challenging environment, despite “indiscriminate, price-insensitive” selling. “As a result, valuations across the UK stock market remain depressed, at a discount both to its own history and relative to other international markets,” he wrote in a recent update***.

Adrian also pointed out that many companies had been using their cashflows to buy back their own shares. “As their share counts are shrinking, their earnings and dividends per share are growing,” he added***.

UK smaller companies

Another way of playing UK equities is through smaller companies. This is arguably the best route if you’re after more pure exposure to the UK economy and don’t mind the risk of investing in smaller companies. However, many innovative smaller firms also have international customers so it’s worth seeing what type of stocks a particular manager favours. As well as potentially surprising on the upside due to the fact smaller firms are less closely followed by analysts, small-cap businesses may attract the interest of larger rivals.

In fact, takeover activity has been a notable feature of the recent performance of the Liontrust UK Smaller Companies fund, according to its recent update. It pointed out that many firms were looking vulnerable to opportunistic bids from private equity or corporate acquirers due to the UK stock markets significant discount to long-run average.

“Ergomed (which provides specialist services to the pharmaceutical industry and the development of new drugs) recommended a cash offer of 1350p a share from private equity group Permira, a 28% premium to the share price before the deal announcement but a level at which the shares traded as recently as December 2022,” it added***.

*Source: Investment Association, January 2023
**Source: Investment Association, August 2023
***Source: fund update, September 2023
****Source: fund factsheet, 30 September 2023

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

Published on 07/11/2023