3rd November 2023
“We are currently in a doom loop, where valuations are low, liquidity is reducing, investors are seeing withdrawals and there is little desire to IPO. If this continues, the UK could lose a crucial part of its financial ecosystem. Regulatory reform should help, but it is the demand side that requires serious attention.” Charles Hall, Head of Research, Peel Hunt, 31st October 2023.
Charles wrote an excellent note this week (available only to research clients of Peel Hunt, I am afraid) outlining how critical the situation currently is for the UK equity market – especially for smaller companies. Charles writes that the number of FTSE SmallCap index constituents has reduced 30% over the last five years, with the available market cap reducing by c. 50%.
As supporters and followers of our Funds and these blogs will know, we have been materially increasing our exposure to UK equities over the past 18 months. We have no home market bias, so this has been a function of the incredible valuation opportunities being presented to us. It is the flip side of the coin that Charles is highlighting: too few investors want to invest in UK smaller companies, prices have fallen precipitously and as he rightly diagnoses, it is the demand side that requires serious attention. This is especially concerning in light of the trend of very high quality companies now looking to list in overseas markets where the value of their equity is more highly valued.
Per Investment Association data, UK equity funds have seen 27 months in a row of outflows (the pace of which is running at c. £1bn per month). We believe there is a very clear explanation for this. The wealth management industry in the UK is being consolidated very quickly. The trend is for fewer and larger wealth managers. At the same time, the regulator understandably is keen to see consistency of client outcomes within firms across branches. This means wealth managers run Centralised Investment Propositions (CIP) – the system of there being one universal set of illustrative portfolios for each risk level and income or growth objective, or a Buy List of funds. CIPs are becoming industry standard. They, in combination with ever larger firms in terms of AUM, result in the requirement for greater levels of liquidity from their underlying investments. Smaller open-ended funds investing in smaller companies or investment companies below a certain market cap can’t be included on a Buy List servicing a wealth management business with tens of billions of pounds of AUM.
At the same time, the business risk from constructing portfolios that look widely different from “benchmarks” is increasing. Wealth management firms are loath for their portfolios to look too different from their peers. Rather than focus on differentiated portfolios (and thus performance) they tend to compete on service, technology, brand and trust. One active UK equity manager we spoke to recently was utterly pessimistic about the prospects for people wanting a career in the actively managed UK equity fund management sector such is the lack of interest and demand for smaller active funds currently. Indeed, UK-focused active funds in the UK have seen only two years of inflows since 2005 (2009 and 2015)!
All of which is having a disastrous impact on the UK equity market. The UK is now only c. 4% of the global equity market. Wealth managers that are benchmarked to commonly used market-cap weighted indices will thus require their investment managers to have similar weightings in the equity parts of their clients’ portfolios. Given the historic (and understandable) tendency for UK-based managers to have a much higher proportion of their equity weightings in the UK, the amount of selling required to reduce this “overweight” has been significant. In addition to selling by wealth managers, institutional flows have also been deeply negative with pension funds inexorably reducing their allocations to UK equities over the years as they ‘go global’. Eradicating the hitherto home market bias might have some validity in a structural sense, but the timing of the shift seems utterly strange in the context of prevailing relative valuations where UK equities currently trade on one of the deepest discounts to global markets in history.
Our belief is that investment decisions should be guided by valuation, not the composition of an arbitrary benchmark. But then, we have the luxury of not running such huge sums of money. We thus think we have the explanation for why the UK equity market offers such a wonderful valuation opportunity.
Eventually, we believe, valuation always wins. It is terrible as a timing tool in the short-term (over periods of up to 3 years) but over longer time periods it wins out. In a worst-case scenario, we will simply witness the UK stock market continue to slowly die. This will manifest itself in de-equitisation via company buybacks (which are currently running at historic highs) or take-privates or M&A. In 2023 we have already seen 27 companies either leaving the market or in the process of leaving the market. We will make money in this scenario but we’d rather that the UK stock market returned to the thriving provider of capital to growth businesses it once was. For this, we will need to see a reversal of the current trend of wealth management industry consolidation, with smaller boutiques once more thriving. Consumers need choice: our industry needs to support a wide variety of investment firms with different philosophies and value propositions. But one can’t build an investment case for UK equities waiting for this to happen. There are various policy initiatives that would help and we are already seeing the current government suggest some of these (witness the Mansion House Compact for example). Investment incentives around ISAs, SIPPs, reduced CGT, and stamp duty to name a few would all help and are widely being discussed.
But in the meantime, we will continue to maintain and grow our exposure to managers investing in the many world-leading companies listed on the UK’s stock exchange. We have no idea when our patience will be rewarded, or even how. Were catalysts known in advance, they would be priced in. But at least we can explain what’s happening: we do not think we’re exposing our investors to value traps. Quite the opposite. The cheapness of the UK equity market and the ability to buy some of the best companies in the world at close to record valuation lows should lead to excellent returns for our investors. Let’s hope it is via a return of structural demand for UK-listed shares rather than a permanent reduction in supply.
Ben Conway – Head of Fund Management
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