Our view on the UK market

Steve Clayton - Fund Manager

27 December 2017

From Bitcoin to Brexit there has been plenty for investors to think about over the past twelve months. So what’s our view on the market and opportunities ahead?

At the headline level, we believe certain areas of the market have become overvalued and it is becoming more difficult to identify new opportunities. So we need to be very selective. However, we do not see many signs of a bubble in the equity markets, certainly not a widespread one. After all, at the time of writing (27 December 2017) the FTSE 100 has only risen by around 6% so far this year (without reinvesting dividends).

Please note that any yields quoted are variable and not a reliable indicator of future returns.

Smaller companies

High quality, small cap stocks have done very well and high valuations are fairly widespread across the small cap sector with the ‘disruptors’ doing especially well but even well-run, fairly dull businesses now attract commanding multiples.

Having said this, there will always be opportunities in this higher-risk part of the market but with current conditions we have to search further and wider. Examples we’ve found in the last year include Medica and GB Group (held in HL Select UK Growth Shares) – neither of these stocks are cheap in absolute terms, nor offer much initial yield, but we think they are capable of growing very strongly for a number of years.

Medium size companies

There are a number of very high quality mid cap businesses that we would like to own but consider too expensive.

We can still find opportunities in this environment. Sanne, the fund administrator which we own in both HL Select UK Income Shares and HL Select UK Growth Shares, trades on a premium valuation but is growing so strongly that we feel it is well worthy of a place in both portfolios.

Ascential and BCA Marketplace, which we also own in both funds, offer lower ratings yet are growing at double-digit rates. Both businesses are unique and would be virtually impossible to replicate – the importance of this is difficult to over-state in a world where cheap money (combined with digital disruption) has brought so much new supply into various industries.

Larger companies

There are a group of high-quality larger businesses which are seemingly more expensive than their longer term average but are growing at mid to high single digit rates. We own a number of these including Sage, Relx, Compass, Diageo, Reckitt Benckiser, Unilever and Experian.

These companies are trading around a 25-30% premium to where they have done historically. However an earnings yield of c. 5%, growing at about 7% does not seem unreasonable when compared with government bond yields just over 1%.

A lot hinges on interest rates. If you think rates are going back to pre-financial crisis levels in the near future then these stocks might seem unattractive. This seems unlikely to us. Indeed, with real incomes under pressure in the UK, the scope for interest rates to rise much further seems rather limited.

Quite a lot of companies now are attracting the attention of activist investors, especially the consumer goods sector. This tends to manifest in cost reduction, higher leverage and buybacks and/or acquisitions.

This has increased the pressure on companies to become leaner and more efficient, while paying greater attention to capital allocation. This is helping to drive earnings, with both Unilever and Diageo being notable examples of this trend. Both have stepped up their cost control efforts leading to improved margin expectations and stronger earnings forecasts.

Overly pessimistic on the UK

It feels like investors have become overly bearish on the UK’s economic prospects which opens up potential opportunities for us, however you have to be very selective. We own a number of domestic stocks, of which Close Brothers and Auto Trader have underperformed the market while Lloyds and Rightmove have outperformed. All have reported solid trading, however, and we continue to see value in each company.

Some domestic stocks are clearly struggling, though. The consumer environment has become a bit tougher, but there has also been a lot of new supply into various sectors, from traditional outlets and new digital channels (retail and casual dining being prime examples).

If you don’t offer a differentiated proposition then you’ll struggle to compete in this environment. Greene King, held in our Income fund, is currently facing the impact of increased competitor outlets and rising costs as the Living Wage and business rate increases are absorbed. The shares look cheap relative to history and yield over 6.5%. We believe a lot of bad news is already priced in.

Dull but worthy

There are other areas where value is presenting itself, including utilities, pharmaceuticals, tobacco and banks. We have strong representation within the Income fund in each of these sectors. Whilst we wouldn’t describe these areas as deeply out of favour, investors seem to be looking elsewhere at the moment. Bitcoin being the latest craze…

Imperial Brands, for example, has seen its valuation fall and the shares now offer a yield of over 6%. It isn’t growing much, if at all, but it doesn’t need to in order for investors to do quite well. The exact same comments can be made for GlaxoSmithKline. Utilities have been hit by political and regulatory concerns but offer highly defensive earnings streams and yields of over 5%.

Tech boost

In the Growth fund we have benefited from the strong performance of tech stocks, particularly our holding in Just Eat. The shares now trade on 35x forward P/E which is not out of line with the range they have traded in over the last year. This does not feel overly expensive for a business growing at 30% plus per year.

Like other well-known tech stocks, Google and Facebook, Just Eat benefits from network effects (more restaurants on the platform = more users, a self-reinforcing cycle) giving it a wide economic moat. While competition is high, competitors like Deliveroo and Uber Eats are reportedly losing money at quite a pace, so we struggle to see how these businesses are viable in the long run.

Again though you need to be very selective. It’s one thing paying a high multiple for a dominant tech company with a wide moat, but it’s dangerous to pay a very high multiple for a business that will struggle to defend itself against competitors.

Challenge for investors

One of the biggest challenges facing investors at the moment is technological disruption. For an example, think Amazon entering the grocery industry when it bought Whole Foods Market earlier this year.

Traditional retailers and cars are obvious candidates for disruption but it is also spreading into other industries such as media, distribution businesses and even consumer goods. Evidence is emerging that a whole host of companies could be set to find life more difficult, with the internet having weakened the historic distribution and scale advantages of incumbents.

Digital disruption is undermining many traditional business models and those that fail to act in time risk becoming irrelevant to their customers. Think Kodak or Blockbuster, where the digital product fast became superior to their traditional offerings. Investors must ask themselves whether the stocks they own will be winners or losers as technology evolves and position accordingly.

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