The great British bargain hunt

John Baron explains why the outcome of the EU trade negotiations may spark a market rerating

December 10, 2020

Last month’s column explained why the portfolios retained their ‘growth’ focus while recognising the importance of rebalancing holdings that had become outsized. In suggesting such a discipline also allowed the channelling of monies into contrarian opportunities, it briefly touched on examples including commodities, smaller companies, commercial property and the UK market – the latter being one of the more attractive, particularly as the key factor most likely holding it back is about to be resolved.

Valuation metrics

To suggest the domestic market is unpopular is an understatement. The respected analysts Alan Brierley and Ben Newell of Investec recently suggested UK stocks are approaching "pariah status". Various metrics certainly suggest they are trading at their biggest discount to global equities in decades.

The MSCI UK index is a composite valuation that blends the price/book ratio, dividend yield and price/earnings ratio when comparing different markets. On this measure the UK market is trading at its biggest valuation discount on record. The 40 per cent discount to the MSCI World index is around twice its historical average, while the discount to the MSCI Europe ex-UK index is around 30 per cent.

There appears to be no shortage of bad news baked into the price. Yet this is usually the time investors should buy – when the underlying investment is being shunned – provided the fundamentals stack up and there is a catalyst for a re-rating on the horizon. Poor sentiment can be a good friend to well-sighted contrarians.

There is little doubt the market’s composition has not helped. At a time technology companies have swept the board, a disproportionate exposure to unfashionable sectors such as financials and commodities has proved a headwind. Furthermore, while yield may be one useful measure, we know that dividend cover is low in comparison with other markets.

The lack of entrepreneurial flair among our bigger companies, courtesy perhaps of managements too focused on short-term investment returns, is another factor. This was a theme examined in more detail in the column ‘Where are our pioneering giants?’ (8 February 2019).

Yet these factors are not new. They have been known for some time. They are valid reasons for a discount to exist, but not the extent to which it does today. The challenge for investors is to identify the reasons responsible for this extra discount, question whether they are valid and then ascertain if any catalysts are likely to improve sentiment.

Examining the tea leaves

Some point to the government’s handling of the crisis. In accepting there is no perfect answer to this unprecedented event, and as part of a family which has suffered personal loss due to Covid-19, to me the evidence suggests the UK has generally done as well as most developed nations that have introduced measures broadly similar to those introduced here.

The first duty of government in such a crisis is to protect lives and so Number 10 has been right to err on the side of caution regarding restrictions when we know so little about the virus. It has also been right to cushion the economic impact. The £200bn-plus cost of the various and generous support packages also needs to be seen in perspective – HS2 will end up costing more than £100bn. And courtesy of us no longer belonging to the EU, the UK is the first country in the world to start administering a vaccine, which the government had the prescience to purchase in advance.

The extent of the market’s discount is more likely because of the ongoing uncertainty regarding the EU trade negotiations. Concerns about a no-deal outcome still run deep. Yet the evidence the world over suggests the comparative advantage of lower corporation tax, more flexible labour markets, an entrepreneurial and skilled workforce, top universities, language and time zone are, in aggregate, more important in determining investment and jobs than average WTO tariffs of 3-5 per cent should there be no deal.

Some suggest no country simply trades on WTO terms. There is indeed a myriad of little known side-deals for those trading relationships based on WTO terms, but most are not about trade, those that are prove rarely essential, and over half are international agreements to which the UK may already be a signatory or able to accede in its own right.

For example, the EU trades on WTO terms with the US and this arrangement involves around 150 micro arrangements. Yet over 80 of these are multi-lateral arrangements – the Air Transport Agreement and Convention on the International Recovery of Child Support being recent examples. Of the remaining bilateral agreements, half do not relate to trade. And those that do, such as the Coordination of Energy-Efficient Labelling Programmes for Office Equipment, will be worth replicating if relevant to products traded.

For perspective, the EU has 97 side-deals with sanction-hit Russia, given trade is conducted essentially on WTO terms – the EU is unlikely to be less willing to replicate similar deals with the UK. Importantly, WTO Agreements impose obligations on countries to agree mutual recognition agreements where it is justified – refusal would be regarded as discriminatory.

Britain will remain an attractive place to do business whatever the outcome of the negotiations. By way of evidence, the economy was doing better than most prior to Covid-19, with unemployment well below international and EU averages. The corporate sector globally is focused when seeking a profit on its investment, and yet inward investment in recent years has been twice the level of that of France and Germany combined. And this in the full knowledge that a no-deal outcome was and remains a real possibility.

That said, a free trade deal remains the more likely outcome. It is in the EU’s interest given its trade surplus – particularly in the case of Germany. Even low tariffs under WTO would cost EU businesses billions and add further to unemployment. There is usually compromise on both sides in any negotiation, but Number 10’s insistence that our sovereignty be respected and the European Court of Justice be excluded from determining internal matters is reasonable and essential. Again, to the prime minister’s credit, our negotiators have stood firm and it appears the EU has finally ceded these important principles.

A trade deal was close last week until the French got cold feet about fishing. In time honoured EU tradition, the concerned parties will probably be bought off by the Germans so allowing a deal to be secured. This will not surprise anyone. It has been standard practice since the EEC’s inception.

However, what might be surprising is the extent to which markets respond to the ending of the uncertainty. Quantifiable concerns can be surmounted, and such walls of worry are usually climbed. But markets dislike uncertainty – the unknown procures fear and dread. Whatever the outcome, certainty could well be the long-overdue catalyst for a market rerating.

Portfolio implications

Given the extent of disconnect between sentiment and fundamentals, most of the nine real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk – including the two covered in this column – have been increasing their exposure to the broad UK market.

Recent examples in the column’s Growth and Income portfolios have been Dunedin Income Growth (DIG) and Murray Income Trust (MUT). Factors considered have been strong revenue reserves, proud dividend records, determined boards and a flexibility in approach in coping with the dividend drought.

However, the better opportunities lay with smaller companies. The portfolios have long been overweight for good reason – the asset class has outperformed over the long term and there is every indication it will continue to do so. Increasingly, many smaller companies operate in niche and growing markets, possess better and more entrepreneurial managements, and offer faster growth in part because they are particularly benefiting from the advance of technology.

Indeed, as highlighted in a column last year, the technology that is disproportionately helping these smaller companies to reduce costs and access new markets is also helping them to embrace disruptive practices and therefore better compete with their larger brethren. In an economic environment of low growth and high debt, the larger companies will continue to struggle to produce the returns of the past courtesy of increased competition eroding their margins.

A few genuine growth stories, particularly in the ‘growth’ sectors, will continue to command lofty ratings. However, many large companies will be slow to respond to this changing environment. Some have withered at a rate faster than first imagined. The assumption that ‘big’ is ‘strong’ will come to be increasingly tested across large swathes of the stock market.

And whisper it gently but, even in this year with economies in freefall, smaller companies have outperformed the broader UK market. So, despite the expected re-rating of the broader market, investors need to be overweight smaller companies – a sector which, in addition, is becoming more important to those investors seeking income given the number of high-profile dividend cuts.

Non-specialist examples held by the website’s nine portfolios include JPMorgan Mid Cap (JMF), BlackRock Throgmorton Trust (THRG), Schroder UK Mid Cap Fund (SCP), Henderson Smaller Companies (HSL), Invesco Perpetual UK Smaller Companies (IPU), Montanaro UK Smaller Companies (MTU), The Mercantile Trust (MRC), Oryx International Growth Fund (OIG), Standard Life Smaller Companies (SLS), Acorn Income Fund (AIF), River & Mercantile UK Micro Cap (RMMC) and, in the Green portfolio, Jupiter Green (JGC). Those held by the Growth and Income portfolios will be covered in more detail in forthcoming columns.