Will the UK escape the worst of the bear market?

Should we be thankful for small mercies? We can still debate whether there is a bear market in London’s shares, but that discussion is pretty much over and done with in the US, as the small table shows.

When a market drops 5 per cent in almost six months, as has London’s as measured by the FTSE All-Share index, it is meandering with, perhaps, a better-than-even’s chance it will finish the year higher than it began. When it falls over 20 per cent from its high, as in the case of the S&P 500, the US equivalent of the All-Share, then it is a bear market. End of discussion.

London’s muted response to the forthcoming recession, and whatever else is causing this global run on equities, probably owes much to its poor performance in earlier years. Even after this year’s comparative resilience, the All-Share has still underperformed the S&P 500 by 40 per cent over the past five years in sterling terms. That is a pretty big opportunity loss. It means that, simply as a result of choosing UK shares over the US equivalent, an investor is left with less than £97 for every £100 invested in mid 2017 compared with £163 if the capital had gone into an S&P 500 proxy fund. Okay, the extra dividend income received from UK shares would narrow the gap, but not that much. Adding in dividends, over the same time span the All-Share’s underperformance is still 34 per cent.

What this suggests is that because UK shares have already been beaten senseless they will receive further treatment from an adolescent grizzly bear rather than get the works from a fully-formed adult.

Then again there is inflation. The unfashionable, but still much-used measure of UK inflation, the RPI All Items index, is already running well clear of 10 per cent. It was 11.1 per cent in the year to April, its highest since 1981 when Margaret Thatcher and Geoffrey Howe were using interest rates as the bluntest of tools to bash inflation out of the system. Who knows how much higher it will go, especially as we can’t tell how far feedback effects will lock a high rate into the system.

Meanwhile, the extent to which inflation has eroded real returns on UK equities over the past 20 years or so is miserable. On the chart, focus on the two lower lines, which show rebased values for the All-Share and for UK inflation since the Bearbull Income Portfolio’s launch in late 1998. The message is that for almost a generation UK shares have lost real value. The inflation line rises steadily but inexorably with an ominous upwards tick this year. Equity values swing either side of the inflation line but spend much more time below it than above. Of the 285 months shown in the chart, share values have trailed inflation in 188 of them. Worse, with inflation in acceleration mode the gap looks set to widen. Underperformance in real terms may be baked in for years to come.

Granted, investors in the UK may be saved by mean reversion. The bad get better even as the good get worse. It does happen. Witness the progress of the UK economy and its shares in the 1980s and 1990s. The difficulty is that in the real world there need to be catalysts and they seem to be in short supply. So it’s a sobering time to be running a UK-focused equity portfolio, but it has been for a long time.

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Meanwhile, a complete Horlicks seems a fair description of the fun and games surrounding last month’s rejection of a bid for specialist insurer Randal & Quilter (RQIH), whose shares sit in the Bearbull Income Portfolio. None of the actors in the farce emerges with much credit, including – for what it’s worth – Bearbull in a tiny non-speaking part (see this column, 20 May 2022). To re-cap, a Florida-based private equity fund made a recommended 175p-a-share offer for R&Q’s equity, onto which was bolted the promise to inject $100mn-worth of new equity. However, with the offer teetering on the edge of rejection, the private equity player strode off in a huff. Result – R&Q’s share price has collapsed to 100p, and approaching £100mn of new equity is being raised via a placing and offer at 105p a share.

R&Q’s bosses should have made clearer the imperative to raise new equity and the consequences if the private equity bid failed. Simultaneously, both parties should have assembled a takeover package that left something for existing R&Q shareholders if the group’s future turns out as brightly as R&Q’s bosses claim it will; a convertible loan-stock alternative with rights to sell to the private-equity firm, for example.

Meanwhile, the moral is – if we didn’t already know – that insurance company profits are often illusory, especially when long-tail risks are underwritten. Much of the damage that leaves R&Q scrambling for capital relates to reinsurance contracts it acquired back in 2006 via the acquisition of Brandywine Reinsurance. Only now – 16 years on – has it become clear that claims on some of Brandywine’s contracts will be higher than expected. Thus policy refunds R&Q had accounted for as assets won’t materialise. This means a $90mn accounting write-off and early termination of contracts that might otherwise have brought in cash.

It does not help that this week’s share placing is not underwritten, but R&Q’s bosses say the book-building is going well enough to increase the size of the offer. That’s encouraging since R&Q will be in breach of borrowing agreements if the placing fails. A further hindrance is that a 12 per cent stake in R&Q’s equity, which would have been sold to the private equity buyer, is also up for sale.

As I say, a right Horlicks and, although R&Q’s bosses talk a good talk, I doubt if the Bearbull portfolio will stick around to see what transpires, especially as the final dividend for 2021 has been axed. Sure, companies such as Randall & Quilter always offer the prospect that, with just one more push, the good times will roll and new capital will never be needed again; except that, in the insurance business, there always is a next time.

One disposal the income portfolio has made – and which I had threatened before – was its holding in housebuilder Berkeley Group (BKG). Happily, the timing was decent. I sold on 31 May at 4,248p a share, 8 per cent higher than the current price. The difficulty with holding Berkeley shares in an income portfolio is that too much of its returns to shareholders are via buybacks and too little via cash dividends. There was a big cash distribution last September – 371p a share (9.4 per cent on this week’s share price) – but that’s as good as it’s likely to get for a while.

In the past five years, Berkeley has spent £738mn buying in shares and, in theory, enhancing shareholders’ returns by 16 per cent. Yet at its current 3,944p, the share price is just 6 per cent higher than the average buy-in price. That might look as though Berkeley’s plan is failing, but it’s not possible to know that. Since there is no counter-factual, we can’t know what total returns to shareholders would have been had Berkeley distributed all its surplus capital. Even so, I would have preferred to get more cash to pass on to Bearbull investors and leave to chance how the share price would have responded.

bearbull@ft.com