Global Perspectives Podcast: Where are the opportunities in undervalued UK equities?

Adam Hetts: Welcome to Janus Henderson's Global Perspectives. Today we're mapping out opportunities in the UK equity market where we know valuations are attractive, but of course it's not as simple as just buying the entire market. To help us along we have Laura Foll and Indri van Hien. Laura and Indriatti make a great pair for this conversation with Laura being more value and contrarian in style and Indri, a concentrated growth investor. And I'm your host of course, Adam Hetts, Global Head of Portfolio Construction and Strategy. And in my team's portfolio consultations with our UK clients, it's clear that UK investors love their local equities as evidenced by a ubiquitous UK home country overweight. So I think the important question for the audience seems not to be why on UK equities, but how to own UK equities. And that's what we get to discuss with Laura and Indriatti today. So thank you both and welcome to the show.

Laura Foll: Thanks for having us.

Indriatti van Hien: Thanks, yes.

So I guess let's start with what I mentioned already. We all know the UK market is cheap relative to most of the world, but besides just buying low, what unique opportunities within the market do these low valuations create? And Indri, maybe you can go first on that.

Indriatti van Hien: Well, I think it's not just that you're buying low valuations. It's what you're buying at low valuations, revenues of UK-listed companies across the market cap scale are actually very international by nature. So you have businesses operating in same industries, same geographies and therefore, seeing the same pressures trading at 20% or 30% discounts to their US or European-listed peers. The recent spate of activists cropping up on UK share registers and M&A (mergers and acquisitions) in the market has served as a really good reminder of this valuation disjoint and should be seen as a real catalyst for a re-rating. So the outlook for UK-listed or international earners in particular are looking pretty good.

You're also buying the UK when earnings forecasts for the year ahead are really quite muted, which feels anomalous in the context of above-trend GDP (gross domestic product) growth. So buying low valuations when you've got low expectations at a time when investor sentiment is fragile, often proves to be a really sensible strategy.

Adam Hetts: And how do those opportunities map out across kind of large versus mid versus small within the UK, from a market cap perspective?

Indriatti van Hien: Well, value looks most apparent on a headline basis in the large-cap space. That's where there are some very large under-owned sectors such as oil, materials and banks, which are trading on single-digit multiples (valuations). Rising commodity prices and steepening yield curves provided those sectors with really good upgrade momentum and certainly, better upgrade momentum than lower down in the market cap spectrum.

That being said, while mid-caps look more expensive in comparison to large caps they're still trading at a discount to international peers. As has been the case for a while, there's actually some exciting structural growth stories in that part of the market. So once those headline multiples look more expensive the gross-adjusted multiples actually look more reasonable. You see some of those similar growth dynamics in the small-cap space but cost inflation-driven downgrade risk (driven by higher prices of raw materials and wages) seems a lot higher there because in this part of the market, you can be more impacted by price rises because the companies don't have the scale to buy ahead and therefore tend to pay spot (current market) prices.

But I actually think a better way of looking at the market at the moment is to compare international earners with UK domestics (companies that generate majority of their revenue in the UK) because that's the sort of valuation elastic that looks to be stretching once again.

Adam Hetts: Okay, thanks. So the lowest valuations, there’s value in large-cap, but then mid and small-cap - higher valuations but still relatively cheap compared to ex-UK peers. Laura, how about you, anything to add across the market cap spectrum as far as opportunities you're seeing there?

Laura Foll: I definitely agree with all of what Indri said. The one thing I'd add is that when you think about large, medium and smaller companies in the UK, the dynamic people need to be aware of and it might be a kind of obvious thing to say, is that smaller companies on average are much, much more domestic for the purely common-sense reason that they start in their domestic market and then you know, if things are going well, they move overseas.

So what that means for smaller companies is that they're more exposed not only to the domestic economy, but also to sentiment towards the domestic economy. So we think post the EU referendum in 2016, there was a period of really poor sentiment towards a very particular type of domestic UK company and a very prolonged period of underperformance after that referendum as we went through years of political uncertainty and then a brief period of re-rating and then COVID hit.

So there has been this very long period of underperformance for a subset of domestic smaller companies that are generally well managed. They're often market leading, often they don't have structural issues, but they are the subset of the market that they might have done well since that COVID vaccine news last year. But actually on a longer-term basis, they've still materially underperformed and it's left this subset of the market, of companies that you probably wouldn't have heard of, but where we see a good valuation opportunity and where there's often a dividend income opportunity, as well. So if we were to try and generalise and it's not really how we do it, we don't come in one day and think, “Oh, we want a large company or we want a small company,” it’s very much bottom-up (focusing on the analysis of individual stocks). But if I were to generalise you know, I do think there is an opportunity among some of these smaller domestic companies.

Adam Hetts: I think that's an important point. It seems the sentiment you know, post-Brexit and now getting into post-COVID, the idea of if you liked UK equities, then you'd love them now. But I think to really action on that, you need to take that all-cap approach. I think because you're getting more of that domestic focus, the farther down the cap you go, of course. So that's great. And you mentioned the dividend focus. And I think Laura, you're very much dividend focused overall. So from a dividend perspective, how is this recovery environment a different landscape for equity and income investors compared to the pre-COVID landscape?

Laura Foll: I think the first thing to say is that last year, you really need to bear in mind how much of a dividend cut there was in the UK last year, which was roughly 40%, so a much, much bigger dividend cut than we saw during the financial crisis. This year is better. We'll probably see a just over 20% dividend rise this year on the latest forecasts.* But it goes without saying that with those numbers, you're not getting back to 2019 levels just yet. But it does leave the UK with a dividend yield of probably just under 4%. So still an attractive dividend yield versus international markets such as the US.

The one thing I would say though, as a multi-cap investor, so going all the way down to small-cap is what we're seeing is quite a number of companies doing it's given a sizable portion of companies cut their dividend to zero last year, we're seeing quite a lot of management teams and company boards take the opportunity to say, “Well, now that our dividend has been cut to zero, we're effectively starting with a blank sheet of paper anyway, what should that dividend be?” And really taking the opportunity to think actually historically, were we over distributing? And the answer that they're coming to in some cases is yes. And what we're seeing is companies, not all companies, but some companies choose to take their dividend payout ratios from maybe 50%, 60% to more like a third or even lower. So it means that there is a section of the market that won't go back to all else being equal, it won't go back to the dividend yield that it's been historically.

Now, we in the majority of cases, we support company boards in that decision because I think it's really important as income investors to have a time horizon where we say, “Actually that company taking that cash and using it if they need to for organic purposes or for M&A if they can see attractive opportunities, we are happy for them to do that.” We are long-term owners of these assets if that's a better use of capital, then we will fully support them in that. But it's just worth being aware that there is this dynamic and it could mean that for some smaller and medium-sized companies that they could pay a lower dividend yield in the future than they have done historically. But from a total return perspective, I see that as a good thing.

Adam Hetts: That's interesting. So that payout versus reinvestment decision and how that's changing, is that explained, do you think broadly at the sector level? Like can you say mostly at different sectors you're seeing this play out differently or is it even within sectors just at the security level, every company's making different personal decisions on this payout versus reinvestment on dividends?

Laura Foll: It's a good point and it does definitely vary by sector. So what we're seeing is that there were certain sectors that were not unaffected by the pandemic, but certainly less affected by the pandemic. You think pharmaceutical companies, think utility companies or some consumer staples, they would generally be carrying on with dividends and dividend payout ratios just as they were before. Where we're seeing more of an impact is in the more cyclical (price sensitive) sectors that often were more prone to cutting their dividend. So this would be in particular, some of the media sector, it would be some of the industrial sector where there are potentially interesting takeover opportunities or to be completely upfront you know, in the media sector, things like free to air television companies. There are structural risks to some of these industries, and companies need to get on the front foot if they are to make sure that they're not going to be in structural decline over the next decade.

I think that's always the number one risk if you are an income investor, you have to always think, “Am I buying a company that is paying out too much cash and that could be in decline?” So I think it's really important that we as long-term investors, make sure we're picking those companies that are trying to get on the front foot and if it's, if they feel they need to reduce their payout ratio in order to do that, then we're happy to support them with that.

Adam Hetts: And then I think besides valuations in dividends, inflation is of course, another huge theme right now. And I think the three of us would agree to sidestep the debate over what kind of inflation is in the market and just focus on the fact that we're all feeling it in different ways. I think the most important question for you as portfolio managers right now is, where is inflation creating divergence and opportunity that you wouldn't have without inflation? And Indri, could you talk a bit about that first?

Indriatti van Hien: I suppose from my perspective, rising inflation expectations have just added to the market uncertainty as rate rises loom. You know, the fizz was certainly taken out of the market in September. And when this happens, you get a lot of share price dislocation and lots of opportunities arise. It's worth noting that studies of past rate rises show that the worst of the market moves actually comes in anticipation, so roughly three months before the actual rate rise rather than after the event. Now, what we've seen recently is IPOs (initial public offerings for shares) getting pulled or price ranges being slashed below the range, which if you believe in the long-term growth, it really is to the benefit of the investor buying today.

I also think that the real opportunity comes in the form of investing in companies that have a strong degree of pricing power and balance sheet, or niche circumstances to sort of withstand this inflation and the supply chain issues. Companies that have balance sheets can build inventories, can take market share, so you have better availability. And similarly, companies with strong pricing power and low inventory turnover are benefiting from marking up their products in response to those price increases that they you know, they didn't pay really. So I think that at the micro level, there is opportunity in companies seeing off competition through this period. But from a higher level, it's just causing a lot of price dislocation and when that happens, opportunities always arise.

Adam Hetts: And there's talk Indri, about with inflation driving potential rising rates and so on, the duration of growth equities compared to value in that there might be higher duration in growth equities and they're the beneficiary of rates going down. But if rates go up, then growth equities might disproportionately take that on the chin. Do you feel like you can explain the growth style more broadly by saying it is higher duration and potentially underperforming and rising rates? Or to you, do you think it's that dynamic is really overwhelmed at the security selection level? And like you said, defining securities with pricing power and so on and so forth?

Indriatti van Hien: I think that the market has already anticipated this, and what growth stocks have in their favour is that they've got top line (sales and revenues) growing faster than cost. And if you're looking at the growth that we look at, its structural and persistent growth. So real (inflation-adjusted) returns from those companies will still (likely) remain attractive, regardless of the short-term pressure you're getting from that sort of discount rate (rate of return) normalisation.

But I go back to my earlier point of markets anticipating this. You look at the studies, it's really the tech sector, so a very low duration sector that gets hurt after the event. Once we start to have those rate rises and we're on a normal diet of rate hikes as we go through the next year you know, investors seem to be more sanguine about the reality of it. I don't know, Laura, if you would agree or disagree with that?

Laura Foll: I think the thing I'm grappling with, and me and Indriatti are the same in this regard, is that for the whole time we've been in a market investing, which is post the (Global) Financial Crisis, inflation has been a bit of a non-issue for all of that time. And the thing that I'm trying to decide and we won't by the way, completely change the position of the portfolio on what we do, so we do things stock by stock. But what I'm wondering is, is the next decade going to be different to the last decade? You know, we have had Brexit, we now have a tighter labour supply here in the UK, the government seems pretty firm in that decision. And now we've also got the government, has very recently published a net zero strategy; that seems that we are very firmly going down the route of some really sizable green investments here in the UK. And that in my view is, has to be inflationary.

So there are two factors that mean we might have higher inflation in the next decade than we had since the Financial Crisis. And it's trying to work out what that means. And I think for a lot of the types of companies that I invest in, which are generally not all of the time, but generally in more traditional cash generative industries, the way I see inflation is that it almost greases the wheels for them in that they can put through, just Indriatti was saying, they can put through more of a price rise than they have for the last decade or so. And it might just allow them that bit of margin improvement that they've really been struggling for in the previous decade. I'm talking here about some of the industrial companies, potentially some of the food retailers, those types of businesses where actually, a modest, not an out of control, but a modest inflationary environment could actually be I think, a positive for those types of businesses.

Indriatti van Hien: Just to add to that, I agree with Laura. You know, high inflation hasn't been a feature of our careers, but the acknowledgement that we've been operating in a low inflation environment certainly has. So if you look at inflation-sensitive stocks, maybe infrastructure assets and you look at the discount rates used to discount the cash flows of those companies, they're still 8%, 9%. You know, I don't know what rates going to 1 or just above 1 is really going to do to that valuation. You know, investors were aware that we are operating in a low interest rate environment and valuations were reflecting the potential for that to change one day, even though it hasn't so far.

Adam Hetts: That's great. I think that's pretty consistent with our conversations with fund managers on other episodes we've had, that no doubt, inflation's a risk and risks are uncertain. But it's well within the range of being able to manage that inflation risk and even to your points, use it to your advantage in certain situations. So then, I think we can move over to sustainable investing. The UK is hosting the UN Climate Change Conference starting next week, I believe. So whether it's something that comes out of the conference or not, can you both talk a bit about just how ESG is changing the UK investment landscape in your markets?

Indriatti van Hien: Sure. I think the ever-increasing focus on ESG (environmental, social and governance factors) in the UK market is really having two impacts. The first impact is that it's putting pressure on investors  to ask more questions about carbon emissions targets and social issues and on managements to actually do something about these key issues. You know how well a company scores on ESG factors is becoming just as important as the more traditional indicators of quality such as cash flow or returns on capital in determining how that company is valued.

You know, you only need to look at Matt Moulding, the Founder and Exec Chair of The Hut Group giving up his golden share this week is an indicator of how much boards are waking up to the fact that these issues are impacting their (ESG) ratings. I think the second impact is separate but related. Those companies that score less well and are being punished with lower ratings are actually being pushed off the market. You know, I'd point to BHP Billiton, who's collapsing their dual listing and moving to Australia. You know, a move, which the board and investors certainly hope will re-rate those shares. Overall, I think the increased scrutiny is a good thing. You know, ESG may have started in Europe, but the UK is doing its best to take over the baton and lead the charge. And it's only a matter of time before these issues rise to similar prominence in other markets, I think.

Laura Foll: I’d agree with all of that. I think when we think about ESG, it is still to risks and by that, I mean the likes of Shell and BP in thinking, “Okay, what are the risks to cash flow here?” We are clearly trying to phase out fossil fuels. You know, to what degree is that priced into the valuation? “Okay, well do we need to put them on a lower valuation when we're thinking about where they could get to, where they have been in the past? So maybe the free cash flow yield should be a higher level to discount that risk that we move faster away from fossil fuels and potentially that people are anticipating.

So I think there's a risk factor to bear in mind and that's clearly much more material for some companies than it is for others. And then the other thing that we need to bear in mind, and I think the thing that people potentially talk about less is the opportunities from ESG and which companies could really benefit from what's going to be a huge amount of investment that happens you know, not just in the UK although we do seem quite determined to make, to sort of really get at the forefront of it in the UK, but globally, as well. And there are companies that can benefit that would maybe be a bit surprising you know, me and Indri, we were just talking before the recording about a company that does double glazing. Actually, that might not be the most glamorous company, but if we're going to make all of our buildings more efficient, we're all going to need more double glazing, more insulation and someone's going to have to supply it and someone's going to have to fit it. And there will be companies that really benefit from this green investment that happens. And it's something that we're really starting to think about now that the government has published its net zero strategy, trying to identify, okay, which of our domestic companies are going to really see some of this investment over the next 10, 20 years? You know, there could be some really good structural growth opportunities for us to identify here.

This was great. I think we've covered a lot already. We've had valuations across market caps, inflation, income, now ESG. Laura, Indri, thanks for joining.

Indriatti van Hien: Thank you very much.

Laura Foll: Thank you.

And for our audience, the views of Laura and Indriatti and their teams and Janus Henderson's other investment teams and other thought leaders are freely available within the Insight section of our websites. And we look forward to bringing you more Global Perspectives in the near future.

References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase, and neither should be assumed profitable.

Footnotes:

Market capitalisation: is the total market value of a company’s issued shares and is used to determine a company’s size, often abbreviated to ‘market cap.’

Steepening yield curve: a yield curve graph plots the yields of similar quality bonds against their maturities. A steepening yield curve typically indicates that investors expect rising inflation and stronger economic growth.

Re-rating: occurs when investors are willing to pay a higher price for a stock, typically as they expect higher earnings in the future.

Dividend payout ratio: the percentage of earnings distributed to shareholders in the form of dividends in a year.

Inventory turnover: measures how many times in a given period a company can replace the inventories sold. Retail companies and supermarkets are high volume, low margin businesses and typically have high inventory turnover.

Low duration sectors/equities: are typically high-value, high-profitability, low-investment and low-risk stocks.

Discount rate: “discounts” future cash flows to a present value. Measuring the present value of future earnings allows an investor to have a better idea of the value of a business today.

Golden share: a type of share that gives its shareholder veto power over changes to the company's charter. One golden share controls at least 51% of voting rights, and may be issued by private companies or government enterprises.

*Source: Link Dividend Monitor Q32021. Forecasts may vary and are not guaranteed.