Looking beneath the surface of the UK market’s performance
Despite increasing economic and geopolitical headwinds, the UK market has been relatively resilient compared to global peers. However, beneath the surface, all is not as it seems. In this article, David Smith, Portfolio Manager of Henderson High Income, examines the performance of the UK market and asks whether now is the time to invest in cyclical stocks.
5 minute read
The UK equity markets’ performance this year could be described as relatively resilient with the FTSE All-Share only down -2.1% on a total return basis to the end of August, despite fears over recession, surging inflation, tightening monetary policy, a cost-of-living crisis and a war in Europe. The UK market has also materially outperformed other overseas indices with the S&P 500 down 16.1%, Nasdaq down 24.1% and FTSE World Europe ex UK down 15.2%, all in local currency terms for the year to end of August.1
However, taking a closer look at UK returns shows a large discrepancy of performance of companies within the market. The FTSE 100, representing the largest 100 companies in the UK market, has returned +1.6% over the period, while medium and smaller companies have suffered a similar fate as overseas indices, with the FTSE 250 and FTSE Small Cap indices falling 17.3% and 13.0%, respectively.1 Dissecting the FTSE 100 further shows the performance of the UK market is even more skewed; the top 20 largest companies in the UK market, are up 12.4% on a weighted basis for the year to end of August. For the same period, the other 80 stocks in the FTSE 100 are down 19.3%.1 This has been a very unusual period for the UK market where performance has been so dominated by such few large companies. Looking at those companies, however, one can understand why. High commodity prices has led to the outperformance of BP, Shell, Glencore and Rio Tinto, rising interest rates has supported HSBC, defensive positioning has driven shares in the likes of British American Tobacco, AstraZeneca, National Grid and Vodafone while more stock specific reasons have aided Compass Group and the London Stock Exchange.
So although at the headline level the UK market appears to have been relatively resilient this year, looking beneath the surface shows that the vast majority of UK stocks have suffered the same fate as overseas equities and have been weak, reflecting investors’ concerns over recessionary risks etc. Given this underlying weakness, the question becomes whether now is a good time to invest and what to buy?
Unsurprisingly the sectors that have come under the most pressure this year are cyclical in nature and are most exposed to slowing economic growth. Consumer discretionary (-18.9%), industrials (-18.4%) and financial services (-20.5%) have all performed poorly and are where valuations are now starting to look attractive.1 This creates a quandary - although valuations appear attractive, is it too early to start buying cyclicals when the outlook is so uncertain and current earnings forecasts, which those valuations are based on, may prove too optimistic. To buy cyclicals here an investor needs to believe that either the earnings forecasts are correct and the valuation is indeed attractive or that the valuation is so depressed it already discounts a too bearish expectation for earnings.
The Bank of England, in its August monetary policy report, is now projecting the UK enters recession from the fourth quarter of this year. While this may sound alarming one needs to put their forecasts into context. The chart below shows their projections verses previous recessions, highlighting any potential recession could be less severe than experienced in the past. While consumers’ discretionary spending is under significant pressure currently, generally, corporate balance sheets are robust, banks have strong capital positions and labour markets are tight, which would all support a less severe recession, something that is mirrored in other developed market economies. This therefore helps to judge what the correct level of earnings a cyclical company can generate in a more difficult trading environment.
Source: The Bank of England, Monetary Policy Report – August 2022
Two good quality, albeit cyclical businesses, we currently like are PageGroup and Vesuvius where we believe a recession is already discounted in the valuation. PageGroup is a specialist recruitment consultancy. The company provides mostly permanent recruitment service for executives, qualified professionals, and clerical professionals across a broad range of industries and geographies. Currently, the consensus of analysts covering the company forecast its net fees (effectively a recruiter’s gross profit) to grow by 1.3% in 2023. This feels particularly optimistic given the current economic outlook. If we assume net fees fall by 25% in 2023 (They fell 28% during the pandemic) and apply the same average Enterprise Value (EV) / Net Fee multiple (a valuation metric used to value recruitment companies) of 1.6x the company traded at during the Global Financial Crisis this would approx. yield the current share price.2 While there are risks to this analysis; the fall in net fees could be more severe than our assumption and the market could ascribe a lower multiple to the business than during a previous recession, we believe our assumptions are on the conservative side and hence we have concluded a too bearish outcome is currently being discounted in the current share price.
Vesuvius is the global market leader in the manufacture of products and systems that regulate and control the flow of molten steel, as well as consumable products for the foundry casting process. While an inherently cyclical business, it has strong market positions, technical leadership, a strong management team and robust balance sheet. Similar to PageGroup, consensus earnings expectations are forecasting growth in 2023. Applying our own assumption of a similar fall in revenues to the pandemic (-12.7%) in 2023, the current share price would imply an EV/Sales multiple (a valuation metric used to value industrial businesses) of 0.75x. All else being equal, the market is suggesting at this valuation the company will make a through the cycle 7.5% operating margin going forward. This compares to an average margin of 9.2% the company has made over the last 13 years and a 7.0% margin low during the pandemic. Again this is one of the cyclicals held in the Trust where we think a too bearish scenario is being priced into the current valuation.3
The UK market has been resilient so far this year despite a worsening economic outlook but within the market there has been a significant divergence in performance between the largest 20 companies and the rest of the market. This has created a buying opportunity in certain cyclicals despite the negative economic background but only in those companies where the valuation is already discounting a too bearish outcome for revenues and earnings.
1Source: Bloomberg as at 31/08/2022
2Source: HSBC Research Note: “Recession priced in, churning out profit”, 03/08/2022
3Source: Factset as at 26/08/2022
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