This article was originally published on Citywire.

Faith and values

In the United States there’s an unusual online community called the Clergy Project. It’s for vicars and other religious professionals who no longer believe in God but carry on working, hiding their crises of faith. I sometimes wonder if we need a similar organisation for UK equity managers.

We’ve had our faith well and truly battered by the past decade or so. We all talk about the UK being undervalued. We point to the beaten-up price/earnings ratios and the premiums being paid by private equity managers who continue to swoop in on the bargains. We offer signs of a resurrection to come in the market. But do we truly believe?

Let’s not be in doubt. Investing is an act of faith. You’re buying a stake in a company for a share of the rewards. This isn’t fixed income – there’s no promise of getting your pound invested back. You do your analysis, looking for the best companies with the best chances of growing and sharing profits. And then you wait for those rewards – trusting that, if you’ve done your research properly, they will come. The ultimate test of this is that you’re prepared to hold for the long term, because equity should be the ultimate form of permanent capital. There’s no set timeframe to move the business on, as there is with much of private equity. We, as public equity investors, should have the longest time horizon of all.

Short-termism

Why, then, does it increasingly feel the opposite? If you want evidence of fund managers struggling with doubt, it’s seen in our investment behaviour. Why are we spending so much of our time with companies debating what will happen in the next six months? Listen to any trading call – you will hear it.

In a world where trading conditions are changing by the day – even the hour – that short-term debate is of even less value than normal. Yet it seems harder than ever to take a step back from the noise and assess what a business is truly worth beyond the next six months.

For the individual DIY investor the temptation to buy and sell on mood swings must be even stronger, especially given how easy it is on platforms these days. “Buy well and wait” should be the mantra.

So how did it come to this? I think it’s partly that when times are tough – when a market has been out of favour for a long time and net flows have been weak – it’s difficult not to see shadows everywhere. It makes it more difficult to ‘look up’ and see the long-term opportunity rather than look for the next problem.

For professionals, if you’re constantly looking for a place to raise cash rather than make investments, your mindset can change over time.

The brutality of the past decade may be shaping our investment decisions in other ways, too. If certain end markets have been weak for a long time and you have become used to a sector (whether it’s industrials, building materials, etc) having constant earnings downgrades, the muscle memory of steep earnings inflections when end markets ultimately do improve has faded. Herein, though, may lie the best opportunities.

Valuations

If investing is about faith, it’s also about values – or valuations. And this is the nub of the problem. The UK isn’t cheap because its companies are poor or under more duress than those elsewhere. It’s the valuations that are flawed. The growing evidence of this is the sheer volume of takeover and broader corporate activity we’re seeing.

Take Renold, an industrial chain maker held in our funds. It announced it had received two separate (unsolicited) bids from private equity, both at a premium to the undisturbed share price of more than 40%. Yet even at the lower of the two bid prices the shares continue to trade on under 10x current year earnings forecasts.

Similarly, pawnbroker H&T has agreed to an offer from an American peer. Even at the bid price – an over-40% premium – the shares trade on a low-teens earnings multiple.

I could go on. Spectris has received a takeover offer from private equity at an over-80% premium. Johnson Matthey sold a relatively small division for roughly 80% of its group market capitalisation.

How is it that the UK public market seems to be getting the value of these businesses so wrong? In my view, it’s mainly down to scarcity of capital – or, put another way, years of net outflows. We have limited resources. We can invest in only so many companies, many of which are clearly undervalued (in other words, I might not have that undervalued company, but I have this equivalent one that looks equally wrong).

What does this mean in practical terms? It means being willing to be active, to move away from the benchmark towards the areas of more outlandish value in the UK. The mooted Spectris offer, with its eye-catching premium, gave me a jolt – I’ve been too focused on short-term earnings outlooks. I’ve missed the bigger picture. Yes, of course we need to think about short-term bumps in the road, but we also need to look up from our spreadsheets and think about what might go right, as well as wrong.

We’ve all had our faith in UK equities tested over the past decade, I think we’re close to seeing that faith rewarded.

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