Outlook 2021: UK equities
Outlook 2021: UK equities
- Many mispriced opportunities for stockpickers.
- Pick-up in M&A activity.
- Companies are adapting following Covid-19.
If the job of stockpickers is to work out when the market is “mispricing” shares, then there is plenty for those with a focus on the UK to get their teeth into right now.
As investors look beyond events over which they have no control – such as Covid-19 and Brexit – opportunities abound at an individual stock level. Indeed, in terms of potential, today’s market for stock picking is comparable to the one that followed the Global Financial Crisis (GFC).
This is at a time when many companies are looking to the future again and increasing investment. There has been some sensible bolt-on merger and acquisition (M&A) activity and many dividends are being reinstated. Plenty of companies have surplus cash to grow their businesses and reward their shareholders.
Investor confidence in the UK dropped away amid the pandemic. Having briefly re-engaged in late 2019/early 2020, global fund managers retreated back to the side-lines, according to regular investor polls by Bank of America Merrill Lynch.
As a result, UK shares are on track to lag other regions for yet another year. While the gap has recently closed a little following some positive vaccine news, the market is significantly trailing other regions year-to-date.
However, investors observe plenty of stocks whose prices are failing to properly reflect company prospects to sustain and grow earnings over time. Against this backdrop, two Schroders stockpickers explain how they’re looking at the market heading into 2021.
Sue Noffke, Head of UK Equities:
"The possible reasons for not owning UK shares have been extremely well publicised in recent years. We can currently see this with Brexit and the devastating Covid-19 crisis, which are both top of many investors’ minds.
"The reasons for owning UK shares are much less well-known and have frequently been overlooked. It seems to me that the bad news is crowding out the good. This, in part, explains why there are so many mispriced opportunities at present.
"It’s certainly good to see our optimism affirmed by other large and experienced long-term investors. This is apparent from the resumption of “inward” M&A activity as global deal-making has picked up again.
"The trend of inward M&A had begun to gather pace prior to the global pandemic (see Who’s buying UK shares are what does it tell us?). We see many indications that it is starting to regain momentum.
"Recently announced deals include a recommended bid for RSA Insurance by a consortium of overseas rivals. Meanwhile, the eponymous owner of Las Vegas’s iconic casino Caesars has seemingly prevailed in a heated contest for gaming group William Hill. This is as two North American rivals vie for control of security group G4S.
"This bid interest underlines the unloved status of many UK shares. A large number of companies are trading on very depressed price-to-earnings ratios (a commonly-used valuation metric), similar to the situation we saw in the wake of the GFC (see chart, above).
Companies back on track
"Since peak Covid-19 uncertainty around the time that the World Health Organization (WHO) declared a global pandemic in early March, we’ve seen many companies get back on track.
"Even before the positive news on potential vaccines, the companies we follow were looking ahead again. They were feeling sufficiently confident to give some guidance on their likely future financial performance.
"A number of these companies have also paid, or indicated plans to resume dividend payments deferred last spring.
Quintessential “exogenous” shock
"Many in the market had judged these dividends more vulnerable than they’ve transpired to be. Their reinstatement is a really good signal of corporate confidence, which may have been obscured by 2020’s high profile dividend cuts.
"These cuts have been concentrated in the hardest hit sectors of banks, oil & gas, travel & leisure and other areas within the wider consumer services industry. Some dividends have been “rebased” to a lower level, as may also happen with the banks when they resume distributions.
"Other companies outside of these sectors have been less impacted by the pandemic. As a result confidence, and dividend payments, have been able to resume more swiftly than many had previously assumed possible or likely.
"Having said that, Covid-19 is the quintessential “exogenous” shock, one which arises from outside of the economic system, such as an extreme weather event. These shocks are less quantifiable than those which come from within, like the global financial imbalances which set the scene for the GFC.
"The acceleration of technological trends, changing consumer behaviours and the loss of demand as a result of the crisis will have long-lasting impacts.
"In some instances, these impacts may become permanent if it takes longer than expected to resolve the pandemic due to the many potential challenges which face vaccination programmes.
"These challenges could relate to manufacturing, storing and distributing a vaccine as well as levels of public uptake.
"This increases the risks around some of the worst-hit sub sectors, and underlines why valuations need to scrutinised in the context of company fundamentals.
"For this reason I’m avoiding some apparently cheap property companies (traditional retail/office), airlines and cruise operators within the travel & leisure sector.
Positives come back into focus?
"More broadly, markets could fall if expectations around vaccination programmes prove too optimistic.
"Global stock markets have recovered quickly since news of the vaccine progress. UK equities are global in nature, international developments often set the tone, and in this regard a number of uncertainties remain.
"If it does take longer than expected to resolve the pandemic, I’d expect the strongest companies with the strongest balance sheets to outperform.
"It’s worth noting this scenario would not necessarily preclude UK shares in the broad performing relatively well. There are some country-specific factors at play here.
"Should, for instance, uncertainty around Brexit subside, it could create space for the UK stock market’s positives to come into focus.
Strongest consolidate their positions
"The degree of negativity towards UK shares remains really quite entrenched. This is reflected in the extreme positioning of global fund managers.
"However, I’m glad to report that many of the companies we follow have unveiled new investment plans. I’m also seeing some sensible “bolt-on” M&A proposals to accelerate growth.
"I’ve already mentioned dividends, which in a number of cases have been reinstated on a progressive basis.
"In summary, many of the strongest companies have been able to consolidate their positions and are adjusting very well to the changes."
Andy Brough, Head of Pan-European Small and Mid Cap Team:
"Markets dislike uncertainty and, thankfully, we may have a bit of certainty heading into 2021 after an eventful 2020. In addition, I’m reasonably optimistic on the outlook for the UK economy and many of the domestically-focused small and mid-cap (SMID) companies exposed to it.
"It’s not just the beneficiaries of the country’s flourishing digital economy which are exciting me at present, but also plenty of the so called “old economy” stocks.
"Many of these businesses have cast aside entrenched behaviours and achieved years of change in a matter of months. That can arguably only be a good thing for their long-term profitability and the health of the economy.
Wages and salaries higher than pre-crisis
"It’s easy to get gloomy and forget the positives during a global pandemic. It’s worth pausing, however, taking a moment, and looking ahead to imagine what might happen when the economy restarts.
"News that UK gross domestic product (GDP) grew by 15.5% in Q3 2020 has been dismissed by some commentators as merely the product of pent-up demand. However, wages and salaries are higher now than they were in Q4 2019, which shows that government schemes are supporting income (albeit at a cost).
"The UK housing market is in very good shape, which gives me confidence in the underlying strength of the economy. Meanwhile, the retailers I speak to are really looking forward to the new year.
"The potential for 24-hour opening of stores for Christmas trading is a very interesting near-term development.
Surprising resilience seen by some sectors?
"You may be surprised to learn that UK retailers have broadly held their market values this year. The FTSE All-Share General Retailers sector has returned +0.5% in sterling terms year to date (total returns to close 18/11/2020).
"The sector is up 38% since the start of 2019, on the same calculation basis.
"We always felt that there was a gap between the perception of how retailers were trading and their actual performance (see Death of the High Street? Why we’re still backing UK retail).
"This bounce back is a timely reminder that the job of stockpickers is to work out where the market is pricing incorrectly.
"Once Covid-19 restrictions are eased we could find the economy quickly comes back to strength, with entrepreneurial and animal spirits unleashed again. The recent pick-up in all variety of M&A activity augers well in this regard.
"I would also note that much of the recent recovery in deals involving UK companies (see above chart, which captures announced deals) has been driven by bids for SMIDS.
"In the past, SMIDs have attracted a relatively greater part of the M&A pie.
"Were we to see a strong economic recovery, we could see plenty of jobs being created and wages rising briskly. In this scenario the tax-take would be expected to rise to help pay down national debt.
Most recent disruptive event
"Back in March when the implications of the pandemic were becoming clear, we kept faith in our homework. We felt the crisis would not fundamentally change the investment outlook for many of the strongest companies, which we continue to believe today.
"The GFC was as traumatic for many mid-cap companies as Covid-19. We anticipate a wobbly V-shaped recovery in terms of a rebound in GDP.
"Companies will continue to face headwinds caused by this most recent disruptive event.
"It’s important, however, to keep some investment perspective in what feels like an increasingly short-term world. While the recovery following the GFC felt painfully slow, many mid-caps that had genuine competitive advantages emerged stronger.
Long march higher
"In hindsight, 2007-09 now appears as a minor blip in the long march higher in their share prices – we believe the same will be evident when looking back in five years’ time.
"It is too early to tell, but it might also be the case that behaviour around distribution of earnings as dividends might moderate, long term. As a result we could see management teams seeking to increase investment to grow companies.
"With a cautiously optimistic eye on the UK economy, as an investor I continue to primarily focus on seeking out the next mid-cap disruptor, while looking to avoid the next industry to be disrupted."
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This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
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All data contained within this document is sourced from Cazenove Capital unless otherwise stated.