The great switch out of mid-cap into large-cap equities has left many UK domestic stocks attractively priced, according to Steve Davies (pictired), co-manager of the Jupiter UK Growth Fund and manager of the Jupiter Undervalued Assets Fund, with UK banks looking the most contrarian trade…
It was perhaps inevitable that many investors at the start of 2014 would question whether the strong gains for mid-cap stocks, and UK domestic equities in particular, had run its course. The FTSE 250 Index, after all, had risen 28.8% in 2013 compared to a gain of 14.4% for the FTSE 100 Index. The market view at the time was that UK domestic stocks had become pricey and were trading at far too high a premium to the rest of the market. There was also concern that the Bank of England would likely raise interest rates in 2014 for the first time in over five years, posing a threat to the disposable income of the UK consumer.
While we believed shares in many of the UK domestic companies we owned still had room to appreciate, we thought some kind of correction might be due. We consolidated our gains and decided to keep our powder dry by raising the proportion of our Fund we held in cash.
Six months later, and the rotation into large-cap stocks has dramatically narrowed the appeal of these companies relative to the mid-cap sector – the valuation gap in other words has narrowed considerably. Mid-cap stocks, meanwhile, have continued to benefit from the resilience of the UK economy with earnings forecasts being revised upwards in a number of cases. By contrast, many of the international companies that make up the FTSE 100 have been lowering their earnings outlooks as a rise in sterling against the world’s major currencies hits exports and the ongoing emerging markets slowdown crimps revenues.
Looking at the stocks we currently own in the Jupiter UK Growth Fund, we believe many of the UK domestic companies we hold now look extremely undervalued. Back in February, we calculated that the average upside to our target prices for the stocks in the Fund was much closer to 20% but this is now in excess of 40% (on a two-year timeframe). As a result, we have been adding to existing holdings such as Dixons, Inchcape and Thomas Cook. Good stock selection remains key when seeking to deliver good investment returns from a strong UK recovery and we continue to avoid sectors like food retailing where structural challenges persist and earnings forecasts still look too high to us.
UK banks remain the most obvious contrarian trade in the UK market in our view, with several still trading below their book value. Margins have improved as the cost of securing deposits has fallen, while impairments continue to drop as economic conditions improve. The banks themselves continue to focus on driving down costs through various self-help initiatives, while the sector should also benefit when interest rates do start to pick up. In terms of capital, the Bank of England’s Financial Policy Committee recently noted that there had been “a material improvement in the capital adequacy of the UK banking system”. The banks still have to pass the Prudential Regulation Authority’s Stress Test towards the end of this year, so further patience may be required, but we think we are getting closer to the time when banks can pay out a greater proportion of their earnings as dividends to shareholders.
Our cash position now stands at around 5% of our total Fund, down from 10% earlier in the year. With so much of our current portfolio attractively valued in our view, there has been little incentive to participate in the many initial public offerings (IPOs) that have come to market, often at what we think were heady valuations. That said, we have recently participated in the TSB and Zoopla IPOs.
Looking at the broader investment climate, the timing of the Bank of England’s first interest rate rise since July 2007 continues to preoccupy markets. For us, though, interest rate risk is less of a worry than it has been, particularly as the rate of increase seems very likely to be slow and gradual. We think that from the banks’ point of view, the amount they are having to pay people to secure deposits are coming down because there is less competition and they have reasonably well-balanced funding profiles. In our view they can afford therefore to charge less on their mortgages and still make the same profit margin. The base rate may go up but it is also important to think about the spread the banks make over and above that base rate. If that spread is coming down while the base rate is going up, the net amount that people are paying on their mortgage may not actually change that much.
On top of this, employment levels continue to rise dramatically and, in our view, surveys from the likes of Vocalink and the ASDA Income Tracker now show that wages have been growing faster than inflation for around 9 months now, in contrast to the official earnings data from National Statistics. So, most households should be well-placed to cope with a modest rise in mortgage payments.
With a referendum on independence in Scotland due in September and a general election in May 2015, political risk has undoubtedly moved higher up the agenda. The latest opinion polls continue to suggest the Scottish people will reject a break-up of the union as they have done since the start of the independence debate. There is arguably more uncertainty over the outcome of next year’s election, with a hung parliament, in our view, very much a possibility and potentially a second election called to obtain a more definitive outcome. In the meantime, though, positive momentum in the UK economy should continue to offer a favourable climate for those UK companies that depend on a healthy domestic economy for their earnings.