Returns from UK equities have been muted in recent years, owing to a sequence of political uncertainty, rising inflation, and rising interest rates. Indeed, many investors have abandoned the market altogether in favour of markets with greater levels of growth, such as the US, or more diversified markets globally. Square Mile's Investment Management team, however, have maintained an allocation towards UK equities in the belief that their significant undervaluation and fundamental strengths make for a compelling investment opportunity for several reasons outlined below.

The UK market is cheaper than its historical average and versus most other developed markets.

We believe that if there is a marked improvement in the economic outlook for the UK, such as if interest rates start to come down or if inflation starts to come under control, then UK stocks could rebound strongly. This could lead to higher corporate profits, driving up share prices from their current low point. Of course, there is no guarantee if and when economic conditions will improve, however, the low valuations of the UK market do present an opportunity for investors who are willing to take on some risk.

UK companies have maintained strong earnings growth.

UK-listed companies have recorded strong year-on-year earnings and revenue growth for a number of years. The market, however, has remained broadly flat over the past three years. It is our belief, and the belief of our underlying managers, that there is a fundamental mismatch between pessimistic market values of companies and their rather optimistic earnings growth. Our underlying managers, such as in the case of the AA-rated Liontrust Special Situations fund, report being encouraged by the trading resilience of companies within their funds, despite the prevailing economic headwinds.

Listed UK companies have well-diversified international revenue streams.

Many UK companies have strong international revenue streams, which means they get a lot of their sales from other countries. This diversification factor makes them less correlated to the sluggish UK economy, and therefore less exposed to the UK consumer. This means that many should be able to continue to grow their revenues from global markets, even if economic activity in the UK does not pick-up.

For example, over 70% of the revenue of companies listed on the UK stock market comes from outside the UK. This makes these companies a potentially good investment for people who want to access global growth through established UK names.

Many of the UK’s largest companies that have survived numerous global events are mature and well-managed. In the view of Henry Dixon, manager of the AA-rated Man GLG Undervalued Assets fund, “the current widespread disillusionment with the UK stock market despite a resilient earnings performance and over 70% of profits being generated overseas has created, we believe, an opportunity”.

There is a concerted effort being made to rectify issues with the UK market.

Scott McKenzie, manager of the A-rated Amati UK Smaller Companies fund, states that “there are considerable challenges in re-establishing the UK market as an attractive place for companies to list and raise capital, but we do detect a greater commitment from the Chancellor, the FCA and others to address this increasingly urgent problem”.

Indeed, the UK government is attempting to make the UK market more attractive to investors by incentivising large pension funds to reinvest back into the UK market through potential tax breaks, as well as reducing the regulatory burden on UK-listed companies and promoting the market overseas. This could serve as a factor in breathing life back into the UK.

What would the right set of circumstances look like for a rebound in the UK market?

That is the question many of our underlying managers are asking themselves as they continue to grapple with a tricky market.

There is no telling precisely what could cause a reversal in fortunes, it could be one or a number of factors, and it could be immediate or gradual, but we note many of our managers believe the turnaround could be extremely rapid. It may be that investors gain back confidence in the UK market once they see the Bank of England signal that inflation is under control by lowering interest rates, it could be continued strong earnings growth, a political catalyst such as a cease-fire in the Ukraine, or simply a case of a rising tide lifting all boats, with the UK market benefiting as countries elsewhere grow strongly.

Whatever the future holds, we and our underlying managers believe the potential of UK stocks, in spite of their short-term volatility, should not be ignored.

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