Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

UK equities: time to get active?

The outlook for UK equities may seem gloomy, but we believe it is possible for active managers to generate long-term outperformance in this market.

 

For UK-focused investors, it’s hard not to look at other global equity markets with a degree of envy and frustration. We’ve seen a significant period of underperformance in the UK, notably in 2020, with the UK stock market having by far the worst returns among developed regions this year. In truth, though, the UK has lagged other regions ever since the Brexit referendum.

The cocktail of risks – from a negative short-term outlook on the UK economy to political issues – is clearly unhelpful. Arguably, our green stimulus package also needs to be much more effective in the aftermath of COVID-19, particularly when compared with the EU recovery plan.

At face value, UK equity valuations reflect their relatively unloved status. Given the poor relative performance, this is no surprise.  Most of the UK equity woes stem from market construction, as the stock market has a larger sector weighting to underperforming parts of the economy coupled with an overweight to those areas affected most by the global pandemic.

Compared with the US, and even Europe which has seen a shift in its style bias to become more pro-growth in recent years, the UK remains heavily wedded to an ‘old’ economy, with industries whose business models face structural challenges or other macroeconomic headwinds. Value stocks account for a larger portion of the index, and we all know how much that style factor has underperformed its growth counterparts.

Pro active

These observations may all seem filled with doom and gloom, but we believe it is possible for active managers to generate long-term outperformance from UK equities.

Tech companies have up until recently been powering markets. The UK sadly lacks them, but we are also seeing a broader basket of compounding growth stocks and environmental, social, and governance (ESG) winners prosper. In addition to growth names, we may lack visibility into next year, but we believe there are recovery plays (sectors such as housebuilders, construction, and transportation) that could see a return to form. Pharmaceuticals and consumer staples may be deemed a relatively safer bet, but that doesn’t mean they represent the best prospects for returns.

As ever, picking the long-term winners is what matters most for alpha generation. The UK offers a diverse range of domestic and internationally focused mid-cap stocks that in our view offer strong grounds for growth. Likewise, we believe the UK is home to both industry leaders and thematic winners. Companies that are actually prospering in this environment, thanks to business model strength and strong management, include Aveva Group, Experian, Ocado Group, Rentokil, Croda, Ashtead, Wizz Air and RWS Holdings.*

The “whatever winners”

We have spoken before about stocks generating sustainable revenue growth in excess of 4%, which has become an increasingly scarce commodity. Unsurprisingly it’s these companies that are outperforming due to the resilience of their business models.

As evidenced by financial results and management engagement, these past few months have revealed more examples of the strong getting stronger. These companies are not simply hostage to an investment cycle; they are able to grow and outperform in all environments – they are “whatever winners”.

Crucially, they have maintained an ambitious growth strategy and operate in a way that ensures a sustainable future. Most of these businesses have intangible assets – data, intellectual property, brand reputation or human capital – which help other companies or consumers and ensure they maintain or accelerate compounding growth rates. Others are prospering in an environment where peers are faltering in light of shifts in customer behaviour or other constraints.

The likely winners which we identified pre-COVID-19 still look best placed to weather current storms, given the potential  for industry consolidation, opportunities for transformative deals and a need for continued innovation and investment. In doing so, they are creating increasing barriers to scale and success. UK listed or not, we believe this is a winning formula for value creation in any environment.

 

*All references to specific securities are for illustrative purposes only. The above information does not constitute a recommendation to buy or sell any security.

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