291. Why investors should keep a keen eye on UK equities in 2024

Alexandra Jackson, manager of Rathbone UK Opportunities, discusses the challenges faced by the UK equities market, examining the impact of global events, rising bond yields, and third-quarter results on investor sentiment. Alexandra provides a nuanced perspective on the housing market, particularly focusing on Rightmove’s resilience amid competition. Alexandra shares her views on the UK’s economic fundamentals, valuations, and why investors should keep a keen eye on the market in 2024.

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Rathbone UK Opportunities is a truly active and nimble multi-cap fund with a clear bias in favour of quality growth. Structural winners are balanced out with a strong core of high-quality compounders. The final portfolio consists of around 50 to 60 holdings, with a bias to mid-cap stocks.

What’s covered in this episode:

  • Poor performance of the FTSE 250 in October
  • Do high interest costs affect holdings?
  • The importance of cash on a company’s balance sheet
  • Why companies are being more cautious
  • The mixed view of UK investor sentiment
  • Outflows in UK equities
  • The investment case for Rightmove
  • Why Rightmove is “unassailable”
  • Clinical trial company Ergomed and their private equity bid
  • Should investors back UK equities in 2024?

30 November 2023 (pre-recorded 27 November 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[NTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re discussing the challenges faced by the UK equities market and why investors should keep a keen eye on the market in 2024.

Joss Murphy (JM): I am Joss Murphy. Today I’ve been joined by Alexandra Jackson, manager of the Rathbone UK Opportunities fund. Hi, Alexandra, how are you?

Alexandra Jackson (AJ): Hi Joss, very well today, thank you for having me.

JM: Great to have you, great to have you.

[INTERVIEW]

JM: Alexandra, October saw the worst performance of the year for the FTSE 250. We’ve obviously had a bit of a rebound since then, but it’s still generally been quite a tough period. What’s been happening recently that has caused all this pain?

AJ: Yeah, good question, I’m glad you noted the rebound as well. We’re <laugh>, we’re very happy about that. I mean, October often is a bad month in equity markets sort of, seasonally, September and October seem to be quite tough. And this year, you know, October has really sort of cemented its reputation as being a difficult market.

As always, it’s a combination of a couple of things that I think we’ve seen, you know, coming together at once. We’ve got the awful situation in the Middle East, there was no progress in October [and] that’s going to weigh quite heavily on sentiment. The other big thing was bond yields kept moving higher around concerns about the US government’s fiscal position, which was making people a little bit nervous. And that led to, I guess the term premium rising, and so we saw bond yields keep moving higher. That’s quite a difficult backdrop for equities to perform against.

And then the other thing was that we were in the third quarter results season and I would say that they were a little bit underwhelming perhaps. Investors had to think about and remember what it looks like when we see a little bit of a growth slowdown, when we see interest rates, the impact of interest rate hikes starting to bite. We can see from some of our companies there are a few signs I think coming out that, consumers are pulling back a little bit on spending. And we also had a couple of companies talking about corporates taking a little bit longer to make their decisions.

So again, it’s very case by case. There’s lots of good, lots of not so good, lots of in the middle. But those three things together I think really weighed on equities during October.

JM: Certainly makes sense. Are your companies feeling the pressure of these high interest costs now? How is that affecting what you hold?

AJ: Yeah, it’s a really good point. Some are, definitely, some aren’t. What we’ve sort of talked about earlier in the year was we really didn’t want to see those companies that have hard won operating profit growth – they’ve got higher revenues, higher prices maybe, and they’re keeping control of their cost base – but that higher operating profit is being eaten away by higher interest costs; that’s really frustrating. And we have seen a few of those, in this fund fewer, I think, than the market as a whole because we focus on quality, and one of those kind of classic quality factors is around the balance sheet. So, more than half of the positions in this fund carry net cash on the balance sheet, which is a nice position to be in.

And then actually, if you exclude financials and property, we have nothing that has over two times net debt-to-EBITDA leverage ratio. [A debt ratio that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant. This tells an analyst how well a company can cover its debts.]

And in fact, only 13% of the fund has net debt-to-EBITDA over 1.5 times. And we really don’t want to change that at this point in the cycle, we’re really happy about that.

The other point, obviously is not just that kind of single number, it’s also the structure of the debt whether it’s fixed or floating, that’s been the most important thing. Obviously it’s only the floating debt that will be subject to these higher rates and when the refinances come, so that’s important to look at as well and takes a bit more time.

And then, as I said, that’s the kind of direct impact, but then you’ve got that indirect impact, which is essentially what central banks are trying to do with higher rates, which is to dampen demand a little bit. And that’s what the central banks, you know, they really want to see that companies are maybe making more cautious decisions.

JM: And I guess looking more broadly, what is UK investor sentiment and valuations like at the moment?

AJ: It’s a mixed picture. It’s quite hard to get a definitive answer I would say. There’s definitely some conflicting evidence at the moment. So, the Bank of America/Merrill Lynch fund manager survey recently in November put the UK at the bottom of its list. And that reflects the mood that I hear at conferences and things like that; people do feel quite depressed, I would say.

But then, I look at flows in the industry – or outflows as we should probably call them now – which are continuing, and actually, possibly not improving yet. And then I look kind of beneath the outflows. So, we are still in net outflow as an industry from UK equities, but actually it’s UK wealth managers who seem to be doing the majority of the selling still. Those, I guess, are the people who are overweight UK equities still. And that is being offset, not totally obviously, but a little bit by US investors who are coming in to kind of cherry pick some assets. And that’s really, really interesting to me and a little bit … that gives me some comfort, some hope, definitely.

The global investors that I talk to, they’re quite confused why UK assets are still so cheap, particularly the ones with growth and cash flow and those kind of factors that, when you see those in the States, those are the companies that trade on 25, 30 times. So, it’s a mixed picture, definitely, still some depressed sentiment out there, but there’s so much opportunity. I’m sure we’ll get onto valuations and things, but that’s the sort of the flip side of it.

JM: And you hold Rightmove [Group Limited] which many of our listeners will be familiar with. Are people still looking to move houses? And I believe that they’ve seen some competition in this space recently. Is that a threat going forward?

AJ: Yeah, that’s right, Joss. So, the housing market is the great sort of bellwether, an indicator for the health of the UK markets, isn’t it? And we’re all very interested in it.

So, for Rightmove, actually a very timely question, their November trading statement is out this week and they’ve actually talked about a rebound in new-build home segment since July. So, that’s a very fresh update and Rightmove are talking about seeing an improvement in demand for new-build homes since July. I don’t hear that being talked about in the media, I don’t see a lot of coverage of this. So yes, I think people still are looking to move home.

What we saw was that even during the great financial crisis when banks, they just weren’t writing mortgages at all, we saw 800,000 property transactions go through in the UK. So, that feels like a pretty good base level, you know, a minimum level of property transactions that you’d see in a year, and Rightmove will say that that’s down to those perennial Ds – debt, death and divorce – that just gives that minimum level of property transactions. We’re not a million miles off that now.

But for Rightmove, I guess in terms of the investment case for Rightmove specifically, it’s important to remember that they actually don’t get paid on the price of the houses that are being sold or even transaction levels; they get paid by estate agents who pay a fee to Rightmove per agency branch. So, it’s only when agents actually go bust that Rightmove starts having a problem. And now, since the great financial crisis, many, many more estate agent branches will do lettings now, so that kind of smooths their income a little bit, it’s not as volatile as housing transactions, it’s not as linked to sentiment. And, as we all know, the lettings market is still very busy, so, the agents look a bit more robust. So that I think is a good place for Rightmove to start.

But it’s important not to assume that Rightmove needs a really strong property market in order for the stock to work. Actually, estate agents are more beholden to Rightmove; they need Rightmove even more when the market is a little bit difficult because if the market’s great, actually, when property is flying off the shelf, you barely need to look at them on the internet. It’s actually when things are a bit more difficult that you need Rightmove.

And then the other thing you mentioned very, very important as well is CoStar [Group, Inc.].

So, CoStar is a US-listed, property portal company. They’ve got lots of different app/websites in the US and Canada, and they’ve decided that they will come into the UK and see what they can do here.  They have made an offer for the number three player in the UK residential market, it’s called OnTheMarket, and they’ve said Co-star – they’ve got a very bombastic CEO – and he says he plans to spend hundreds of millions of pounds on pay per click advertising to try and unseat Rightmove. And I think he’s going to spend 50 million next year.

So, what you could see is if pay per click, you know, that kind of investment could definitely drive property hunters to the OnTheMarket website. But if, once you’re there, you don’t find that critical mass of properties that you’re looking for, that money actually is wasted, you’re not going to keep the the customer. And importantly, how do you get the agents to move over? That’s the important thing. As I said, it’s about the estate agents wanting to pay Rightmove.

The CEO of Rightmove has today described the network effect of Rightmove as unassailable after 24 years. He reminds us that 85% of the total time spent on property portals in this country is spent on Rightmove alone, and 90% of those customers come organically, they don’t use pay per click advertising at all. So, I like that word unassailable, it does feel like a very unassailable business. The moat is very, very strong around the business. And we’ve seen competition over the years, Google, for example, come in and have a go at Rightmove. So, we’ll watch it, but we feel like Rightmove can really leverage the strength of this model.

JM: Certainly sounds very exciting and a lot to look forward to in Rightmove’s future. Within the last quarter you bought Ergomed [PLC] which is a company we’ve heard a lot about recently. Can you tell us more about them and why and the team feel that it’s an attractive opportunity?

AJ: Okay. Ergomed is one of those … I don’t really know how to feel about it yet! So, we’ve been looking at it for a while, and then we used some weakness that we saw in the share price while people were a little bit concerned over biotech spending. So, the shares were sold off, we used that to start a position.

They run clinical trials, for example, for big drug development companies, big pharmaceutical companies so that the you know, you don’t ideally want a pharmaceutical company running all of its own drug trials, it sort of smacks of people marking their own homework, so often they’ll outsource them to someone like Ergomed.

There’s been a lot of private equity involvement in this industry already. And then actually Ergomed was bid for during last month. So, I think it was bid for at a 30% premium to the previous share price. We were hoping actually that another bidder might come out of the woodwork to push the price a little bit higher. We thought the price was okay, but still didn’t fully value the forward potential for the business. We think this is such an interesting industry and clearly private equity agrees with us and they’re trying to roll up as many of these as possible. But actually, the way that management had structured the deal, it meant that another bidder coming in was going to be difficult.

So, while it’s always nice to see your stocks pop 30% on the day, that’s great, but I guess we still feel a little bit shortchanged by these bid prices, which we don’t think are high enough for these trophy assets, just because they trade on UK exchanges.

JM: This fund name is obviously ‘UK Opportunities’, so, let’s finish with what opportunities you see in the UK today, and looking forward to 2024. Why should investors be interested and excited about the UK?

AJ: Yeah, it’s a good question because it’s been a rough ride over the last 18 months or so. The [FTSE] 250 has performed poorly during the fastest interest rate cycle for 40 years. But it stands to reason if UK SMID [small to mid-cap] was the area that got hit so badly when rates were rising, actually, it stands to reason that they could be amongst the strongest to bounce back while we see the market becoming happier with the idea that interest rates have peaked and that the next move even is down. And actually we see that the FTSE 250 has become really correlated with five-year swap rates, so, that is quite a good indicator to watch.

The other thing has been the economy, the sort of slightly lacklustre performance of the economy, but actually in the summer, the end of the summer, the ONS [Office for National Statistics] had to really revise their GDP numbers quite significantly in the UK, showing that actually the UK wasn’t this sort of outlier that perhaps people thought it was, and that actually we’re very much within the pack.

So the fundamentals from here, I guess they look to me, they look okay, you’ve got a nice chunk of consumer savings, the labour market is strong, the macro fundamentals generally they look okay if not spectacular, but on 10.5 times, 10.4 times for the market overall, we don’t need spectacular, all we need is for inflation to keep following this downward trajectory. It doesn’t even have to be every month, we’re not expecting it to be every month a perfect inflation report, but for the zoomed-out trend to be downwards. And this will give breathing room to the Bank of England and they can start cutting rates, probably in Q2 next year.

So, these low valuations, you know, we’ve never – this century – we’ve never seen so many FTSE 250 names trading on a PE of below 10 times. And we bemoan these valuations and the lack of interest, but actually this is the key to the opportunity ahead.

And as we’ve talked about with Ergomed, private equity, other corporate buyers, they are interested in this opportunity. They are swinging still for UK assets. Hotel Chocolat [Limited] was bid for a couple of weeks ago. Also City Pubs [City Pub Group] all on the same day. It shows you that long-term private money is very, very interested in the very good quality companies you can get in the UK on a postcode discount.

Going into 2024, we like names with low leverage, as we’ve talked about; we are looking for companies that have innovation, that can drive their own market share, that secular growth, which means that the revenues of the business aren’t wholly dependent on the business cycle. We’re looking for companies that generate lots of free cash flow and then they can use that to invest in more of this lovely organic innovation. They could buy back their shares or they could do accretive M&A and preferably in that order. We definitely don’t see a shortage of opportunities. I see this as a very target rich environment. I think it’s just appetite that’s been missing.

JM: Alexandra, thank you very much for your time today. It has been very much appreciated.

AJ: Thank you, Joss, pleasure to talk.

SW: Rathbone UK Opportunities is a truly active and nimble multi-cap fund with a clear bias in favour of quality growth. Structural winners are balanced out with a strong core of high-quality compounders. The final portfolio consists of around 50 to 60 holdings, with a bias to mid-cap stocks.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.