The U.K. has been beset by political and economic instability in recent months, but as the investment environment undergoes a fundamental transition, investors see opportunity. The makeup of the U.K.’s FTSE 100 differs considerably from many major developed markets, in that it is heavily-weighted toward consumer staples, financials and materials, but contains very little by way of the growth-oriented sectors such as technology that have benefited from the era of ultra-low interest rates. Global financial markets have endured a brutal year against the backdrop of Russia’s war in Ukraine and the aftermath of Covid-19, including supply bottlenecks linked to persistent lockdowns in China. Aggressive monetary policy tightening from central banks to rein in sky-high inflation has hammered risk assets. At a press briefing last Tuesday, GAM Global Investment Director David Dowsett said beyond the plethora of external shocks, the markets were undergoing an interest rate normalization after around 15 years of ultra low rates around the world. He added that this period of monetary policy has ended. and that we are moving to a “structurally different” interest rate environment for the foreseeable future, primarily because the “era of globalization has decisively come to an end” in light of the global supply chain problems caused by China’s Covid-19 lockdowns and Russia’s ostracization. “We move back to an investment environment where not everything is going to pay you back and not everything is going to make a good return on capital, because capital actually costs something,” Dowsett said, adding that liquidity is now a concern for investors rather than capital appreciation at any cost. He argued that in a more uncertain investment landscape, investors should be looking at assets that produce income, which is where U.K. stocks, which tend to yield consistent dividends, come “back into vogue” after many years in the wilderness. Adrian Gosden, manager of the GAM U.K. Equity Income Fund, highlighted six FTSE 100 stocks — all of which the fund holds — with dividend yields of between 5% and 7% that are trading at particularly low valuations. These were BT Group , Barclays , GSK , Lloyds , Imperial Brands and BP , all of which trade at price-to-earnings ratios – a measure of the company’s share price against its earnings per share, used to determine whether it is overvalued or undervalued – of between five and nine. “If you’re on a P/E of five and delivering a dividend yield of 5%, and that P/E goes to a P/E of six, with that dividend, you’ll return your investors 25%,” Gosden said. “My point is that the U.K. has got itself into a position, through many different reasons, where it is sitting there primed in absolute terms … We’re going forward into an environment where we have inflation, which we haven’t had since the 2008 financial crisis, and in that environment, U.K. equity income has a very proven track record.” These attractive valuations for U.K. stocks were also identified in a note last week by BlackRock Fundamental Equities. Portfolio managers Adam Avigdori and Oliver Dixon also cited increased share buybacks and attractive dividends boosting the country’s stocks on a total return basis, while a weak sterling also offers a cushion against recession to companies with dollar -based earnings. “Not only has the U.K. discount widened to a level not seen since 2008, but companies are buying back record amounts of their own shares. This tells us that management teams have confidence in their own businesses and think their shares have become undervalued,” Avigdori and Dixon said. “The £51 billion ($58.3 billion) in share buybacks recorded so far in 2022 equates to a nearly 3% buyback yield on the FTSE 100, according to our calculations. When this is added to a dividend yield of 4.5% – the highest among developed markets, according to J.P. Morgan – the combined income totals more than 7%. This compares to the current yield on UK 10-year gilts of around 4%.” BlackRock also recommended that investors look for selective opportunities in health care, homebuilders and some areas of retail. Small and midcap stocks the ‘octane’ GAM’s Gosden argued that with the majority of the bad news for the U.K. economy priced into the country’s markets, a slight positive shift in the newsflow could mean small and midcap stocks offer “octane” for investors. Small and midcap stocks have been hit much harder during this year’s downturn than major blue chip indexes, with the FTSE 250 down more than 20% year-to-date as of Tuesday, compared to a decline of just over 1% for the FTSE 100. Gosden suggested this was solely down to the fall in the pound, since the midcap index is more domestically-focused in contrast to the export-heavy FTSE 100. That is your octane within the market, which would really produce returns, make 25% look a bit pedestrian, and that will happen if things don’t turn out to be quite so [bad],” he said. GAM holds around 50% of its U.K. equity income portfolio in small and midcap stocks, with a focus on companies with strong competitive moats. This opportunity in small and midcaps was also highlighted in a note last week by Abby Glennie, deputy head of smaller companies at Abrdn, who said some firms may still manage to grow as consumers are forced to cut costs, particularly on food and energy. “High street staple, Greggs , known for its cost-conscious snacks, treats and hot meals, is likely to keep its loyal fanbase and may attract new customers during a downturn, offering food at an affordable price point compared (to) other retailers,” Glennie said. Glennie also identified home furnishings company Dunelm as being able to weather recessionary pressures, based on its range of price pressures and non-seasonal product offerings, which mean inventories can be managed if demand subsides. Rising U.K. mortgage rates are already hitting the housing market, and Glennie suggested that demand at the more affordable end of the market may benefit. She highlighted housebuilder MJ Gleeson , which estimates that owning one of its properties is cheaper than renting, and offers the benefit of building equity.
