Trust managers discuss why they feel the UK’s cheapness is an advantage and something to be celebrated, enabling the Trust to buy high quality companies at attractive prices – Ben Ritchie and Rebecca Maclean, Dunedin Income Growth Investment Trust PLC

The UK has been unloved as an investment destination for some considerable time. You can hardly move for articles lamenting the significant discount that the FTSE trades on relative to global peers.  However, far from something to spend time worrying about we feel the UK’s cheapness is an advantage and something to be celebrated, enabling us to buy high quality companies at attractive prices. Our advice would be to spend less time fretting and more time taking advantage of the opportunity.

This deep discount has prompted some speculation as to what might improve sentiment towards the UK. To date, cheap valuations have not lured investors back, nor has the stronger recent performance from UK companies. Even an improved economic picture has not tempted global asset allocators to revisit UK markets. Again, we would not spend too much time worrying about what the catalysts might be that could change the situation and instead suggest directing efforts to identifying the most compelling companies for investment.

It is however notable that in 2022, at a time when global stock markets were down significantly, the UK did not experience the same de-rating. The benefit of low valuations being that share prices don’t fall as hard when the market turns. As we see it, the UK’s unpopularity represents an opportunity rather than a burden.

Inflation weakens

Inflation has undoubtedly played a role in the poor sentiment towards the UK. The UK has been seen as an outlier compared to the other major economies, with the unfortunate combination of a tight labour market, exposure to the energy crisis and dislocations around Brexit, plus the legacy impact of outsized stimulus during the pandemic. As a result the peak for UK inflation has been higher than elsewhere, and it has taken longer to fall.

As such, signs of weakening inflation are encouraging. Headline CPI dropped from 8.7% to 7.9% in July. Core inflation, which had also been stubbornly high, dropped as well. Since then, there has been better news on food price inflation, even if wage growth remains high.

This drop in inflation has been taken positively by markets. Bond yields have shown signs of peaking and the UK’s economic growth outlook has been revised higher. If slower inflation persists, it could provide a welcome fillip for the domestically exposed mid-cap companies and start to turn sentiment towards the UK market.

Growth stories

A perennial criticism of the UK market is that is doesn’t have exposure to the exciting growth stories that are a feature of the US or Asian markets. There are relatively few technology companies, for example, or companies with exposure to the energy transition. While this is not an unreasonable observation, we believe opportunities are there, but we have to work a little harder to get exposure to those themes.

SSE, for example, is a leading provider of renewable energy, with a strong pipeline of wind power. We also hold National Grid, which is a crucial cog in the electrification of the UK and US economy.  LSE, which we have been adding to recently, has become a data focussed company rather than a financial markets business, which gives it stronger and more stable growth prospects. Further down the market cap spectrum, we have Softcat, a provider of IT equipment, software and hardware for smaller companies, which is benefiting from the digitisation dynamic.

Equally, where a specific sector is poorly represented in the UK, we can use the trust’s flexibility to invest overseas. This has seen us invest in companies such as ASML, a leading European manufacturer and supplier of lithography machines critical to the production of microchips or Edenred, which operates closed systems for expense management and low volume corporate payments. This gives DIGIT a key advantage when it comes to flexibility.

Unilever: is pricing power transient?

When inflation began rising sharply, it was relatively simple for most companies to put prices up, but when the inflationary period extends, it can become more difficult to keep moving prices higher as customers become increasingly attuned and real differentiated pricing power becomes more apparent.

Unilever is an interesting case study. It posted second quarter results ahead of market expectations in July, with its portfolio of brands exhibiting strong pricing power. For the most part, the company has been able to offset higher input costs by raising prices and consumers have accepted the shift. However, a significant question now is whether that pricing power can be sustained and whether the company can continue to grow volumes as well, critical to supporting favourable operating leverage in its manufacturing plants.

Unilever’s business is global, so it is exposed to markets across the world. That means it is not uniquely reliant on the under-pressure Western consumers to grow. In particular, it has a strong emerging market franchise, with businesses in India, Indonesia and across Latin America. As emerging market governments start to reverse course on interest rates, this may be an under-appreciated source of growth, alongside benefitting from the strong relative demographic dynamics.

More broadly, Unilever has not been immune from margin pressures. However, it has worked hard on its cost base It is notable that the group saw a dramatic fall in its cost inflation over the quarter[1].

Overall, we believe Unilever has put itself in a good position with a favourable geographic footprint. It may not be able to continue raising prices across all its products, but it had many valuable brands and has worked hard on improving its input costs. The management team has done a decent job of navigating tough markets, new chief executive Hein Schumacher will soon offer his fresh perspective on the company’s strategy, and it remains an important holding for the trust.