Why the rally in UK equities still has legs

Key points :

• Despite the strong market returns seen over recent months, we believe the UK market looks attractive in relation to its own history and global peers.
• It is a particularly exciting market for investors looking for ‘value’ opportunities.
• The improving economic backdrop has been reflected in a slew of positive earnings news from companies, particularly among UK consumer-facing and housing-related holdings.

 
Buoyed by increased optimism, the UK stock market has continued to rise over the past few months. Markets have been supported by upbeat company results and economic data suggesting a strong rebound, with consumers feeling increasingly confident.* The outlook is bright and we expect the UK economy to recover strongly over the remainder of this year as restrictions ease.

Yet even after the recent strong market performance, the UK stock market is still significantly cheaper than other regions, with shares trading well above their pre-pandemic levels. In our view any recent strength is the result of better company performance rather than any reappraisal by investors of the UK versus other markets. This is one of the key reasons why we believe the recent strong run for UK shares has further to go.
 

The UK’s performance gap

 
Plenty of markets across the world are looking expensive versus their 10-year historic range, but the UK looks attractive relative to its own history and global peers, trading at significant discount to US and European equities, for example.**

Within the UK, we are particularly excited about ‘value’ shares. These are shares that appear to be trading at a low price relative to the prospects for the company in terms of dividends, earnings, or sales. The UK market has a natural bias to this type of company, but the vast majority of UK funds focus on more growth-oriented opportunities. This means value shares are often neglected and today, they appear cheaper and with more potential upside than other parts of the market.

The value available in the UK market hasn’t gone unnoticed by corporate acquirers, especially those from overseas, and we have seen a flurry of takeover bids with another two of our holdings being bid for in recent weeks. Unless the relative valuation gap closes, we expect to see more activity as private equity funds with deep pockets hunt for bargains.
 

Earning recovery

 
At the moment, companies are in good shape. During the last earnings season, we only had two disappointing results among our 100 holdings, with most meeting or exceeding market expectations for growth and profitability. This is unusual in a value portfolio where results are generally more mixed.

This phenomenon has been particularly marked in our UK consumer-facing and construction-related holdings. The signs from other markets that have opened up are encouraging, showing consumers spending across the board, including in areas that had benefited during the pandemic such as DIY and home improvements. Consequently, we retain meaningful exposure to these areas in the portfolio.

We also continue to favour life insurers, which were resilient over the pandemic but remain attractively valued. Life insurers tend to produce solid, consistent growth rates, while also offering attractive dividend yields – characteristics often associated with consumer staples stocks, which are significantly more expensive.

We have been adding to banks over recent months. Compared to other companies sensitive to economic growth, banks still look relatively good value. They have strong balance sheets, with plenty of cash. NatWest, for example, has recently used some of its excess cash to buy back shares from the UK government. An improving competitive landscape in Ireland has also led us to add to our banking exposure there.

Elsewhere, while we have selectively added to travel and leisure-related names over recent months, we remain relatively cautious and favour businesses likely to come out stronger from the pandemic and with a preference for beneficiaries of domestic reopening.
 

Strong potential

 
The prospect of a multi-year economic recovery is encouraging. Domestically-focused and small-cap companies have been more impacted by years of Brexit uncertainty and more recently by the pandemic than other parts of the market and we see good prospects for recovery in these areas now recovery is in full swing. This is particularly true for the higher quality companies we prioritise for the portfolio.

With many of the shares in our portfolios still trading at a meaningful discount to the wider market, investors are today able to access an array of undervalued opportunities, without having to compromise on quality. Debt levels of companies in the portfolio, for example, remain low and we see further scope for earnings to improve in 2022. This should, to our mind, translate into strong shareholder returns.
 
* Source: Fidelity International, Fidelity Special Values Interim Report as at 31.05.2021
** Source: Peel Hunt, Refinitiv Datastream, 7 May 2021.