Investing in the UK: the good, the bad and the ugly
The FTSE 100 has been in decline for a long time, while small and mid-cap stocks have outperformed, says Max King. Will the blue-chips bounce back?
From its formation in 1984 till the end of the millennium, the FTSE 100 index of the UK’s largest companies moved broadly in line with Wall Street, at a level about 10% below that of the Dow Jones Industrials index.
If that relationship had persisted, the FTSE 100 index would today be trading not at around 6,000, but at 22,000.
The UK has always had a higher dividend yield than the US and taking that into account would raise the FTSE 100 to 9,000 – but that’s still less than half where, by the standards of the 1980s and 1990s, it should be.
What has gone wrong? And why do UK investors stick so doggedly to UK equity allocations far in excess of the 6% of the MSCI World index that UK-based companies now account for?
The long decline of the FTSE 100
The FTSE 100 now looks very different from its composition 20 years ago. Many companies have been taken over. Others imploded as a result of idiotic deals in the dotcom era.
Over-expansion and complacency about the online threat dealt a hammer blow to retailers, though food retailers have arrested their decline. The banks succumbed to merger mania, over-lent and exhausted their capital. Having been rescued by the government in 2008, subsequent governments have repeatedly kicked them while they are down.
The merger mania of the late 1990s, cheered on by investors, created unwieldy behemoths of BP, Shell, Vodafone, Glaxo and others, the only beneficiaries being senior executives. Perhaps most importantly, the UK has not seen the wave of entrepreneurial technology, tech-related and biotechnology companies which dominate the US market.
UK investors clung on, comforting themselves with the generous dividend yields and believing that, one day, “value” investing would make a comeback. Instead, the coronavirus pandemic led to a halving in the yield of the FTSE 100 and many so-called “value” companies are now struggling to survive.
The question for investors has changed from “why invest so heavily here?”, to “why invest here at all?” The advice from Charles Gave of research consultancy Gavekal is “only to invest in countries where the bank index has outperformed the government bond index structurally for the last four years”. That advice favours the US and Japan – but not the UK.
Small and medium-sized UK stocks have done just fine
Yet there are exceptions. As Anthony Lynch, manager of the Mercantile Investment Trust, said back in February, “not only has the FTSE 250 index of mid-cap companies trounced the FTSE 100 since 1995, but it has also beaten the US’s S&P 500 index over the same period.”
The FTSE 250, like the FTSE 100, was started in 1984 at a level of 1,000. But in contrast to the FTSE 100, the FTSE 250 now stands at 16,400. The performance of smaller companies has been similar. Those who have invested in UK small and mid-cap specialist trusts have done well, especially as these trusts have, on average, significantly out-performed their benchmarks.
The small-cap trusts of Standard Life, BlackRock, Invesco Perpetual and JP Morgan all have investment returns more than 30% ahead of the small-cap index over five years, while Mercantile is 20% ahead of the combined mid- and small-cap index.
Some of the trusts investing in larger companies have also done well. Finsbury Growth & Income, 82% invested in the UK, has returned 47% in the last five years, nearly ten times the All-Share index, from a concentrated portfolio of branded consumer and financial companies, including Diageo, Unilever, London Stock Exchange and RELX (formerly Reed Elsevier).
Having taken over management of the UK Growth Trust from Schroders in mid 2019, Baillie Gifford has shifted the portfolio to its growth-orientated style, with holdings including Just Eat, Boohoo, Hargreaves Lansdown and Prudential. Performance in the last six months is 12% ahead of the All Share index.
Independent Investment Trust, a self-managed trust with a high level of director and manager ownership, has returned over 50% in five years from a portfolio heavily focused, like Baillie Gifford UK, on mid-caps.
Is the FTSE 100 due a comeback?
Still, it would be a mistake to abandon all hope for the FTSE 100, not least as a steady stream of successful mid-caps continue to be promoted into it. In addition, clothing group Next has shown that mastering change in the retail market is a challenge but not an impossibility – maybe M&S can learn from its tie-up with Ocado.
Meanwhile, there are signs that Glaxo and AstraZeneca are pulling themselves out of a long period of torpor, while Vodafone faces an opportunity in 5G. BT is, at last, recognising the importance of rolling out its fibre-optic cable network to 20 million households, even if it means selling a stake in its digital network, Openreach. The oil majors have stopped wasting money on oil exploration and will, hopefully, now focus on cash generation.
While many of the banks and insurance companies continue to struggle, the share prices of companies in the leisure and travel sectors are recovering well from the pandemic crash. Carnival’s share price has nearly doubled from its low as bookings for cruises, expected to restart in August, soar (while it has recently demoted from the FTSE 100, it may well return in future).
Investors are starting to think that airlines IAG and easyJet (another recent demotee) will benefit from reduced competition as rivals vanish or, having taken bailout money, struggle under the dead hand of government. Aerospace stocks such as Rolls-Royce, BAE and Smiths may be facing fewer new aircraft orders, but planes and their engines will still need maintaining and repairing.
Overseas holidays may be out for this year, but Tui and Intercontinental Hotels are up more than 50% from their lows on hopes for next. House-builders are benefiting from resumed activity.
So maybe it’s too soon to write off the potential of UK companies and the outlook justifies investing rather more here than is gained from relying solely on the global funds to invest where and when they see an opportunity.
Perhaps the opportunities extend beyond the growth companies, the branded goods and services companies and mid/small caps, to the recovery potential of companies hit hard by the pandemic, who have now been shocked into taking overdue action to restructure their businesses.
If so, trusts such as Temple Bar and Lowland will benefit. But bear in mind that chasing yield; hoping for the pendulum to swing back to value investing; or drawing false comfort from companies with a glorious past, is still unlikely to be profitable.