Bargain Britain boasts both value and momentum

Andrew Van Sickle: Will you give us a quick introduction to your fund?

Ian Lance: Temple Bar, which now has a market value of around £900 million and sits within the equity-income sector, will be 100 years old next year. Redwheel took it over in October 2020, so the news of Pfizer’s vaccine in early November of that year was literally a shot in the arm. Returns have been excellent since then. The trust aims to provide both capital growth and income and has a very clear value style.

Andrew Van Sickle: On that subject, we keep hearing that the UK is very cheap. How cheap, exactly?

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Ian Lance: We have a 50-year chart showing the valuation of the UK relative to the MSCI World Index. Across those 50 years the UK typically trades at a 17% discount to the world. That is broadly justified by our skew towards the old economy compared with the tech-heavy US. But the discount today is 45%.

Andrew Van Sickle: Was there a particular reason investors seem to have drifted off from the UK?

Ian Lance: One key development was a new accounting standard called IAS 19, introduced in 2000. It’s effectively mark-to-market accounting for pension funds. It meant that defined-benefit pension funds couldn’t stomach any volatility in stocks.

If you’re a finance director of a company and your pension fund slips 20% in the year, then at the end of the year, the auditors are asking you to write out a big cheque to fill the hole.

And so, over the next 20 years, pension funds reduced their exposure to equities. In 2000, they had around 53% of total assets in British stocks. Now the figure is 3%. So that’s one thing.

Meanwhile, over time, pension funds have started to take a more global approach. Their reference point now is the MSCI World index, in which the US weighting is 73%, and Britain’s is 3%. Consolidation among big wealth managers has reinforced this trend, as they also take a global perspective.

Andrew Van Sickle: There’s an element of circularity here. If the UK market has weakened over a long time, then it is seen as marginal, and people will think it is risky to go out on a limb and buy into it.

Ian Lance: Yes, the overall shift towards passive investing compounded the problem. Still, the good news is that there are two catalysts helping investors crystallise the value in the British market.

One is takeovers. There has been a surge in the number of takeovers in the past few years. Foreign companies and private equity groups clearly can’t believe how low the valuations are for some firms. So they are scooping them up.

The other catalyst is firms buying back their own shares. We have been advising companies with flourishing businesses but lowly valuations to use the situation to their shareholders’ advantage by buying back stock. Last year, that began to happen in a big way.

The banks, for instance, were big repurchasers of their own stock. NatWest and Barclays jumped by 80% last year, yet they were still on price/earnings (p/e) ratios of eight. Sceptics have said for ages that they can’t see how the value in the market can be realised. Now they can.

Andrew Van Sickle: Shareholders will be pleased to be getting some cash returns. One always thinks of America as the main market for buybacks, whereas here it’s all about dividends. But things are clearly changing.

Ian Lance: Yes, a greater percentage of companies in the British market are buying back their own stock than in the US market. It’s also worth noting that the buybacks here are what I call good buybacks. In the US they are mostly bad buybacks.

A good buyback occurs when shares are very cheap, you’re investing in the business, you still have surplus cash flow, and you then buy back your shares. This enhances both earnings and dividends per share.

A bad one is what US tech companies tend to do. They issue a load of stock to pay their employees and then buy it back using shareholders’ money. Having issued stock with one hand, they buy it back with the other. They’re also buying very highly valued stocks.

Andrew Van Sickle: Coming back to the British buybacks, with enough of them, can the market reach lift-off?

Ian Lance: We already have! NatWest’s and Barclays’ gain last year was more than that of the Magnificent Seven in the US. It’s odd how people obsess about tech, yet here on their doorstep, they have stocks producing greater returns than Big Tech on Wall Street.

Moreover, it’s early in the year, but there are signs of investors shifting from overpriced America to Europe, with the Magnificent Seven falling back.

Andrew Van Sickle: Fingers crossed, then, the recovery has already started. We have foreign buyers, private equity funds, and companies themselves buying back shares. How about foreign fund managers generally?

People watch that monthly Bank of America survey of global fund managers and where they’re putting their money. The UK has been out of favour for ages. Any movement there?

Ian Lance: There was an uptick last year, but now the UK has gone back to being the most unpopular region, along with Europe. But that survey doesn’t tell us much. It’s simply fund managers chasing performance.

If Europe and the UK carry on rising, they will become more popular, and everyone will pile in, accelerating the upswing. The survey is not an early indicator of opportunity or success.

Andrew Van Sickle: Do we need to make structural changes to cement the market’s recovery, then, and ensure it’s a lasting one? People talk about stamp duty, and there is the pension fund problem, of course.

Ian Lance: Stamp duty strikes me as tinkering; I can’t imagine we’d see a wall of money coming in if we ditched it. Pension funds’ structural underweight of the market is another matter, though.

The average UK pension fund has around 3% of its assets in local equities. An Australian pension fund has about 40%. In most countries, pension funds seem to have a lot more invested in their local markets than ours do. That strikes me as quite perverse, actually. It needs to be rectified. Another structural issue is that companies are disappearing from the market because they are being taken over or relisting in the US. For now, we can still assemble a very attractive portfolio of UK stocks. But if the trend persists for another decade, it will be a problem.

Andrew Van Sickle: Is there anything one could do on a technical front to make it more appealing to list here or to pre-empt the listings drought?

Ian Lance: Access to funding is key. I was reading about an AI start-up recently that couldn’t secure funding in Britain, and it was eventually forced to go to the US. That just seems criminal given the scientific knowledge and flourishing research at universities we have here. This wasn’t a firm wanting to list, but a private one.

Andrew Van Sickle: If it doesn’t get funding as a private company, it will be even less inclined to float because it will be worried about withering away before maturity.

Ian Lance: Much of this is a question of psychology. Success breeds success. If we had a few years in which the US stock market was going down every year and the British and European ones up, that would change people’s thoughts about where they are going to list. It’s just tricky to turn the super tanker round.

Andrew Van Sickle: Would a macroeconomic recovery help do that?

Ian Lance: It would improve the mood music, but with 75% of FTSE 100 companies’ sales made abroad and 50% of the FTSE 250’s, the link between the UK economy and UK stocks is not as strong as people might think.

I think the key thing to keep in mind is that the extraordinary value on offer should eventually feed through into improved returns. Starting valuations are key to long-term returns. We have a chart of US valuations against 12-year returns for the last century or so. The lower the starting valuations, the healthier the long-term performance.

Andrew Van Sickle: Where are you seeing the best value and dividend yields?

Ian Lance: At present, we are mainly in large caps rather than small or mid caps. There is a great deal of value in blue chips, and while the same applies to medium-sized and smaller firms, we needn’t take on the liquidity risk in that segment of the market if we find value in large caps.

As for income, we are finding it mainly in financials (banks and insurers) and the big energy companies. The yield on the trust is around 4%. Dividends are three times covered and a decent amount of dividend growth is coming through.

Andrew Van Sickle: Financials is the trust’s top sector, with 33% of assets. Barclays and NatWest are the top two stock holdings. Has anything else caught your eye in the sector?

Ian Lance: Aberdeen. People have focused on the struggling fund-management business, but there’s more to the group than that. It owns Interactive Investor, the investment platform. We think that’s a decent business worth £1.5 billion. They’ve also got a financial advisory business, a B2B outfit, called Adviser. Add those two together, and you’re at £2.5 billion.

The fund-management group could be worth £1.5 billion, with a bit of hard work. There’s a pension fund surplus of £700 million and a stake in Phoenix, the insurer, worth £500 million. Add a surplus of regulatory capital, and the overall value is £6 billion, we think. But the market capitalisation today is just £3 billion.

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