25th October 2024
It is almost exactly a year to the day that the UK small cap market troughed on 26th October 2023. I don’t think many people would have guessed that since then, the Deutsche Numis Smaller Companies (ex ICs) Index has exactly matched the S&P 500 Index return in sterling terms, both returning an impressive 33.3% (FE Analytics 26/10/2023 to 21/10/2024 total return GBP). The index that represents the largest 100 companies in the UK has lagged but is still up a respectable 17.4% over the same period. Despite that impressive performance, the UK equity market is still subjected to large and relentless outflows from retail investors – is it now 40 consecutive months of outflows? We have said it before but worth repeating, Microsoft, Apple and Nvidia individually are bigger constituents of the MSCI AC World Index than the entire market cap of the UK equity market. Of course, as active valuation-conscious investors, we don’t agree with an investment process that starts with weights in an index, but that will be why many (most?) UK-based investors are moving to a global benchmark approach and why global investors think “why bother” when it comes to UK equities. Fundamentally, the UK corporate sector is in good shape with strong earnings growth, decent dividend growth, record share buybacks and increasing M&A.
One other reason why the UK market is shunned by many is the persistence of reasons not to invest. Just as we clear the uncertainty of the General Election, we now have to contend with the drip drip nature of the rumours coming from the Government on which taxes are or aren’t going to be raised to fill the £22bn (or is it £40bn now?) black hole those pesky Conservatives left them. The main concerns facing UK investors this year have been the potential increase in the rate of CGT, the increase in employer NI contributions and the removal of Business Relief. This isn’t a political blog so I won’t comment on the rights or wrongs of what the new Chancellor is proposing, but there is no doubt that the uncertainty surrounding these particular taxes is affecting UK listed shares, particularly the AIM market. This important sub-sector of the UK equity market is where certain qualifying companies list so shareholders benefit from Business Relief (no inheritance tax is payable on most AIM-quoted shares passed to heirs as long as they have been held for at least two years). Since the UK election was called on 23rd May 2023, the AIM market has underperformed the UK smaller companies index by over 10%, likely because investors are selling ahead of the potential removal of the tax break. To be honest, faced with that cliff-edge risk, we too moderated our exposure to AIM-listed companies during the last few weeks.
The decision to reduce and sell positions in those UK equity funds with higher AIM exposure was not made in isolation. It coincided with the decision to increase our exposure to investment trusts following the significant change in OCF disclosure rules. We have been able to rotate out of some open-ended UK equity funds into a selection of UK equity investment trusts whose discounts are wide by historic standards, thus providing the potential for a double-whammy of rising net asset values and narrowing discounts. Across our funds we have introduced The Mercantile Investment Trust, Aberforth Smaller Companies, Law Debenture and Temple Bar. The fact that each of these trusts are also geared (ranging from 6% to 15%) allows us to free up some cash in case of a post-Budget sell-off but still maintain the same net exposure to UK equities across the market cap spectrum.
The past couple of months have seen a higher level of dealing activity in our funds in part due to this adjustment in the UK equity allocation, but also to gradually increased exposure to investment trusts more broadly. The average 14% discount for the sector (ex 3i) is the widest since 2004 other than during the GFC and Covid. In our opinion, the main reason for this extreme weakness in recent years is the higher illusionary costs of investing in investment trusts causing investors to flee the sector and preventing new buyers stepping in. The reversion to a zero OCF world should attract more buyers to the sector that will help reduce the current oversupply and see discounts narrow. Turnover in our portfolios varies from year to year, purely dictated by the changing valuations and investment opportunities available to us. We suspect that this period of activity will make 2024 have one of the highest turnover figures since 2020 when the Covid induced volatility created tremendous opportunities. While we have no edge on what will be in the Budget on 30th October, we hope that it becomes a clearing event allowing investors to get back to focusing on the numerous positives within UK plc and take advantage of the value on offer instead of being anchored to its relatively small weight in a global equity benchmark.
Daniel Lockyer – Senior Fund Manager
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