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Rarely have UK equities been as cheap as today relative to the US and global markets
Investors focussing on global investing on the assumption that it provides access to the best companies in every country may overlook many excellent companies in their earlier stages of development
There are numerous reasons why allocating money to the UK market is compelling and these are more apparent to investors with decades-long expertise in domestic markets
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UK equities now only account for 4% of the average UK private sector pension portfolio compared with over 50% in 2001. While institutions have switched into bonds and added to the alternatives space, those with a predominantly retail client base have notably increased exposure to the US market in the past decade. Increasingly, and especially after the strong outperformance of the Magnificent 7 in the US last year, many are asking: why bother with investing in UK equities at all?
As an investor who has specialised in the UK market for several decades, focusing particularly on small and medium-sized companies with strong competitive advantages and market leading positions, I can still think of many reasons to allocate money to my home market. Here are a few.
The first reason for keeping the faith is the valuation differential with the US equity market
Rarely have UK equities been as cheap as now relative to the US market.
Aside from the headline numbers, we can see lower valuations in specific UK companies and sectors compared with listed US counterparts. Three UK companies that exemplify this, and which we have chosen to own, are Dotdigital, Spirent, and GlobalData. All three firms generate significant revenues outside the UK[1], so it cannot be argued that they should be valued more conservatively because of a smaller addressable market.
The comparisons were compiled in October 2023, and since then, one of them – GlobalData - has done something about the difference. In December 2023, it announced the agreement to sell a 40% stake in its healthcare division to private equity house Inflexion for £434m, implicitly valuing the segment at £1.12bn. This is significant, as the division accounted for 36% of group sales but the valuation represented 82% of GlobalData’s £1.35bn market valuation – a considerable discrepancy in the market perception.
Source:Downing Fund Managers, latest individual company's Report and Accounts at time of article publication. Cannacord Genuity, Refinitiv Eikon DataStream consensus data.
Takeovers will continue to benefit UK investors while the valuation differential persists
Cheap valuations coupled with the transparency of UK public companies and an open takeover market mean more UK companies are likely to be on the receiving end of takeover bids. This is not a new phenomenon. Takeover bids for UK listed businesses have been running at around 40-50 a year since 2014. US buyers have been particularly attracted to the UK by the common language, the legal and regulatory framework, and (maybe less so now) the potential beach head into Europe. Why pay up for more expensive US businesses when you can own their UK equivalents and have the optionality of receiving a takeover premium on top? Last year one of our investments, EMIS Group PLC, which is the leading provider of software to UK GP practices and pharmacies, attracted a takeover bid from US giant United Health Inc at a 50% premium to the undisturbed price.
Investing in the UK market does not mean that we are investing in the UK economy
Most large companies in the UK derive the vast majority of revenues from international markets. This figure drops as we look further down the size spectrum, but even for our fund, the VT Downing Unique Opportunities Fund, overseas revenues account for 54% of the total. We do not avoid 100% domestic players, but our wholly UK focussed businesses comprise market leaders such as Auto Trader, Rightmove and Dunelm with clear strategies to grow their addressable markets by entering adjacent areas. More typical however are smaller companies that generally start life selling entirely domestically but over time build up their exports to the point where the UK is a small minority of revenues. An example here is Tristel, a supplier of chlorine dioxide-based disinfectants used to sterilise heat-sensitive outpatient equipment between individual patient appointments. Twenty-five years ago, Tristel started life selling to the UK NHS, but now the UK accounts for only 43% of revenues, and a recent US Food and Drug Administration (FDA) approval, hopefully the first of many, will likely see the UK proportion of sales dwarfed by US adoption.
It is easy to think that all innovation starts in the entrepreneurial US economy but that isn’t always so
Tristel had a 25 year start with NHS on the use of chlorine dioxide, while the US has been using aggressive cleaners such as hydrogen peroxide (bleach), or autoclaves, which are inefficient in an outpatient context and damaging to sensitive equipment. Another of our investments, Tracsis, developed remote condition monitoring equipment for the UK rail system to monitor the performance of rail signals and points in real time. This provides assurance that safety barriers are working and can reduce and predict the risk of failure of points machinery and track circuits, enabling risk-based maintenance schedules. Tracsis equipment monitors over 24,000 devices and 60,000 rail assets. In contrast, the US still relies on manual track inspections but presents an emerging opportunity for Tracsis’ remote condition monitoring technology.
The UK talent pool in universities and university cities is considerable
The UK contains four of the top ten global leading universities (Oxford, Cambridge, Imperial College London, and UCL). This is significant as they create innovation hubs, attract top talent, and subsequently, private sector companies follow. For instance, Cambridge hosts research centres for Apple, Microsoft and Google which tap into the university eco-system. Alfa Financial Software partnered with Bitfount, headed by Blaise Thomson, former head of Apple’s Cambridge engineering team, to deliver the best machine learning models and advanced decisioning scorecards to the asset finance industry. There are many other Russell Group universities in the UK with specific sector expertise. For instance, Tracsis was an IP Group spin-off from Leeds university in 2004, to commercialise world class research and expertise in the field of transport scheduling and software optimisation technologies. In 2019 it moved its headquarters back into the University of Leeds innovation hub. Kainos, a leading player in digital transformation services to the UK central government, and a major European implementation partner of Workday enterprise software, was founded from the incubation unit of Queen’s University Belfast and has grown into a £1bn-plus IT services business but is still headquartered in Belfast.
Beware of concentration risk in global portfolios
The outperformance of the Magnificent 7 in the US means that they – Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla - now account for 17% of the MSCI ACWI, constituting concentration risk for global investors and index trackers alike. A recent industry analysis showed that these seven global technology leaders were valued by investors at more than the entire stock markets of Japan, the UK, China, France, and almost Canada combined. There are a number of scenarios that could unsettle this apparently unassailable dominance, including adverse regulatory, fiscal or geopolitical developments.
Global funds focus on a narrow range of very large companies
Investors focussing on global investing on the assumption that it gives access to the best companies in every country may overlook many excellent companies in their earlier stages of development. Over 75% of companies in the MSCI ACWI have market capitalisations in excess of £25bn. In contrast, in the UK, only 23 companies fit into that category. The VT Downing Unique Opportunities Fund has a weighted average market cap of only £1.6bn and the largest constituent has a market value of only approximately £7bn. The opportunity set is completely different, but the fund contains true world leaders, albeit often in more focussed niches.
Tracsis
Leading UK provider of software for managing the rail network, including remote signal condition monitoring, driver rostering, smart ticketing, delay-repay processing and maintenance scheduling and access. Owned since 2020
Tracsis has recently acquired a complementary US software business in railyard scheduling and is well-placed to sell its Remote Condition Monitoring software to aid automation in the US rail networks.
Kainos
Leading supplier of digital transformation services to UK central government, and major European implementation partner for fast-growing US enterprise software provider Workday used by 10,000 organisations globally. Owned since 2020
Kainos’ excellent reputation for project delivery inside the UK government will ensure further wins in a digital transformation market set to remain strong for at least 20 years. Kainos should also continue to benefit from Workday’s competitive advantage versus SAP and Oracle, both in implementations and sales of proprietary add-on software.
UK mid-market businesses have outperformed in the long term
While it is well understood that the UK Mid 250 index has outperformed the FTSE 100 over the past twenty years, perhaps less well-known is that it has also beaten the US S&P 500.
Conclusion
The current discounts and negative headlines offer a chance for a distinctive perspective not seen for decades, granting access to a broader array of businesses at more appealing entry points. The UK's innovation landscape, driven by top universities, fosters the emergence of groundbreaking companies, while presenting other attractive opportunities for investors, e.g., the optionality of receiving takeover premiums. In the VT Downing Unique Opportunities Fund, we see the UK as one of today's most underrated investment destinations, particularly in the context of its historical outperformance of both the local and global markets.
[1]Spirent and GlobalData generate only 2% and 15% of revenues in the UK respectively. Dotdigital generates 76% of revenues in Europe. Data based on 2023 company Full Year Report and Accounts
Risk warning
This document is intended for investment professionals only. Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing available from Downing or from the ACD, Valu-Trac; your attention is drawn to the risk, fees and taxation factors contained therein. Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. This document contains information and analysis that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing is a trading name of Downing LLP. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
