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An economic recovery is good news for UK mid- and small-cap stocks
Two events that occurred late in 2020 - the first Covid-19 vaccines were approved and the UK officially left the European Union (EU) - could set up a very different macroeconomic environment for UK equity investors in 2021.
Clearance for take-off
After being grounded by the pandemic, the UK economy may soon be cleared for take-off. The UK has indeed gone from laggard to leader in its Covid-19 response, having administered the first jab to over a quarter of its population before the end of February, well ahead of the US and Europe. This vaccination success to date brings the real possibility of the UK re-opening the country and re-starting the economy in the coming months.
Several other conditions support a more positive outlook for the UK economy. UK consumers are still cautious, but their personal finances are relatively healthy, bolstered by the continued rise in home prices and the high levels of savings built up during recent lockdowns. That means when stores, events and restaurants begin to open again, extra spending from pent-up demand may fuel strong sales across a variety of sectors. On the industrial side, signs of recovery are also showing up in data such as the Global Purchasing Managers’ Index (PMI), which bottomed in 2Q20 but has since recovered into clearly positive territory.
At the same time that the UK economy is poised for a cyclical recovery from the pandemic, the fog of Brexit uncertainty that has hung over the UK since mid-2016 is clearing. Although by no means perfect, the agreement reached with the EU at the end of December marks an official exit for the UK and may finally catalyse UK business investment, which has been effectively stalled since the referendum.
Strong tailwind
In addition to the economic recovery, UK equities could enjoy a strong tailwind powered by low interest rates, attractive valuations and improving investor sentiment. Recognising that any potential economic recovery is still fragile, the Bank of England appears committed to keeping interest rates at their current near-zero levels. Low interest rates can support UK equities in two ways: companies enjoy a lower cost of capital, boosting their profits, and equities continue to attract investor flows because bond yields are so low.
Following its recent underperformance versus global peers, the UK equity market has a lower valuation than most other developed markets. Given the extraordinary economic and market environment in 2020, a 10-year cyclically-adjusted price-to-earnings (CAPE) ratio may be the best way to compare markets: the UK market, with a CAPE of 11.9, looks cheap compared to Europe at 15.3, and especially to the US at 31.3. As well as representing good value in comparison with other markets, the UK market appears cheap when compared with its own long-term average valuation levels.
In light of the potential for a cyclical economic rebound, relief from the Brexit overhang, low interest rates and attractive valuations, it is not surprising that investor sentiment is also turning more positive on UK equities. According to a recent survey, portfolio managers have become meaningfully less negative on allocating to the UK in the last few months. As fund managers increase their UK equity allocations, this brings an additional support to the UK equity market.
These factors contribute to a positive outlook for the UK that is shared by The Mercantile Investment Trust, a UK investment trust that seeks to achieve capital growth by investing in a diversified portfolio mid- and small-cap UK companies. The Trust is currently over 10% geared, which could further enhance portfolio returns if UK mid- and small-caps perform well.
Local beneficiaries
While an improving UK macro environment is likely to lift the broader UK market, mid- and small-cap companies may enjoy particular advantages. These companies tend to outperform in an economic recovery as they benefit disproportionately from the combination of accelerating economic growth and low interest rates, compared to larger companies.
Mid- and small-cap companies also tend to have more exposure to domestic revenues, which is especially true in the UK, where mid- and small-cap companies get 52% of their revenues from the UK versus just 23% for FTSE 100 companies - and the number is even higher for The Mercantile Investment Trust at 57%. Domestic UK exposure is attractive right now. First, the UK is on track for a faster - and potentially stronger - economic rebound than many other regions. Second, companies with higher domestic revenue exposure may be more insulated from some of the supply chain, shipping and tariff issues still being resolved post-Brexit that larger companies with international operations and customer bases may face.
First class companies
In the excitement of an economic and equity market recovery, the stocks of the lower-quality companies, such as those with high levels of debt or low valuations, may do quite well in the near-term. Profitability measures, such as return on equity (ROE), can get a bigger boost in highly geared companies - simply because the equity portion of the company is smaller. Low valuations can give a stock more upside - but can also signal a highly cyclical business, poor business prospects or a weak management team. These kinds of stocks may do well in the early stages of a recovery, but they are not the kinds of quality companies The Mercantile Investment Trust’s team believes will help investors generate long-term returns.
Instead, the team remains especially vigilant about investing only in high-quality companies - those with robust and sustainable business models, strong free cash flow, a positive or improving outlook and reasonable valuations - because they believe these companies will outperform over the long term, in part by being more resilient during periods of market stress.
An improving economy is a tailwind for UK equities, but best-in-class, mid- and small-cap companies are the engines of growth for The Mercantile Investment Trust, the home of tomorrow’s UK market leaders.
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