- UK companies have delivered strong operational performance, dividend growth and record levels of buybacks
- Investors remain wary on the UK market despite huge cash generation
- There are tentative signs of sentiment improving as stability is restored
To paraphrase Mark Twain, reports of the demise of UK equity markets have been much exaggerated. Over 2023, UK companies have delivered strong operational performance, dividend growth and record levels of buybacks. Yet investor sentiment has remained bleak. We see a range of factors that might convince investors this is a market worth another look.
Contrary to the alarmism that surrounds the UK market, we believe that UK companies have a clear contribution to make in a diversified portfolio. Most striking is the healthy pipeline of dividends: the FTSE All-Share Index has a yield of almost 4%, compared to just 2% for the MSCI World index. We see an abundant choice of dividend paying companies across small, mid and large cap UK companies. In most cases, we expect these dividends to grow over time.
Buybacks have also become an important feature of the UK market. As at the end of September, companies in the FTSE 100 had announced share buybacks worth £46.9 billion in 2023. This includes significant buyback activity among the UK’s banking sector. This level of buybacks is the second-highest on record and 2023 should outpace 2022, which had already set new records.
These buybacks are a reflection of the level of cash accumulated by UK companies, leaving management teams with the luxury problem of how to distribute that cash. In previous years, they might have issued a special dividend, but with share prices so cheap, buybacks have been a popular strategy. Increasingly companies themselves are the marginal buyer of UK shares.
So if UK equities are cheap and cash distributions are so attractive, why are investors remaining wary on the UK market? The answer seems to lie in the economic and political upheaval of recent years which has been an unwelcome distraction from the continued strength of the UK corporate sector. Having already experienced prolonged selling pressure, leaving investor allocations to UK at record low levels, it wouldn’t take a significant shift in sentiment to see the UK market move quickly.
The appeal of dividends
As we see it, there are a number of factors that may draw investors back. The first is dividends. At a time when investors can get 4-5% from a savings account, they need their dividend portfolios to work harder. With savings rates higher, investors may look for higher starting yields that may also offer dividend growth in future. The UK market has an abundance of this type of company.
We have around one-third of our portfolio in companies where we see consistent dividend growth over a three-to-five-year view. These are not high growth or fashionable technology names, but companies that can deliver consistently over time. These include FTSE 100 titans such as Shell or HSBC that are generating cash, managing costs carefully and growing revenues reliably. Equally, we don’t have to look far to find companies with yields of 6% or even higher, where the dividend is sustainable, but is underpriced by the market.
On almost all measures, the UK market looks cheap relative to its peers, particularly the US. Almost every sector is trading significantly below its 20-year average, with energy, basic resources, financial services and banks standing out. Investors are paying less per pound of earnings growth than in almost any other country. Companies have not been rewarded for operational success, which has left valuations lower.
These low valuations are particularly evident in small and mid-caps. While there are well understood causes for the recent dislocation in this part of the market, notably rising interest rates and a weak UK economy, these factors are starting to adjust. As bond yields start to fall, and inflation finally starts to undershoot expectations, there are tentative signs of a turnaround. If interest rates have peaked, as seems likely, investors may start to reappraise smaller companies.
The UK has been characterised as the sick man of Europe, but stability has been returning to the domestic economy. Wage growth is now outpacing inflation. This means real incomes are growing, making recession less likely. The housing market is starting to stabilise. UK economic growth may remain unexciting, but the UK is no longer an outlier among its peers.
The same is true for UK politics. The US and many European countries go to the polls in 2024, and there are some potentially disruptive results in the mix. After the political turmoil of recent years, the UK appears relatively stable. The worst of the UK’s image problems may be behind it.
With valuations low, we are finding opportunities across the market capitalisation spectrum, and the trust currently holds around 50% in large cap with the rest in mid cap, small cap and AIM. Some exposure to smaller companies could be helpful if the market turns.
Our highest sector exposure is in financials. We see an increasing recognition among policymakers that they need to make a return for the stability of the system. We also hold idiosyncratic positions such as Close Brothers, which is attractively valued and looks ripe for re-organisation.
We also find opportunities in energy and materials. National Grid and SSE are significant holdings, both of which will see a growing regulatory asset base as the shift to electrification gathers pace. At the same time, our holdings in Glencore and BP reflect their strong cash generation, while they also play a role in helping bridge the gap towards net zero.
Our view is that we will see a ‘breathing out’ moment as markets recognise that there is unlikely to be a deep recession. At that point, we expect market leadership to broaden out as investor confidence returns. In 2023, our focus has been on the delivery of dividend yield and dividend growth for our shareholders. In 2024, with a following wind from economic conditions, we see potential for our holdings to deliver capital growth as their solid operating fundamentals are recognised in their valuations by the wider market.
Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.
Risk factors you should consider prior to investing:
- The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
- Past performance is not a guide to future results.
- Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
- There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
- As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
- The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
- The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
- Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
- The Company may charge expenses to capital which may erode the capital value of the investment.
- The Alternative Investment Market (AIM) is a flexible, international market that offers small and growing companies the benefits of trading on a world-class public market within a regulatory environment designed specifically for them. AIM is owned and operated by the London Stock Exchange. Companies that trade on AIM may be harder to buy and sell than larger companies and their share prices may move up and down very sharply because they have lower trading volumes and also because of the nature of the companies themselves. In times of economic difficulty, companies listed on AIM could fail altogether and you could lose all your money.
- The Company invests in the securities of smaller companies which are likely to carry a higher degree of risk than larger companies.
Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. Authorised and regulated by the Financial Conduct Authority in the UK.