Survival of the fittest

Q How would you assess the UK equity market’s performance in 2023?

It has been about the survival of the fittest. The strong are getting stronger, which is usual, but arguably accelerating. In my opinion, high quality businesses with stronger capacity advantages will continue generating steady levels of free cash flow, which creates more optionality in challenging times. In a world where money is no longer free and the economy is rockier, differentiation, pricing power, strong balance sheets and free cash flow generation really matter.

Q What pockets of the market best showcase this? 

The US banking sector and the Silicon Valley Bank saga and earlier in 2023 is a good place to start, as it highlighted that having a flighty funding base and imprudent asset investment policy is unwise. We have been sceptical of certain banking models, particularly those that are not scaled, have bloated cost bases and lend too quickly. These traits go unnoticed in the good times but are being noticed now. They are also very prevalent in the UK banking sector.

In car insurance, we are differentiating between the companies that write policies prudently and have sustainable cost structures and those that do not. In 2021 when inflation was benign, it was easy to write imprudent insurance policies, not anticipating the rampant inflation ahead. In 2023, some insurers have been caught by this, while other scale players have thrived. Animal food processing is another example. You can see those companies with scale, that are well-invested, have sensible contracts with customers and sensible balance sheets. Generally this environment favours the investors or analysts that do their homework properly, conduct thorough analysis of industries and companies and focus on investing in sound businesses.

Q What will drive the UK equity market from a macro perspective in 2024? 

Let’s begin with a recap of recent macro drivers. In 2016, we had the Brexit vote, with the UK narrowly voting to leave the European Union – no one really expected it. In 2020, we had a pandemic – nobody expected that. In 2021, we had a free money-stimulated bull market – perhaps a few people expected that. In 2022, we saw war break out in Europe and rampant inflation headwinds – no one really expected that. In 2023, we have had record rampant interest rate increases, another conflict breakout in the Middle East and developed world growth starting to creak – perhaps some commentators expected the last point.

It has been difficult to call the last several years accurately, so we need to be careful about making sweeping, top-down predictions, which are often difficult to get right. In terms of what we can control, I will say it is important to do your analysis and really understand the difference between good and bad companies. In 2024, as for every year in my investing career, the drivers will likely be the same. The strong will keep getting stronger, and the weak will keep getting weaker, and we will pick stocks accordingly.

Q What are the unique dynamics at play that may be supportive for UK stocks moving forward? 

The UK has been a rather gloomy place to manage long equity money in recent years. Everyone can see that the UK has experienced deep outflows, but things can change quickly, as energy investors have seen in the last few years. In the UK the return on capital has continued to improve over the past decade, while balance sheets have strengthened. At the same time, the UK trades on one of its biggest discounts in history in both absolute and relative terms, relative to the MSCI World.

There are opportunities for attractive returns across the market cap spectrum. We note the FTSE 250 Index is now down almost 30% from its 2021 highs, which is making the valuation of some good growth businesses with high barriers to entry look increasingly interesting. If we look at some of the larger cap stocks, capital allocation optionality has probably never been higher. Many have broken the historical headwinds of pro-cyclical behaviour, which has driven poor value creation over time. These companies now have stronger balance sheets, combined with capital cycle tailwinds, which enable them to pay nice dividends and buy their own shares when they are cheap, as opposed to allocating capital to chase growth at all costs or having to de-lever their own balance sheets.

To summarise, if we flick a heads and inflation is worse than anticipated, economies are weaker than expected and our interest rates remain persistently high, we believe the UK will provide good downside protection. If we flick a tails and externalities are okay, then we believe the forward risk-adjusted returns will make for a very enjoyable ride.