The UK equity market continues to lag other international markets, and this is reflected in the weak performance of many UK equity funds.

Catalysts for a positive re-rating could include 1) A trade deal or mini deals with the EU in the next few days/weeks, 2) A vaccine discovery, 3) A recovery in dividend payments.

We think contrarian investors should take a look at UK Equity funds, which offer a combination of attractive discounts and relatively high dividend yields. Our preferred funds include Fidelity Special Values for undervalued stocks, Edinburgh IT as a recovery play with Majedie as new managers and for mid/small caps we like Mercantile and BlackRock Throgmorton.

UK underperformance

UK equities have underperformed both US and European markets significantly during 2020 so far. There are a number of reasons for this divergence including the relatively historical high yield generated in the UK market being a support in the past, with this now being taken away as a result of dividend suspensions and cuts. Some other markets, notably the US have a significant number of growth/tech companies which have been key drivers of performance in recent months.

UK Equity Trusts

This relatively weak performance from the UK equity market has been mirrored in the returns from many Trusts. For example, City of London Trust has seen a 1-year NAV TR of -13.6% and 6-month NAV TR of +3.1% (at 09/10/20).

In addition, a number of Trusts have also seen a significant widening of their discounts in recent months. For example, JPM Claverhouse is on a 5% discount, compared to a 12-month average of 1% and Fidelity Special Values is on a 7% discount, compared with an average of 3% discount. The UK Equity Income sector average discount has widened from 3.0% at the start of this year to 5.4% currently.

Factors that could encourage a re-rating of UK Equities

1) Trade deal with the EU: There have been indications from the UK/EU trade negotiations that significant progress has been made either towards a full deal or at the very least a series of mini deals. The reaching of a deal in the next few days or weeks would provide clarity for business and is likely to be helpful for the UK equity market.

2) Vaccine discovery: If and when there is the development of a viable vaccine would be expected to give the UK equity market a boost, given that it would hopefully provide a route out of the current stop-go business closure cycle. The UK is particularly sensitive to sectors including tourism and hospitality which are being especially badly hit with international travel and other restrictions, so any mean of easing these would be helpful for the economy.

3) Dividend recovery: The UK market has traditionally had some significant support from ‘yield-seeking’ investors. We think if the corporate background was to improve and dividend suspensions were lifted, this could be helpful for the UK equity market.

Attractive valuations

Whilst there is clearly some significant doubt about the ‘E’ or earnings number, in the UK the FTSE All Share is currently on a PE ratio of 17.5x and the FTSE 250 Index on a 15.1x ratio. This is significantly less than the S&P 500, which has a PE of 27.7x. Whilst European markets are on PE’s of between 20x and 25x.

Potential IPOs vs discount valuations on existing Trusts

It is interesting to note that a number of new Investment Trusts are hoping to IPO in the weeks ahead to take advantage of the current valuations in the UK equity market, although we note that one Tellworth did not manage to raise its minimum amount. Given this renewed interest in UK equities, we think the existing trusts offer both attractive discounts and good long-term track records with many experienced managers.

Attractive dividend yields

We think the UK equity funds are offering some attractive dividend yields – typically around 5%. We take some comfort from the fact that many of the trusts have now provided clarity on their dividend intentions for the current year and some into 2021. In many cases, dividends will be at least maintained at prior year levels – although this is likely to often require the drawdown of revenue reserves to maintain these dividend.

However, given that reserves are for ‘rainy-days’ it is fair to say that if these are not used in the current situation, we do wonder when will they be actually used. A few trusts have announced cuts in dividends – these have typically been in situations with manager changes such as Temple Bar’s 25% reduction and the lower proposed dividend level at Perpetual Income & Growth following the merger that is proposed with Murray Income.

Selected funds

Our preferred funds include Fidelity Special Values for undervalued stocks, Edinburgh IT as a recovery play with Majedie as new managers and for mid/small caps we like Mercantile and BlackRock Throgmorton.

Further reading

UK savers miss out on £38bn of income as cash piles soar

Dynamic Planner expands risk profiling service to analyse investment trusts

Coronavirus will push more global asset managers towards sustainable investing