Dog Days of Summer?

The dog days of summer are behind us, but the UK equity market still feels stagnant*.  Another reporting season has come and gone and the directionless air that has characterised 2023 to date remains.  Various explanations for this malaise have been well documented – an uncertain macroeconomic outlook, the relative attractiveness of the UK as an investment destination for overseas investors,  UK pension funds cutting their demand for equities.  The pessimism could prove overwhelming.  Through the long days and short nights there has been one source of optimism though… corporate reporting.

Disappointingly, however, this hasn’t always been reflected in their respective stock prices.  Airlines Ryanair and Easyjet have both had consensus earnings expectations for calendar year 2023 and 2024 increase by over 10% over the summer and seen their stock fall.  TI Fluid Systems, a supplier to the auto industry, has upgraded profit forecasts by over 20% but it’s share price has flatlined.  Overall, c.2/3 of the holdings in the UK Opportunities portfolio have either held earnings expectations** or increased them over the summer months.

When we meet with the management teams of many of our holdings, they often ask us, as ever-more wizened sages of the investment industry, why we think their share price fails to reflect the fundamental strength of their business.  What can they do to shift perception?  The answer always used to be the same – just keep doing what you’re doing.  If a company keeps delivering strong performance then this will ultimately be reflected in the share price.  Over the past few months our conviction in that answer has wavered.  There are too many small and mid-cap companies who’ve done everything that could possibly be expected whilst remaining unrewarded.  Norcros, the UK bathroom and shower company, is expected to deliver underlying operating profit of c.£43m in the financial year to March 2024.  Unsurprisingly, given the pressure facing the UK housing sector, this will be lower than the record levels achieved in FY23.  It is still, though, over 3x its FY 2013 figure of £13m.  Nor has this been achieved by turbo-charging growth through debt.  Net debt to EBITDA should actually be lower than it was a decade ago.   Further to this, the company has made great strides in de-risking and shrinking its sizable pension scheme.  The company’s reward for this performance – a share price 10% lower than it was decade ago.

This is why we now tell management teams, quite candidly, that their best route to value realisation may have to involve an exit from UK public markets.  Lookers, a holding in the portfolio, announced this summer that it was being acquired by Alpha Auto Group (AAG), a Canadian-based car dealership chain.  We have written previously about how despite being underwhelmed by AAG’s initial offer, we reluctantly accepted that it was about as good as it was likely to get.  A subsequent 10p bump in the offer price did little to change our sentiment.  At the time it was the latest UK car retailer to exit the market following Marshall Motor’s purchase by Constellation and Cambria Automobiles management buy-out.  Subsequently, the US-based group Lithia have agreed to acquire Pendragon in a £280m deal.  The UK equity market once had a thriving sub-sector of UK automobile retailers and investors will soon only have one option, Vertu***.  Global peers and industry insiders are clearly of the view that the UK public markets have persistently been undervaluing the space.

Thankfully, it appears that there is a recognition at all levels that change is required.  Some suggestions are welcome (Mifid 2 reform) and some seem misguided to us (the Mansion House compact) but at least progress is being made.  This, combined with data that reveals that the UK is perhaps not the economic pariah it has been characterised of by some will hopefully provide a catalyst for UK equity valuations.  Over the summer it’s been clear from their reporting that UK plc is doing its share of the heavy lifting – it’s time for others to step up.

*Thanks to a stuck jet-stream we really didn’t have too many days in Edinburgh hot enough to qualify, so we’re using creative license with this metaphor.

**Held defined as consensus 12m forward consensus EPS forecasts being +/- 2% at end August vs end May

***Inchcape also operate some UK retail sites, but these represent a small proportion of overall group profits.

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