Keep calm and carry on

November 10, 2022

Financial district of London and the Tower Bridge.

The UK has been going through an unprecedented time. From the death of the Queen, to three prime ministers in a little over two months, what the country needs now more than ever is stability and unity from both the new monarch and incumbent governing party.

A disastrous 44 days as prime minister by Liz Truss led to tremendous turmoil in the gilt and sterling markets. The pound hit a record low against the US dollar towards the end of September, forcing the Bank of England to step in and stabilize markets. 

New Prime Minister Rishi Sunak has an unenviable task ahead of him. While being the sole candidate to achieve enough support from MPs to stand for the Prime Minister position prevented further infighting within the Conservative Party, the fact remains that there are still factions and loyalties pitted against each other. With this as a backdrop, it is even more difficult to regain the confidence of voters ahead of the next general election. Latest opinion polls show the Conservative Party facing a 26-point deficit.

Perhaps the most difficult task of all will be to reassure investors and increase credibility concerning public finances. Initial reactions to Sunak’s appointment were positive due to some goodwill built up through his handling of COVID and furlough schemes as Chancellor, a reputation for being fiscally conservative and the belief that he and the current Chancellor, Jeremy Hunt, are both singing from the same hymn sheet. Contrary to his predecessor, Sunak has already stressed the importance of government policy working hand in hand with the central bank to combat inflation, while emphasizing the independence of the Bank of England over interest rate decisions.

The next financial statement, due on November 17, will go a long way to re-establishing some credibility. Difficult, but necessary decisions on increased taxes and spending cuts are to be expected. Even freezing income tax thresholds will see more people enter the income tax system, or into a higher tax band, due to the wage inflation currently being experienced. Only one area has been designated as off limits for cuts – the National Health Service. Other areas such as welfare, education and­—perhaps controversially given the current geopolitical environment, defense—could be in the firing lines, as well as reviewing the HS2 rail project. 

Fiscal responsibility is at odds with regaining the favour of the voting public. Just this week the Bank of England hiked interest rates by 75 basis points to 3%, the largest hike since 1989, and said that the UK is potentially facing its longest ever recession. Unemployment is expected to almost double, albeit from its lowest level in 50 years.

The instability surrounding the UK government and future economic prospects means investors want a discount on UK equities to compensate for current additional risk and uncertainty. However, based on the forward price-to-earnings ratio, the UK is at its lowest valuation versus global peers since records began. The attractive valuations combined with weak sterling and/or strong dollar leads us to believe that there is a significant opportunity for international and more specifically U.S. corporates or financial institutions to increase takeover activity. Longtime holding, Clipper Logistics (CLG.LN), was acquired by U.S. peer GXO Logistics (GXO.US) earlier this year. Current holding, Biffa (BIFF.LN) is being acquired by a private equity firm, with the transaction expected to close by the end of Q1 2023 at the latest.

The larger question is if there remains compelling reasons to own UK equities right now given the warning of a deeper recession than other regions. We would argue that this is a good environment for bottom-up fundamental stock pickers. Some quality international companies are now available at a significant discount. The FTSE 100 derives around 70% of its revenues internationally, while the FTSE 250 is at 50%.

When looking at our holdings in the UK, we have a diverse mix of companies, many of which have diversified their source of revenues away from just the UK. Often the market leaders can capitalize in economic downturns and increase market share while competitors struggle. This could also be the case for our holdings, briefly summarized below.

Our UK holdings with significant overseas revenues include:

Coats Group (COA.LN) is the world’s leading industrial thread manufacturer with market-leading position in apparel and footwear, plus a leading and growing position in performance materials. The company derives the overwhelming majority of its revenues from Asia and the Americas.

IWG Pls (IWG.LN) is the world’s largest provider of hybrid workspace with a network of 3,323 locations across 120 countries. The UK accounted for 16% of group revenues in 2021.

Oxford Biomedica (OXB.LN) is a leading cell and gene therapy group and does not disclose the geographical segmentation of revenues.

Safestore (SAFE.LN) is the UK’s largest self-storage group with 130 stores located in the UK and 48 stores located in Europe, mostly in Paris but with locations in the Netherlands and a growing presence in Spain. Around 25% of revenues come from overseas.

Savills (SVS.LN) is one of the leading real estate advisors in the world with 57% of revenues coming from outside the UK.

Our UK holdings with largely domestic revenues include:

Biffa (BIFF.LN) is a UK-based waste management company whose operations include collection, recycling, treatment, disposal and energy generation. As mentioned above, the company is in the process of being acquired.

CVS Group (CVSG.LN) is one of the largest integrated veterinary services providers in the UK (plus a small presence in the Netherlands and Republic of Ireland). The firm has four main business areas: veterinary practices; diagnostic laboratories; pet crematoria; and e-commerce (non-prescription medicines, pet foods and pet care products).

Onesavings Bank (OSB.LN) is a UK specialist lender which targets market sub-sectors that are underserved by the mainstream banks, most notably the professional landlord buy-to-let market.

Global Alpha Capital Management Ltd.
November 10th, 2022