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The demise of UK equities? – Let’s talk numbers

Josh McCathie
Josh McCathie

Fund Manager

Josh McCathie
Josh McCathie

Fund Manager

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Josh McCathie, manager of the VT Downing Small & Mid-Cap Income Fund, explains why the UK is a very attractive market for investors seeking income  

Despite most UK investors suffering a degree of home bias, there is no disagreement that the UK stock market’s importance on the global stage has dwindled over the last decade or more. The UK makes up just 3.6% of the MSCI All-Cap World Index. Why? The FTSE 100 has returned 289% over the last 20 years whilst the S&P 500 has returned 511%. This underperformance has reduced the UK’s weighting in world indices as market capitalisations have struggled to keep pace with international counterparts.

Dividend distributions have contributed 34% of cumulative investor returns over the last 50 years, and digging down further to periods of high market volatility it can be significantly higher. Taking the 10 years from 2000 to 2010, capturing the dotcom crash and the global financial crisis, the return contribution of dividends was in excess of 80%.  

The UK offers the highest dividend yield

The UK stock market continues to offer investors the highest dividend yield of the major equity indices. The FTSE All-Share currently sits on a 4.1% yield, this is a large premium compared to the 1.5% offered by the S&P 500 or even the 3.4% on offer from the Euro STOXX. Abrdn recently pointed out that this yield premium now stands at its highest point for the last 15 years. Furthermore, as highlighted by Simon French of Panmure Gordon, the UK equity market isn’t just trading on a dividend yield discount. Looking across other conventional valuation metrics; price to earnings and price to book, the UK is trading at its largest discount compared to the rest of the world going back as far as 1993.

Further arguments for falling UK equity exposure and valuation discounts outside of lacklustre returns are Brexit, political faux pas, and labour force participation to name a few. All of which many feel have a degree of lasting effect.  

Inflows – Global v UK

However, this yield premium and the importance of dividend income for overall returns haven’t translated into flows into UK equities. According to the Investment Association, over the last three years, the IA Global Equity Income sector has seen a 42% growth in assets under management compared to just 9% for the IA UK Equity Income sector. UK equities’ lacklustre capital returns and declining weighting in overall global equity markets has resulted in poor sentiment towards UK assets and this appears to have benefitted global equity income flows which are now seen as the destination for income-seeking investors.  

Looking more closely at the Global Equity Income sector, we found 16% of its exposure was held in UK equities. This suggests the sector is more than 400% overweight UK equities relative to the MSCI All-Cap World Index. But this makes sense as the sector needs to provide investors with dividend income and the UK offers this to the greatest degree.  

High concentration

Within the sector’s overweight UK position, this is split across 56 different companies. 84% of these companies were FTSE 100 companies, and 12 of the top 15 dividend-paying companies listed in the UK. This is important because the UK Equity Income sector is highly concentrated, with 52% of all assets held within just 10 funds. Those top 10 funds on average have 3.3% exposure to each of the top 15 dividend-paying listed in the UK. In turn, this is a very similar exposure to the UK exposure within global equity income funds.  

If the UK only constitutes 3.6% of overall equity exposure as per MSCI and global equity income funds that already offer similar exposure as the largest UK Equity Income funds, then it begs the question of why not do something different with that 3.6% UK equity exposure.  

The VT Downing Small & Mid-Cap Income fund has no FTSE 100 exposure, no exposure to the top 15 dividend-paying companies listed in the UK, and no exposure to the 56 UK companies currently held within the Global Equity Income sector.

Let’s compare some of the previous points about UK small and mid-caps specifically.  

UK small and mid-cap outperformance

The FTSE 250 and FTSE Small Cap have returned 515% and 378% respectively over the last 20-year period. This has significantly outperformed the 289% delivered by the FTSE 100. Both the FTSE 250 and FTSE Small Cap have outstripped the returns of major indices such as the Euro STOXX and Nikkei 225. More impressive is how the FTSE 250’s 515% return even trumps the mighty S&P 500.

The UK yield premium of the FTSE All-Share is driven more so by the FTSE 250 than the FTSE 100. The FTSE 250 currently sits on a 3.9% yield, this is the highest level in the last decade and nearly double the trough of 2.0% in 2020. The FTSE 100 is currently on a 4.1% yield, down from its peak of 5.1%. Therefore, the yield premium of the UK is largely driven by a lack of yield dilution of small and mid-caps, rather than growth in large-cap dividend yields.  

The FTSE 250 currently trades on the same EV/EBITDA multiple as the FTSE 100, compared to trading at a premium for 94% of the last 20 years. This is despite delivering superior investor returns, a comparative dividend yield that is forecast to grow by 31.7% over the next three years compared to the FTSE 100’s 14.2%. Therefore, the VT Downing Small & Mid-Cap Income Fund offers investors a “double discount” - an overall UK valuation discount, but also a UK small and mid-cap discount relative to UK large cap.  

One might query if the discount is justified given small and mid-caps offer more UK-specific exposure? Potentially. However, UK small and mid-caps have on average 59% revenue exposure to the UK, 318 companies have exposure of less than 50%, and 145 companies have exposure of less than 10%. This suggests it isn’t as simple as assuming the entire UK small and mid-cap universe is UK-centric.

Seizing the value opportunity

There are many valid arguments to explain falling UK equity exposure and the rising popularity of global equity income funds as the replacement for those investors seeking dividend income. If global equity income already offers adequate UK large-cap exposure, why not seek to diversify further with the remaining UK-specific exposure? Returns and valuations suggest the odds are stacked in favour of those investors that do. The £27bn worth of acquisitions in UK small and mid-caps over the last 12 months suggests that if equity investors don’t realise this value proposition sooner rather than later, then others will seize the opportunity.

Josh McCathie

Manager of the VT Downing Small & Mid-Cap Income Fund

August 2023

Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please note that past performance is not a reliable indicator of future results. Capital is at risk.  

This document is aimed at professional investors, is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. This document contains information and analysis that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.


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