Beagles: Investors Won't Allocate to UK Unless Gov't Forces Them to

Christopher Johnson: There's no denying that uncertainty has dominated investing in 2024, but the FTSE 100 has remained surprisingly resilient and has even surpassed expectations. Several factors have contributed to this, particularly the return of M&A activity to the U.K. marketplace. But should investors be concerned by the shrinking UK equity market? To discuss all this and more, I'm joined by Clive Beagles of JO Hambro Capital Management.

Clive, thank you so much for being here with me.

Clive Beagles: Pleasure.

Johnson: So, my first question to you is, should UK equity fund managers be concerned about the rate of takeovers in the UK?

Beagles: Well, I don't know if concern is the right word. I mean, ultimately, we're in the industry of trying to make returns and money for our clients. And clearly, a number of takeovers at substantial premiums crystallizes that sort of upside potential, if you like. So, in the short term, I think it's helping returns. But clearly, if the rate carries on, on the current trajectory, there's a danger we won't really have a market left in 10 years' time. So, in that regard, I don't think it's—it's not healthy in that respect.

But having said that, I think that's highly unlikely. Because I think at some stage the pace and trajectory of takeovers will slow down because I think prices will adjust. The UK is trading on such a big discount to any other developed market. That's why we're seeing so much incoming M&A. And I think at some stage, maybe when outflows have slowed down, which feels like it's beginning to happen, or maybe when fund managers' views of what they think an acceptable takeover premium, I think those are beginning to increase a bit. You look at some of the more recent activity, a few bids are being rejected by major shareholders. So, I think that process is beginning to happen already. Valuation gap is beginning to close. People's expectations about what kind of premium they ought to be able to expect is rising. So, I don't think the markets dwindle away to nothing.

I think what would be just as interesting—if we had a high-profile bid for a very large company in the UK, what would the new government's attitude be? Particularly if it was maybe in one of the more controversial areas. If BP, hypothetically, if BP got bid for by Exxon, obviously, all industry has been one which has hardly been top of the agenda for politicians' love list. But I suspect certainly BP would be deemed to be part of the UK's crown jewels and how on earth should we allow this to happen and all that kind of debate. So, let's see what happens from here.

Johnson: And what are the solutions, do you think, or are there political solutions that can be made to make the City of London a more attractive place for people to list? Or do you think that would just come naturally?

Beagles: Yeah, I'm not sure it's going to come naturally. I think we may need something a little bit more legislative than that. I mean, I think on the one hand, we've obviously been through a period of a lot of uncertainty. You mentioned in your introduction we had five prime ministers in six years; we've had a Brexit referendum to grapple with and so forth. And I think that hasn't helped. Equally, we can't lose sight of the fact that all developed markets have underperformed the world index because of US exceptionalism. So maybe if we're beyond that phase, maybe there's an element of other markets kind of catching up. Because really, when we look at the discount, most people look at the UK versus the US really.

Having said that, the one very live topic of debate, which I don't think people are talking about enough is the whole issue of domestic allocations to UK equities and the fact that the UK has got the lowest—it's got lowest allocation to its domestic equity markets and whether government might mandate allocations to be higher, particularly for tax-advantaged wrappers, whether it's individual pensions or whether it's corporate pensions. And I think, look, let's see what happens, but it wouldn't be a huge surprise to me to see some kind of mandate reaction, because I don't think—people aren't going to do it—it doesn't feel to me like people are going to do it voluntarily.

Obviously, all other equity markets in the world have much higher domestic allocations, and when we get into that philosophical debate about how has the country benefited from giving someone a tax break in terms of invest in their pension for themselves to invest in Nvidia or Amazon or Microsoft, the country hasn't really benefited from that. So, whether that comes as soon as the Budget or whether it comes late next year when there's a new pension act being discussed, I don't know, but I think the direction of travel is that's quite likely.

Johnson: And can the FTSE 100 reach record highs by the end of the year, do you think?

Beagles: Yeah, I mean, it can do. I mean, we're not that far off, are we? It would only be 2%, 3%, 4% from where we sit today. So, I think there's a reasonable chance. Obviously, at the moment, we've got uncertainties in terms of conflict in the Middle East and so forth to work our way through, and none of us can predict how that's going to play out on a sort of one, two-week, even three-month basis based on by the end of the year. But clearly, the market remains relatively modestly valued.

I think having said that, I would suggest there's probably more upside in the 250 and the small cap than there is the 100. They're further below their previous peaks. We're going to have an environment in which interest rates are going to be coming down, inflation being close to 2%, and I think the more domestically orientated parts of the market, which are those indices, are more likely to be beneficiaries. The FTSE 100, as you know, is rather more dominated by international companies.

Johnson: Could one argue that investors are getting too accustomed maybe to the sugar high that mergers and acquisitions provide for their portfolios? Is that a fair assessment?

Beagles: I don't think so. It doesn't feel like that to me. It doesn't feel like there's a great deal of euphoria around UK equities. I certainly wouldn't describe it as a sugar rush. The one change maybe has been that the constant persistent outflows feel like they've slowed down in the UK, but actually we haven't—look at our fund and I think it's similar to a number of the other larger UK equity funds in the market, outflows have stopped, but money hasn't really started coming in yet. People are still more likely to be able to tell you what the Nvidia share price is and what it's done in the last three weeks than the share price of any FTSE 100 company we could choose to mention.

Johnson: Do you see UK dividend paying stocks doing better next year than this year?

Beagles: Well, I think that's part of a wider debate around the value versus growth as an investment style. And obviously, we had a period in which growth stocks, including the big tech stocks in the US, but actually growth stocks elsewhere in the world performed much more strongly because we had more than a decade of effectively zero interest rates and zero interest rates meant people could use low discount rates to value future earning streams and as a result growth stocks were beneficiaries from that. I guess we're now in a more balanced environment. Interest rates have gone up. They're now going to come down a bit, but they're not going to come back down to zero. I think in that environment I think investors need to look on a more balanced way across different parts of the market. In that regard, I think value historically has performed very well over the very long term but has underperformed over the last 15 to 20 years.

So, I think, clearly, we have a very strong view that that should be a part of someone's portfolio, but I think many people who've only been—market participants who have only been in the market for the last 10 or 15 years have really seen what's the point. It's all been about capital growth rather than thinking that dividends might constitute 40%, 50%, 60% of your total return. Look at a fund like ours that yielding close to 5%, you've got that and then the opportunity to get some capital growth on top of that. And it's a dividend stream that grows, it's not a static stream, it's not like you're buying a government bond. Our fund is 20 years old this year. On average, our dividend distributions have grown by almost 10% per annum. So, you've got a useful starting yield that then has the potential to grow. That combination of characteristics should be attractive really in the current environment.