By David Beggs, co-manager of the SDL Free Spirit fund
The landscape of UK pension fund investments has undergone a significant transformation in recent decades.
They have historically allocated a substantial portion of their assets to domestic equities, reflecting a strong commitment to their home market. But this trend has reversed markedly over the past 20 years.
Currently, UK equities constitute only a small fraction of pension fund portfolios, with many funds instead diversifying into global markets and alternative asset classes.
The declining allocation to UK equities is set against a backdrop of relative underperformance when compared to global markets over the past decade. This underperformance has contributed to the perception of UK stocks as less attractive, leading to further divestment by domestic pension funds and creating something of a vicious circle.
The shift away from UK equities has exacerbated the undervaluation of many UK companies and this opportunity is being seized upon by both private equity and overseas trade buyers with a flurry of merger and acquisition activity. In the first half of this year alone, bids totalling approximately £43bn were made for UK companies.
Whilst the associated takeover premium can offer a short-term boost to UK investors, it comes with a long-term cost, as the number of delistings far exceeds the number of new IPOs. The FTSE SmallCap ex Investment Trusts index, for instance, has already seen its number of constituents drop from 160 in 2018 to 114 at the end of 2023.
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Within our own portfolio, we have seen several takeover bids, including network testing specialist Spirent Communications and DIY investment platforms Hargreaves Lansdown.
Spirent is set to be acquired by a much larger US competitor at a staggering 86% premium to the undisturbed share price, perhaps giving some feel of the level of disconnect between share prices and underlying value.
Meanwhile, the board of Hargreaves Lansdown have indicated their willingness to recommend a firm offer from a private equity consortium at 1,140p, a level that feels highly opportunistic to us as long-term investors. This is particularly the case given the recovery potential of the UK market.
What it does underline is that while UK asset allocators continue to reduce their exposure, international investors are increasingly recognising the value on offer in the UK.
But what might reverse this seemingly inexorable trend? From our conversations with UK investors, it is clear that many recognise there is a compelling argument for increasing their allocation towards the UK.
However, sticking one’s head above the parapet and going against the current zeitgeist entails both career and reputational risk. There is very much a ‘safety in numbers’ feel which is why financial markets are so prone to herding.
See also: UK dividends reach all-time high in Q2
If the carrot of higher prospective returns does not change allocations, then one suspects the stick of regulatory change will be forthcoming with the new Labour government well aware of the need to increase domestic investment.
The Labour manifesto committed to “act to increase investment from pension funds in UK markets” and undertake a review of the pensions landscape to consider what further steps are needed to improve pension outcomes and increase investment in UK markets. You might say, in this regard at least, that things can only get better.
For those considering reallocating towards the UK, the most compelling opportunities are in small and mid-cap companies. These are often not as well covered by analysts and are less likely to be efficiently priced by the market.
The well-known trade-off at the smaller end of the market is of course patchy liquidity but this is a challenge that pension funds should not fear, given the long-term nature of their investment capital. A strategy focused on buying and holding quality companies could mitigate liquidity challenges, as quality companies are far less likely to trigger a sell discipline in our experience.
The underlying investors also benefit from the ability of quality small and mid-caps to compound their earnings and free cash flow over time. The icing on the cake would be that any meaningful increase in allocations towards the UK would likely reverse the multi-year equity de-rating and further compound the overall return. A double whammy if you like.
