By David Smith, manager of Henderson High Income trust
What does a retailer, a bank and a tobacco company have in common? They all outperformed the magnificent seven over the past three years.
Yet if you asked most investors which stocks have stood out over that period, most would turn to the technology giants that have dominated markets returns thanks to a boom in artificial intelligence.
More traditional businesses often get overlooked, but these UK stocks have outpaced the magnificent seven, especially as interest rates have increased – and none of them are technology stocks.
They are more traditional businesses, yet the scale of outperformance has been significant. Private equity investor 3i, for example, has produced a 180% return since 31 December 2021 versus a 42.5% return from the magnificent seven.
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Its share price has been driven by the success of European discount retailer Action. Its EBITDA has grown over 150% throughout the past three years, driven by both organic sales growth and new store openings.
Action’s business model of using its scale to reinvest in lower prices drives its popularity with customers and is very hard for competition to match.
While one can point to 3i benefitting from the popularity and fast growth of Action as the driver of its strong returns, the likes of NatWest and Imperial Brands have also managed to accumulate total returns of 111% and 98% respectively without strong underlying growth.
NatWest has significantly outperformed due to the growth in its profits aided by higher interest rates. Its net profit increased 60% and aided the company’s cashflow, meaning it could afford to pay an attractive dividend to shareholders and buy back the government’s stake in the company.
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Tobacco company Imperial Brands also experienced a successful turnaround strategy with market share losses turning into gains and more resilient earnings. The company used its strong cashflow to pay an attractive dividend and buyback its own shares at a low valuations, boosting its earnings growth and leading to a re-rating.
Although NatWest has benefited from the change in the interest rate environment and Imperial Brands has delivered modest profit growth by stemming market share losses, there is another factor at play that is vital for investors – the significant cash returned to shareholders.
A proportion of returns drawn from the businesses came from dividend payments, which have grown over the past three years. These have been supplemented by share buybacks at low valuations.
Management teams have recognised their businesses are undervalued and used excess cashflow to buy back their own shares at attractive prices.
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All this has compounded to create an attractive proposition for investors over the past three years. Despite the strong total returns from both Imperial Brands and NatWest, they still trade on low valuations – less than 10x price-to-earnings.
Similarly, other companies are also returning cash to shareholders through dividends and share buybacks, such as HSBC, Shell and Compass Group.
Like NatWest, HSBC has benefited from increased interest rates driving higher profits, but also from the streaming of its operations. The company has sold off some of its lower returning non-core assets while a greater focus on its Asian operations has seen good growth in wealth and personal banking in the region.
Shell has clearly benefited from a higher oil price post the start of the Ukraine war, and the better operational performance has also aided growth in its cashflow. The war also relaxed some investors’ attitudes to the sector with more focus on the importance of energy security supporting the shares.
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Contract caterer Compass Group has solidified its market leading position by taking market share and winning new first time contracts in the tough high food price and wage inflation environment. This has led to stronger than expected growth driving the share price.
Despite all three companies not being tech businesses, they have still produced a significant total return over the last three years ahead of the magnificent seven.
While the UK equity market gets overlooked due to its lack of exciting tech businesses in hot areas such as AI, one shouldn’t ignore it given the potential for strong performance among more traditional businesses.