Upbeat about the prospects for the UK stock market from here, fund managers Gervais Williams and Martin Turner look back several decades to explain why they have nonetheless maintained an element of insurance for the MINI portfolio in the form of a FTSE 100 Put option.
From globalisation to protectionism, from beta to alpha
Around the world electorates are driving a political evolution from favouring globalisation towards policies that favour nationalism and protectionism. We believe that this will drive an equally significant evolution in terms of the financial markets. We could see financial markets moving from favouring market beta (a well-established concept that measures moves in a company’s share price relative to movements in the overall stock market), to a future that will, in our view, favour market alpha (the excess return on an investment after adjusting for market beta).
As part of that process, within the large company arena, this will likely involve an evolution from capital growth appreciation strategies. These are focused on increasing the value of an asset or investment over time, and where by implication near 100% of the return is driven by the direction of the stock market, i.e. enhanced by market beta. We expect a move towards equity income strategies. These are ones where a stream of income is provided through listed companies’ stock dividends, and where a much smaller percentage of return is enhanced by market beta.
If market beta were zero or worse, equity income strategies would nonetheless continue to generate a return via compounded cash dividends. This is where dividends are calculated on your deposits plus dividends reinvested and you earn on those too.
As investors favour equity income strategies, we believe this will lead to the UK stock market, dominated as it is by equity income stocks (companies listed on a stock exchange that pay a dividend), to outperform the US exchange, which comprises a large proportion of growth/capital appreciation stocks. The FTSE 100 Index has recently beaten its 1999 record high. We believe this market signal is significant, occurring at a time when redemptions from local UK Open-Ended Investment Companies (OEICs), the professionally managed funds which pool investors investments together, have been running at near record levels for several years. Over time, as local UK OEIC selling moderates, and as the impact of politics moving from globalisation to protectionism/nationalism becomes more obvious, we expect the rate of UK stock market outperformance to accelerate. We also believe that the new trend will persist for many years. At the same time, UK equities are currently standing on unusually low valuations, and very few institutions – including local pension funds and insurance companies – have significant allocations to UK investments.
We anticipate the outperformance of the UK stock market will surprise in both scale and duration.
The FTSE All-Share Index vs the S&P 500 Index, both in a common currency (1965 – 2024)
Source: Bloomberg, S&P Dow Jones Indices LLC., FTSE Russell. Data from 31.03.1965 – 28.06.2024. Past performance is not a reliable indicator of future returns.
Why we’re upbeat
For this reason, we have been very upbeat about the prospects for the UK market. We are also incredibly upbeat for MINI’s portfolio, which might seem at odds with the statement regarding equity income stocks. The reason we are upbeat about MINI lies in our assumption that in future investors will evolve from favouring market beta to market alpha.
We have highlighted how this might impact mainstream large company (or “large-cap”) stocks, with investors moving from capital appreciation/growth strategies into equity income strategies. But in general, it is very hard to generate sustained alpha of any scale within large-caps. Nor is it easy within smaller companies (or “small-caps”), but there is much greater scope to succeed, and we would argue the potential alpha for micro-caps, the smallest listed companies, is even greater.
Overlay this with an investor climate where, rather than UK investments being cut by UK institutions, they are steadily increased. In this context, the combination of UK micro-cap alpha, plus the recovery of micro-caps from absurdly low valuations, together with their potential to enhance growth further by acquiring overleveraged but otherwise viable businesses, and in our view this could be of benefit to the holdings within the MINI portfolio. The UK stock market may be dominated by equity income stocks at the top end in market capitalisation terms, but it also leads the world as an exchange that comprises numerous genuine small and micro-caps. If investment alpha is the objective, then the UK micro-cap universe appears to have the greatest upside potential of all.
Performance of Deutsche Numis 1000 vs Deutsche Numis Smaller Companies Index* vs FTSE All-Share Index 1955 – 1988
Source: Deutsche Numis Securities, FTSE Russell, Elroy Dimson and Paul Marsh of London Business School. *Formerly RBS Hoare Govett Smaller Companies Index. Past performance is not a reliable indicator of future returns.
So why include a FTSE 100 Put option in a micro-cap trust?
What is a FTSE 100 Put option?
A FTSE 100 Put option is a type of derivative contract in which the underlying value is based on the level of the FTSE 100 index which tracks the performance of the 100 largest companies by market value listed on the London Stock Exchange. Such contracts should increase in value if the FTSE 100 Index falls, therefore potentially protecting the value of a trust invested in UK companies. It can be thought of as an insurance policy.
Given this background, why does the MINI portfolio include a FTSE 100 Put option? The simple reason is that we believe that asset prices will probably be incredibly volatile as investor behaviour evolves. As potential evidence for this, we find it helpful to review a similar period of change in the early 1970s, a period when for at least a decade the UK stock market became about the best performing stock market in the world until globalisation started to become the key global policy. During that period, global stock markets suffered a major crash, falling in many cases by over 50%. In other words, while we believe MINI’s strategy is well placed to deliver some of the strongest returns from here, we also believe that if there were to be a stock market crash, it could be much more severe than those of 2008 and 2020.
As current expectations are for lower levels of stock market volatility, the cost of buying a FTSE 100 Put option is also relatively low at present. As such we believe this is an appropriate time to insure a small portion of the portfolio. In the absence of a global crash, and if the UK market outperformance accelerates from here, with UK micro-caps being the best performing part of the stock market as they were in the period following its COVID-induced fall, then MINI should deliver strong shareholder returns to offset the relatively modest cost of a Put option. Conversely, if markets do suffer a crash, MINI’s net assets will not suffer such a large fall, and the potentially quite sizeable profits on a Put option could then be used to reinvest in additional micro-caps at distressed prices, potentially adding considerably to the portfolio’s upside.
Gervais Williams & Martin Turner
Fund Managers, Miton UK MicroCap Trust
