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Alternative Market Briefing

The UK is a nice place for us to fish

Monday, October 31, 2022

Alyx Wood
B. G., Opalesque Geneva for New Managers:

Kernow Asset Management is a boutique in London that only trades UK-listed stocks. The UK is their home market, and as far as home markets go, it is a very interesting one, they say.

This conviction does not ignore the fact that UK equities are currently unloved. That's even if the UK has been the best-performing developed market this year in local currency terms, reported the Financial Times on Oct.20. Bank of America's fund manager survey for October showed global investors are more bearish about the UK than any other region. European fund managers, who were quite pro the UK in August and September are now neutral. Barclays' recent analysis showed the biggest year-to-date UK equity outflows on their records, dating from 2006. Meanwhile, UK valuations (measured by the forward price-to-earnings ratio) are now at their lowest compared with their global peers on record.

The interesting part for investors

In the UK funds sector, "culturally, there's a lack of differentiated research, and as the companies are consolidating into one company, there's essentially a lot of index hugging going on," co-founder Alyx Wood tells Opalesque in a recent video interview. "A lot of funds now are plus or minus 1% or 2%. If you go back 10, 15 years, that might have been plus or minus 10%, so things can get out of hand quite easily, and that creates a lot of opportunity for us." Investing in equities long short can go a long way; the Barclay Equity Long/Short Index has annualised c.9% since inception in 1997, compared with c.4% for the FTSE All Share index.

The FTSE 100 index (the Footsie), a share index of the 100 companies listed on the LSE with the highest market cap, is down 6% YTD (as at 31 October). The FTSE 250 Index, which consists of the 101st to the 350th largest listed companies, is down 25% YTD. The latter consists of smaller businesses with fewer resources to weather today's economic storm.

The UK is a liquid market with many buyers and sellers on the London Stock Exchange. As of September 2022, the number of companies trading on the LSE stood at 1,970 (down from 2,400 seven years ago). Kernow's universe of 500 stocks focuses a lot on mid-caps, a "sweet spot" as they have a structural lack of high-quality institutional investors and low and inefficient research output.

Brexit in 2016 was a disappointment for international investors who became uncertain about the environment and priced in risk, Wood continues. Now UK equities trade at a 30 to 40% discount to global developed peers, "it's a once-in-a-decade trade," the opportunity has become obvious and some investors are coming back.

"At the end of the day, you have to have some exposure to the UK equity market. And the market essentially is priced as if it's in structural decline and the UK is not going to exist anymore... That's certainly not the case, we can see how well the bustling city of London is doing, it's the largest financial hub of this time zone, and over the long run it's beaten its counterparts in Europe in terms of GDP. We might not do that in the future to the same extent, but it's certainly going to be near the top, and so it's quite an attractive trade from an asset allocation point of view. It's a nice place for us to fish and not cast our net too wide."

The country has a 4% share in the MSCI World Index (which is down 25% YTD after losing 9% in September).

The UK is the sixth-largest economy in the world (by GDP (nominal)), according to the IMF. Among the other European countries, Germany is fourth, France seventh, and Italy tenth. The UK is expected to fall to seventh place by 2023.

Furthermore, Wood adds, the UK has more tenbaggers than the USA as a percentage of market cap. A tenbagger (or 10 bagger) is a term coined by legendary fund manager Peter Lynch in his book One Up On Wall Street. While tenbagger can describe any investment that appreciates or has the potential to increase tenfold, it is usually used to describe stocks with explosive growth prospects.

Indeed, over the past decade you would have had a better chance of picking a tenbagger in the UK than the US, Schroders reported in January:

The UK also has a good IPO pipeline as it has the most unicorns in Europe, Wood adds. The UK has indeed built a deep unicorn pipeline this year, reported in June. The country has produced 122 billion-dollar companies and is home to a further 258 startups on potential future unicorn track, more than double any European neighbour:

Investment philosophy

Investing in UK equities "means that we sift through the disregarded, the misunderstood, the esoteric opportunities to find risk/reward situations that are skewed in our favour," Wood says. "Put in another way, we find hidden gems in non-fashionable areas. The way we actually execute that is with our contrarian mindset. That means we're a fundamentally driven mean reversion trader. Fortunately for us, the output of all this is that we get an uncorrelated high return stream from UK equities which is generally a pedestrian, very liquid market."

Contrarian investing works because cash flows and business models move slower than emotions and sentiment, he explains. It works because "when we're presented with something in life, we under-react, and then massively overreact. We live in the status quo until something becomes threatening or interesting enough."

And so the manager applies the two tenets of overreaction and underreaction to UK equities - and in his UK equity long/short strategy. "The philosophy makes sense and it should provide a decent return, but it means nothing unless you have a very disciplined investment process. The investment process can be split into three simple parts - simple, but not easy: Number one, we value a company; number two, we pay less for it; and then number three, we trade the catalyst."

The Kernow Portfolio, a managed account strategy that invests in All Cap UK equities on both the long and short sides, has returned 25% from its inception in November 2019 to September 2022, compared to the Barclay Equity Long/Short Index's 19%. The CF Kernow Equity Navigator Fund, a UK equity long/short hedge fund launched in April, follows the same strategy.

Kernow Asset Management is a boutique UK equity specialist that runs a UK equity long/short hedge fund, SMAs, and an onshore fund. It is based in London and Cornwall and was co-founded in 2019 by CIO Alyx Wood and CEO Ed Hugo. Prior to that, Wood, a chartered accountant, was a fund manager at Downing LLP, vice president at Deutsche Bank, and management consultant at KPMG. Hugo did a Master's in Microsystems and Nanotechnology and was Head of Equity Research at boutique investment bank VSA Capital.

You can watch the whole interview on Opalesque Virtual Manager Visits here: Kernow Asset Management: Capturing Contrarian UK Alpha

Related article:
17.Jan.2022 Opalesque Exclusive: Boutique manager Kernow to launch UK equity long/short hedge fund

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