What’s the difference between a pessimist and an optimist?

A pessimist says, "Things can't get any worse", while an optimist replies, "Oh, but they can!". We joke of course, but they do say optimism is often the key to perseverance and this sentiment feels especially relevant as we recently celebrated five years of managing our highly differentiated UK equity income fund, focused on the UK mid-market. Reflecting on the journey since January 2020, we have navigated an extraordinary period in history: a global pandemic, conflict in Europe, inflation surging to forty-year highs, the sharpest rise in interest rates in decades, and much more.

Understandably, such dramatic events have produced their fair share of volatility in markets, as can be seen in the chart below of the UK’s Mid-250 Index (ex-Investment Trusts), over the five-years to the end of January.

Over the full five years the index, in price terms, is down -2.7%. Whilst that does not sound particularly dramatic, it clearly masks huge volatility during the period. In just one month (Feb - Mar 2020) the index fell -43% as Covid struck. It subsequently rebounded +93% over the next 18 months or so, only to decline -35% the following year as the Ukraine war developed and inflation and interest rates shot up, before rallying c. +31% over the last couple of years. No wonder investors nerves are frayed!

On a total return basis, including dividend income, the index has increased by +11.2%, or +2.1% per annum over this time. Whilst that might sound respectable, considering all the events described above, it is actually an extremely poor five-year return for this, historically, high performing index. For context, the index delivered +11.5% per annum returns over the previous twenty-five years, a period which included two of the biggest bear markets in history, namely the ‘Dot Com’ crash and the ‘Global Financial Crisis’, not forgetting of course the vote for Brexit.

Alongside the dramatic events of recent years, UK investors have also been contending with well documented, and relentless, outflows from domestic equity funds, as the perception of the UK as an attractive home for investment has continued to sour. Whilst this trend started post the 2016 Brexit vote, it has accelerated significantly over the last five years as the chart below highlights all too clearly.

It is also fair to say that, alongside persistent negativity towards the UK’s economic outlook, these outflows have had a disproportionate impact on companies lower down the market cap spectrum. That is one of the major reasons why, despite a long history of outperformance, the UK mid-market has struggled relative to its more international FTSE 100 peers over this period too, as shown below.

So, with the UK economy and markets facing seemingly insurmountable problems, why do we insist on remaining hugely optimistic for the UK mid-market - and our fund - as we embark on the next five-year leg of our investing journey? In no particular order, we would reiterate the following:

• After a sustained period of subdued performance and perpetual outflows, the UK mid-market is, in our view, outstandingly cheap. Regular readers will recognise the importance we place on the price you pay at the outset in determining your ultimate returns from investments. Currently, we see a huge array of investment opportunities at valuations we have rarely seen before in our careers. We cannot be anything other than enormously excited about future return prospects from today’s starting point.
• Investing always has a psychological element associated with it and, in our experience, situations are rarely ever as good as they appear or as bad as they appear through the eyes of the often manic ‘Mr. Market.’ Given the dire state of sentiment towards the UK economy and markets today, we do not believe it will take a lot to incrementally improve the ‘narrative’ going forwards.
• In that context, the UK domestic economy continues to show an admirable degree of resilience, in the face of numerous headwinds, persistently surprising the doom mongers in the process. We believe it will likely continue doing so, given solid consumer and corporate balance sheets, a healthy banking sector, low unemployment, stable inflation and gradually falling interest rates.
• Furthermore, in our view there are incremental signs of progress in many aspects of UK capital markets which are currently being dismissed. These include developments aimed at rebalancing the regulatory system to drive growth and competitiveness, pension consolidation to create mega funds and increase investment, a new financial services growth agenda and more besides. For sure, these initiatives will take time to bear fruit, and more will likely be needed, but market participants are unlikely to wait until the jigsaw is complete before adopting a more positive outlook.

To be clear, we understand the frustrations of investing in the UK, specifically down the market cap spectrum, in recent years – indeed we have shared in them frequently! However, we genuinely believe that perception, as is often the case, is significantly worse than reality today. We also believe that most, if not all, the problems we face are eminently fixable, even if solutions take time to implement.

As a final note, despite all the issues and volatility we have had to contend with over the past five years, we are still relatively pleased that our fund has delivered a positive return of +37.7%* over the period, or c. +6.6% per annum. Not exceptional by any means, but a reasonable start from which we hope to significantly build on in the future. Consequently, we very much look forward to the next five-years and we are excited for what lies ahead. Does that make us optimists?