FTSE 100: Extinction? Rebelled

“Is there ever a portfolio question to which the answer is Vodafone?” mused a broker to me recently. As an investor in Vodafone I laughed nervously but kept quiet and moved on to something he might find far more interesting. Back to this in a moment.

As a business transformation investor focused on the UK we rarely get to invest in disruptive technology. Our usual market is companies that are more established, going through tough periods, but which – under new management and armed with new strategies – are becoming better versions of themselves.

It is perhaps sad but true that the FTSE 100 is probably one of the best hunting grounds for us. The index is packed full of established companies that generate cash flow, but do not necessarily excite with their growth prospects or innovation. This runs in contrast to the FTSE 250, where growth and innovation are typically far easier to find.

Over the last 20 years the dizzying cocktail of breakneck technological shifts, breathtaking monetary easing, and more latterly innovative investment products that allow access to investment themes far more easily than ever before, has led investor preferences in a particular direction. A growth direction. And we can all recite the well-rehearsed argument that the UK doesn’t do growth particularly well.

However, at the start of 2021 we noticed a trend beginning to occur – we were finding more and more opportunities within the most unloved parts of the FTSE 100. In fact the weightings to these parts of the market were the highest we’d had in years.

Given that we do not make explicit top-down calls, and neither do we particularly invest in companies so challenged that their very existence can be questioned, why was this happening? To answer this we need to think about what we do, and the environment we were in.

Quaint as it may seem in a world of thematic investing and factor tilting, we still believe that the price you pay for an asset will be a key determinant of the return you make from it. And the FTSE 100 was, in parts, ludicrously cheap. There was not just value, but deep value. But cheapness alone is not good enough. Whilst we do not use the word value as a pejorative term (as many seem to), we do think that value needs to be attached to three things in order to get the best out of it: management change, strategic change and hidden growth.

This gets to the heart of business transformation – change. Companies (and markets) are forever changing, yet often the accompanying investment narrative is slow to catch up, and the valuation backward-looking – as the pain of recent experience leaves lasting scars. This is why some stocks, regions, indices or even styles can become so mistrusted, and fall so out of favour. And when we looked, these companies had deep scars, but were changing fast – and the market was not yet paying attention.

Last but not least we look for value-creating management teams. Business transformation does not happen in isolation; there must be an agent for change, and that agent has to have full stakeholder support, and exhibit real commitment to better capital allocation.

Returning to our 2021 capital allocation decisions, in every case for these larger-capitalisation FTSE 100 companies there were big, company-defining changes to capital allocation going on – in full view of the markets – by new management teams that were specifically employed to make these strategic shifts. Given their unarguably strong market positions and cash flows, we felt that all these companies had a strong capability to reinvent.

Things started to change in the outlook for FTSE 100 stocks as 2021 progressed. What started as an existential threat to life as we knew it progressed to being seen as the supply shock it clearly was, but with a monetary response more fitting to the worst demand destruction ever witnessed. The pandemic and the global response have quite simply been inflationary. And so the supply shock, demand recovery, energy crisis and resulting inflation narrative shift are where the FTSE 100 rebellion story started for the masses. As large global asset allocators trawled around for things to buy that might protect them from inflation, their eyes, spurred on by strategists’ siren calls, alighted on the UK.

What did those eyes see? Yes, an index full of old-world energy, pharmaceuticals, materials, banks, insurance companies and telecom stocks that might just benefit from this new inflation narrative – and in a world where value just might not be a dirty word any more. But they saw so much more. They saw large, established and highly cash-generative companies with real asset bases and real market positions being aggressively managed for change, to fight the successive and often existential threats they might face.

They saw companies, often with new boards, committed to dealing with their issues, allocating capital accordingly, and making revolutionary strategic decisions that call into question the very basis on which we have thought about and valued these shares for many years. They have rebelled against their own extinction, becoming better, less challenged versions of themselves. Results are most definitely therefore improving.

And they now have an added sense of urgency. Nowadays nothing is too big in stock markets not to feel and succumb to the pressure for change and improvement. And when the alternative is to give in to private equity interest (for them to do the job for them) or have an activist shareholder call the agenda, many boards have rightly chosen to chart the new course themselves. For doing so they should be applauded and backed.

This is not just a dead cat bounce as value revives for a period. One of the most interesting and common themes from some of the management teams of this cohort has been the sustainability of the recovery in trading that they are seeing.

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