History suggests that buying good stocks when they are on a low valuation enhances your long-term returns. Many UK equity fund managers have been scratching their heads this year, wondering why investors were not pressing ‘buy’ on what look like screaming bargains in front of them – especially in the world of UK investment trusts. But is that now changing?

My own forehead is feeling pretty sore from scratching, too. The past couple of years have felt brutal. Take one of the portfolios I co-manage – Lowland Investment Company (LWI ) whose annual results are out today. This is a multi-cap UK equity income fund. As of the end of September the price/earnings multiple of the underlying portfolio had fallen to around 8.5 times.

If you take the 10-year average, the number was 12.5 times earnings. In short, Lowland’s underlying stocks were trading at a roughly 30% discount to their historical average. The sort of stocks it holds have not changed significantly, so why had this happened?

I believe disinvestment by UK insurance companies, wealth managers and pension funds over recent decades has created an underlying fragility in the UK equity market. Three decades ago pension funds and insurers owned half of British shares. Today it is about 4%. Without this core of institutional holders, UK equities have been exposed to the sentiment swings of international investors.

The global perception would appear to be that post-Brexit Britain is a mess. It is not – far from it – but you get the point. Investors are not in a hurry to increase their exposure to the UK – and especially not to more domestically focused smaller companies. Fragile sentiment has been further weakened by fast-rising interest rates that have hit many cyclical stocks in particular.

Returning to valuations – that 8.5 earnings multiple reflects significant earnings pain. There are effectively recessionary conditions across much of building materials, housebuilders, some retailers and the advertising industry. The most cyclical areas have already seen considerable downgrades.

We do not own UK bricks manufacturer Forterra (FORT), but we see this from its recent third quarter trading update: ‘These figures also highlight that UK brick industry despatches are currently running below the levels seen in 2009.’

It begs the question: if we are already talking about volumes below those of the global financial crisis, how much worse do we think things can realistically get from here?

With tough economic conditions arguably reflected in many of the numbers, investors could be looking at a situation where – in some stocks at least – they can buy trough earnings at trough valuations.

Trust discounts

Compounding the above, we have also seen share price discounts widen on trusts. According to the Association of Investment Companies, the average discount on 21 November had narrowed to 13% from 17% a couple of weeks earlier. But many trusts are still trading at deep discounts. To me, this feels like being offered an extra discount on top of an existing sale price. And maybe, just maybe, that sale is now beginning to close.

Looking ahead, where could a sustainable total return come from? The obvious suggestion is that economic conditions might improve. Earnings that have already fallen in more cyclical areas could then recover.

When that happens, sentiment is likely to change. Moves from private equity buyers suggest this is beginning to happen already. So a company trading on nine times earnings could recover to the low teens, for example.

Improved sentiment could also help lift trust discounts, with mean reversion seeing that 13% discount close back to 5%.

The benefits of this triple boost could be powerful. Take a completely illustrative example…

A company – let’s call it Optimistica – starts with a £9 share price, with £1 earnings per share. These earnings have fallen from £1.30 per share – in other words, by roughly a quarter. The price/earnings (P/E) ratio is nine times.

Earnings recover back to where they were previously – £1.30. That would put Optimistica on a P/E of 6.9, but instead improving sentiment means it re-rates to 11 times earnings. The effect of this on the share price is to lift it from £9 to £14.30 – a hike of nearly 60%. If that happened across a portfolio, trust investors might then enjoy an extra 10% as the discount narrows.

Clearly there are big caveats here. Some will fear I have not just been scratching my head but banging it against a wall and am now suffering concussion. They might be right!

We do not know when earnings will recover, and if and when they do, earnings recovery is likely to take several years. We also cannot guarantee valuations will recover in the UK, although we can show they are low versus history. We can show there is large upside potential.

And the downside? In the more cyclical areas of the market, where companies like Forterra are saying business is as bad as it was during the global financial crisis – and this in a country with a chronic housing shortage – it would be logical to think the asymmetric risk now looks increasingly lopsided.

You may have to wait. Who knows how long? But in a trust like Lowland you are being rewarded with a 5.3% dividend for your patience. For the sake of impartiality, I should say there are other UK equity income trusts out there – 23 in all. On average they offer a dividend of 4.3% currently. This is close to what you can get from cash but with the hope of an additional pick-up in the share price – potentially even a big pick-up if my analysis is right.

Laura Foll is co-manager of the Henderson Opportunities Trust (HOT ), Law Debenture (LWDB ) and the Lowland Investment Company (LWI).

Any opinions expressed by Citywire, its staff or columnists do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account people’s personal circumstances.