Finding value in UK equities

Outlook for UK equities

The UK equities market has experienced a difficult number of years, which has caused investors to lose confidence in the market.

Key events that have led to this include Brexit and political uncertainty, plus the fact that the makeup of the UK stock market is seen as being in old-fashioned sectors, not high-growth areas such as technology.

That left UK companies very much unloved on a global basis.

Another factor is that the UK market has underperformed the global market, and as the market has underperformed, investors have reallocated from the UK, causing it to continue to underperform.

But is there still value to be found in UK equities?

Opportunity for investors

Sophie Lund-Yates, lead equity analyst at Hargreaves Lansdown, says that while the UK equity market is in “an incredibly difficult position”, it does offer nuggets of opportunity within the “beaten-up” financial sector.  

She adds: “It also has some strong consumer-facing names that are well placed to weather the incoming economic storm, especially those on the logistics and distribution side of things like big box warehouses with high calibre customers, and fast-moving consumer goods and e-commerce-facing packaging giants all offer resilience in my opinion.”

Describing the UK equity market as being in a “sorry state”, Darius McDermott, managing director of Chelsea Financial Services, notes UK equities have severely underperformed the US and global equities over a medium and long time frame. 

“Even in the past couple of years, when the value style has done better due to higher interest rates and inflation, the S&P 500 has still beaten the UK by more than 5 per cent,” McDermott adds.

“The UK is dominated by old world stocks and is struggling to attract newer businesses that might inject some life into it."

He says the UK also shot itself in the foot; by encouraging pension funds to divest from UK equities it has severely weakened the UK stock market.

McDermott adds: "Unsurprisingly, companies, even British companies like [chip designer] Arm, are now looking to list elsewhere where there is a greater pool of natural equity buyers.

“More recently, the UK has shot itself in the foot again. One of the few bright spots in the UK over the past few years has been the investment trust market. Many new trusts have launched, offering investors everything from song royalties to wind farms. 

“Sadly new cost rules (which in our view are misleading and wrong) have forced many investors to reduce their investment trust holdings. With most investment trusts now trading on huge discounts, there is no prospect of any new trusts listing any time soon.”

Valuations

However this, McDermott notes, does not mean the UK is a bad investment today: “In fact, the reason some stocks are looking at de-listing is precisely because there is a feeling the UK market is undervaluing them, which means there may be good potential returns for investors.”

Scott Gallacher, director of Rowley Turton, says while the low price to earnings (P/E) ratio means investors are still pessimistic about the prospects for UK companies and their share prices, investors can be wrong, adding there is scope for UK businesses to surprise the market.

“Today’s low P/E ratios mean that if good profits and growth do materialise from UK companies, then the UK stock market could deliver a significant positive return simply from a re-rating,” Gallacher adds.

“A lower P/E ratio for the FTSE All Share index (11.6) compared to the S&P 500 (20.34) suggests that, at least based on this metric, UK equities may be relatively undervalued compared to US equities.

“However, it's essential to consider other factors as well, such as earnings growth prospects, industry trends, and macroeconomic conditions."

Additionally, Leigh Himsworth, portfolio manager of the Fidelity UK Opportunities Fund, says that as CPI has fallen back to just short of 7 per cent (6.7 per cent as of September 20), “all of a sudden” equities are beginning to rediscover their appeal.

Further, Himsworth says he believes UK markets remain healthy at the very least on a relative basis versus peers.

He points to recent data from Peel Hunt, which shows the FTSE All-Share stands on a forward price per earnings multiple of 12.1x forecast growth of 6.8 per cent and a median yield of 4.2 per cent – growth and yield adding up to 11 per cent.

Himsworth says the latter point is important, as this time last year the market offered little in the way of growth and so yield alone at just over 4 per cent stood well below CPI at 11.1 per cent.

He adds: “This ‘taming’ of inflation is helping, but bond yields need to keep falling as treasuries still offer attractive returns with gross redemption yields still beating 5 per cent, at least.

“It is also useful to break down the earnings growth number. I use the median, as this strips out the skews of the largest companies.  

"Following on from post-Ukraine spikes, the large energy and mining companies are seeing forecast earnings fall over the next year, which, as these generate their earnings largely from overseas, implies that more UK-focused companies are the ones likely to generate the returns.”

UK smaller companies

Despite some of the challenges with the UK equities market, the UK smaller companies market is expected to generate better returns for investors.

McDermott says while UK small caps have been “left for dead”, there is a lot of potential value there which will be realised when sentiment turns more positive. 

He adds: “UK smaller companies have done much better than large caps over the past 20 years and you do get a lot of very interesting UK smaller companies with good growth potential. We think this area will recover at some point. 

“There is value across the UK market in all sectors relative to global peers. Even if you want to avoid areas like oil, banks or mining, there is still a discount in a business like Diageo relative to its global peers and the same is true of virtually all sectors. 

“We also see tremendous value in the investment trust space at the moment where there are huge discounts and large dividend yields – although for full disclosure we own many investment trusts for the VT Chelsea Managed funds we advise on.”

Himsworth says: “Mid and smaller cap companies look highly appealing, especially if, as bond yields drop further, the market looks for its returns increasingly from growth again.”

While inflation is likely to remain ‘elevated’, Himsworth says UK equities seem to be following the lead of the US markets and nudging themselves back to looking for earnings growth: “This should push us back towards mid and small caps and the nimbler businesses.”

Additionally, as China appears to have struggled to gain momentum after emerging from Covid-19 lockdowns, this has left investors to both seek returns elsewhere and avoid those related to problems from the Far East.  

Economies such as France via luxury goods and Germany via its cars and high-end machine tools have struggled; Germany in particular, as the car manufacturers have slowed significantly.

Himsworth says: “The UK being a little more tilted to the US has benefitted from the US being one of the first countries to emerge from Covid-19 and so its economy has gathered some momentum, but more importantly has been given industrial impetus from the Inflation Reduction Act (IRA) and Chips Act that have both given a huge boost to related businesses, many of which UK industrials are enjoying the benefit from.

“Within UK financials, there is a split between the larger stocks such as banks that perform well as bond yields rise versus those smaller businesses who thrive on asset markets and net asset values. This means that real estate offers substantial value (where not structurally impaired) as do some of the small wealth/asset managers.”

Building a portfolio

When it comes to how UK equities fit into a portfolio, Gallacher says it can serve as a valuable component of a diversified investment portfolio, helping to spread risk.

Gallacher adds: “The UK equities sector is diverse, with companies representing various industries and market capitalisations. Investors often use UK equities for income, capital growth, or a combination of both. 

“That said, it has historically been viewed as a ‘value’ market rather than a ‘growth’ market and lacks the high-tech high growth companies of the US market.”

McDermott says while the level of diversity is much reduced at the large cap end of the spectrum – the UK is dominated by old world stocks like oil companies, miners, and banks – he sees value in UK small caps.

He adds: “The UK famously has little in the way of technology. You definitely wouldn't want to have all your investments in the UK. That said, given current valuations, we like the UK and we particularly like UK small caps for the long term.”

Looking ahead, the continued delisting of companies away from the UK could affect investor sentiment and market perception.

McDermott says there is a network effect with stock markets.

“Losing companies will mean losing trading volumes, losing relevance and make it even harder to attract new listings. It will make it easier for global fund managers to ignore the UK.”

The economy

Inflation seemingly reducing, the recent monthly fall in GDP and interest rates rising will have varying effects on different parts of the UK equities sector.

Higher inflation is likely to cause it to outperform the rest of the world. This is mainly because of its large overweight in energy and mining companies that benefit from the higher commodity prices that usually come with high inflation. 

McDermott says: “The UK is a bit of a strange market…High inflation also means higher nominal growth, meaning growth is less scarce. This benefits a value market like the UK versus a growth market. 

“Higher rates can also help banks and insurers to make higher profits, although this is more mixed as higher rates can sometimes hurt banks as well. Overall, I would expect lower inflation to be bad for the UK on a relative basis, however only large caps not small caps.

“The UK market as a whole is dominated by its large multi-nationals, so UK GDP is relatively unimportant to it. Lower inflation and lower rates are likely to have a much more positive impact on small and mid caps and might cause them to outperform their large-cap peers.”

According to Gallacher, a slowing GDP growth rate may also affect corporate earnings. 

However, the relationship between these factors is complex, and it is essential to consider them in the context of the broader economic landscape.

Reinvigorating UK equities

While an established and trusted market, the recent increases to corporation tax will have reduced the UK’s attractiveness for listing. 

This, along with seemingly a lack of a long-term focus or industrial/economic strategy by successive governments, hindered by years of internal conflict over Brexit and how it should look, Gallacher says he cannot see a reinvigoration of the UK equities market on the horizon. 

He adds: “The political parties of all colours should unite to agree on a shared long-term economic strategy that we can all work towards. However, I cannot see this happening due to our first-past-the-post system.”

According to McDermott, there are steps the government can take to help reinvigorate the UK equities market, such as:

• Encouraging UK pensions to invest a little more in equities.
• Making it easier for companies to list.
• Abolishing the misleading cost disclosure rules for investment trusts.
• Abolishing stamp duty on shares.
• Supporting more venture capital in the UK to allow new companies to come through.

The Capital Markets Industry Taskforce has commissioned a report to be published this autumn on how to rejuvenate the UK’ capital market.

The work is being carried out by a group led by Nigel Wilson, former group chief executive of Legal and General.

ima.jacksonobot@ft.com