The darkest hour may have passed - Shift in sentiment could see UK shares back in fashion

Key points: 

• UK markets offer exposure to leading global companies at highly attractive valuations – $1 of earnings is 20% - 30% cheaper when purchased on the UK stock market versus the US stock market (source: Berenberg as at 27 April 2023).
• Global investors are significantly underweight UK equity relative to history – a change in sentiment for the UK could see markets rise as fund managers realign portfolios.
• The risk/reward on offer is being exploited by private equity in particular – nine corporate take-overs of UK listed businesses in April 2023.

UK equity fund manager Chris St John outlines why investors should look again at UK equity as the end of the rate hiking cycle comes into view.

While the FTSE100 was one of the few equity markets to offer a positive return over 2022, this doesn’t reflect the whole story for UK equities. The FTSE100 is dominated by ‘old economy’ sectors such as oil and gas, resources and banks, which are typically cyclical, capital intensive and environmentally damaging. These benefitted directly from either rising interest rates or rising commodity prices – or both – giving the index a positive total return over the year at the aggregated level.

Further down the market cap scale, it’s a different story. If you retreat down the UK equity All-Share Index, below stock number 20 by value, you find more dynamic, less capital-intensive, faster growing and in many cases, global businesses. These companies have seen valuations retreat to even more lowly valuations relative to other global markets, thanks to the general market malaise and a prolonged period of declining demand for UK equities in global portfolios.

While market volatility remains high, there are signs that the tides of inflation and central bank rates cycle are shifting. With a potential change of market dynamics in sight, investors might want to think again about the potential for UK listed companies that offer compounding earnings growth and cashflows – private equity buyers are not waiting.  

Valuations are low – for now

Much has already been said about the attractive valuations in the UK, but it is a point worth reiterating. The UK equity market is currently trading at a 28% discount on a forward 12-month price-to-earnings basis when compared to global equities (excluding UK) and a much larger discount from a price-to-book perspective (source: Berenberg as at 27 April 2023). After adjusting for industry weightings, UK equities remain on a substantial discount to US equities – it is therefore cheaper to buy a stream of US cash flows on the UK stock market versus the US.

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While this provides a compelling argument for the UK on a total-return basis, investors are likely to be looking for the catalysts that will see UK equities return to favour and improve prices.

The question is, when might this happen? The answer lies, at least partly, in an understanding of why UK equity prices are currently so low. 

Some of the explanation resides in the effects of capital flow. UK equity allocations within UK pension funds have fallen from 29.3% in 2006 to 1.9% in 2022 (source: RBC as at 31 December 2022). Since the Brexit referendum, UK equity outflows have averaged £1.6bn per annum, providing a significant additional capital-flow headwind.

The negative direction of these flows has been influenced by a number of factors. For example, US-based tech companies – the so-called FAANGs most prominently – have attracted enormous inflows, drawing capital from other markets such as the UK.

A change in market sentiment could benefit UK shares

The UK equity discount has not always existed. It is worth noting, that on 1 June 2016, shortly before the Brexit referendum, UK equities traded at a 2% premium to global equities (ex UK) versus the 28% discount that they currently trade on.

This valuation anomaly has not gone un-noticed by private equity buyers, who have bid for nine UK listed companies over April 2023 alone.

This hints at a something that could contribute to a revival for UK equities. A more emollient approach to Europe and a change in the mood music could spell an adjustment in the perceived potential for the UK economy. Perhaps the Windsor Agreement is the first step to a meaningful shift?

A change in the inflationary environment could also see a change in pace, and leading indicators suggest inflation will fall from current elevated levels over time, although a return to the 2% targeted by western central banks continues to feel some way off. Many of the distortions to global trade are normalising, reducing inflationary forces to some degree:

Over the past year the price of copper has fallen 14%, wheat 33%, cotton 41%, and natural gas 61% (source: Bloomberg, 27 April 2023), while shipping costs – as reported by the Global Freight Rate Index – are close to pre-COVID levels, as at 1 May 2023.

The predictability of supply chains has improved with port congestion falling materially, reducing the need for companies to over-order and distort the real level of demand.

While labour inflation remains stubborn, particularly in the UK, company management teams we talk to are highlighting reduced staff churn and expect wage inflation to reduce over the next year.

In the meantime, the UK is home to many global companies that are well-placed to benefit from secular thematic and economic tailwinds, and current valuations could make them very attractive as and when the global economy improves.

Government initiatives may also change the picture. Interventions such as the Inflation Reduction Act in the US are encouraging companies to see the US as their natural home. Our conversations suggest that businesses are well aware of the issue, as are UK politicians across the political spectrum, and we would hope and expect to see measures adopted that will encourage incremental investment in the UK economy. A period of dollar weakness could also make a big difference.

Where are the opportunities, what are the risks?

Rising interest rates, as central banks have responded to inflation, mean that the days of a risk-free borrowing rate anchored at zero are likely to be over. As a result, the ‘creative destruction’ heralded by Joseph Schumpeter can function once again as the economic bar rises and businesses that are heavily indebted, have no pricing power and cannot grow organically will languish or disappear.

This fits with our theme ‘the Strong Getting Stronger’. Companies, such as Dunelm, by virtue of their market position, funding structure and management ability, will continue to take additional market share.

With this in mind, we look for companies with pricing power, a return on capital ahead of cost of capital, strong balance sheets and where the opportunity exists to increase the number of goods or services sold over time. Existing examples in our portfolios include Rentokil, LSEG, Rotork and Weir.

Over the last six months we have taken positions in SSP and GB Group. GB Group provides identity intelligence solutions to both businesses and consumers that transact online to ensure both parties are who they purport to be and is benefitting from the growth in online payments. SSP is a market-leader in the global food and beverage travel concessions market. With a focus on travel, in particular airports, SSP should deliver high returns on capital employed as well as multi-national profit growth as it adds additional space, recently added space matures and legacy space benefits from ongoing recovery of the travel sector as the effects of COVID recede. Both share prices have de-rated materially.

Patience is the investor’s greatest virtue

Market volatility will remain in the near term as central bankers move into a new data-dependant framework and investors will no doubt pay close attention to data releases and the output of central bank meetings. If inflationary pressures unwind and interest rates fall, perhaps combined with a change in the mood music around the UK economy, there is a potential for a boost for UK equities as global investors show renewed interest.

In the meantime, it is important to look for companies that can not only weather the hard times, but which have the capacity to thrive where others fail. When a change in sentiment comes, these are the companies that could provide the largest benefit to patient investors.