UK companies: Why now?
Could 2021 be a breakout year for UK equities? A combination of improving fundamentals, attractive valuations, and returning dividends are strong catalysts for performance in 2021, with share prices benefiting from improving sentiment as vaccines are rolled out and life begins to return to normal. With 50% of FTSE 250 earnings coming from overseas, the UK market will also benefit from any wider pick-up globally.
In this piece, we aim to set out some of the core arguments for investing in the UK today, and why UK-based investors in particular should be considering their home market. While international sentiment has been poor in the aftermath of the Brexit referendum, this is unlikely to hold back the UK in 2021, as global investors have largely rotated out of the market. In fact, there is potential for UK stocks to re-rate upwards if we see a reappraisal from international investors.
For the meantime, however, the clear catalyst for UK equities is the end in sight to the COVID-19 pandemic, with a vaccine rollout now underway.
A shot in the arm for shares
With the mass roll-out of a vaccine, the UK economy should see its fastest growth since the late 1980s. Our economics team forecast a rebound of 4.6% in 2021 and 6.5% in 2022, compared to consensus forecasts of 5.4% and 4.0% for 2021 and 2022 respectively. While our figures are predicated on relatively cautious assumptions, the UK could see faster growth in 2021 if the vaccination programme ramps up quickly.
While the shape of UK growth will partly be determined by the speed of the vaccine rollout, UK growth is likely to pick up markedly in the coming year. As well as the usual post-recession rebound, there is substantial pent-up demand from consumers, with household savings surging to a record level during the first nationwide lockdown.
While the deal between the UK and EU does create barriers to trade, it should at last provide certainty for businesses. The initial reaction of the FTSE All-Share to the deal shows how the market can now begin to put Brexit uncertainty behind it.
Standout developed market on valuation grounds
UK shares look attractive on a wide range of valuation metrics, even after the market’s sectoral make-up is taken into account. On a price/earnings basis, for example, UK shares are the cheapest relative to their American counterparts than at any time since the creation of the FTSE 100.
The UK market retains this valuation advantage on more sophisticated measures too. Robert Shiller, the American economist famous for his cyclically adjusted price/earnings (CAPE) measure, has further enhanced his traditional metric to take account of low interest rates, creating the excessive cape yield (ECY).
Shiller’s ECY measures a company’s earnings as a percentage of its average share price, minus the prevailing interest rate. The ECY for the UK is at an all-time high at 10%, and significantly higher than other markets such as the US, Europe and Japan. As Shiller notes, “the only other time ECYs were this high using our global data was in the early 1980s,1 with equities subsequently seeing strong returns.”
For investors still concerned about economic uncertainty, the relative opportunity in the UK becomes even more attractive. In contrast to US equities, which are trading ahead of their closing 2019 level, the FTSE All-Share has yet to recover its previous high.
Dividends poised to strengthen valuation arguments
UK dividends are expected to recover strongly in 2021, likely growing by around 10%. With the FTSE 100 currently yielding around 3%, this is an attractive opportunity for income seekers, particularly in the context of historically low interest rates in bond markets elsewhere.
While the headline numbers provide a compelling case for UK dividends, there is also a lot going on underneath the surface. The Prudential Regulation Authority recently announced that banks would be able to resume dividend pay-outs, for example.
A growing number of companies are now reinstating deferred dividends, with trading having proven more robust. We also see some potential for ‘catch-up dividends’, as companies return previously deferred payments to shareholders or return cash with trading having been better than expected.
Constrained consumer demand
As we have seen from several management teams, there is growing evidence that consumers are getting ready to spend again. While COVID-19 will have negatively impacted the finances of many people, the overall picture is encouraging. The UK household savings ratio reached a record peak of 29.1% in the second quarter of 2020, with UK consumers paying off around £13bn in credit card and other unsecured debt in the ten months to the end of October, effectively cancelling out the increase from 2019.
We are now seeing consistently strong demand across the companies we invest in, with many posting trading updates ahead of expectations. Consumption rose by 18.3% in the third quarter, and we expect this trend to continue throughout 2021.
Value, cyclicals, but don’t forget growth
Any economic recovery will likely help the more value- and cyclically exposed parts of the stock market initially, with the UK tending to have a higher preponderance of these companies.
However, investors should not overlook their growth exposure in a world where many of the secular growth drivers prevalent in the UK and wider global economy are likely to accelerate and where interest rates are likely to remain supressed. Even amidst an economic rebound, UK unemployment is still expected to peak at around 7.5% next year, with the recovery in investment tracking lower than in previous recoveries.
Well-run growth companies often have the opportunity to invest at much higher rates of return than their own cost of capital and the returns offered by structurally challenged, value names, for example. In many cases, we believe the pandemic will have either strengthened the growth opportunity those companies face and their ability to take advantage of weaker competitors. DFS, for example, expects its market share to increase by around six percentage points as other furniture stores shut down.
The current focus on pandemic recovery stories may even present buying opportunities amongst UK growth stocks. Aveva, for example, has experienced close to a 15% pullback in its share price over 2020, providing an attractive long-term entry point.
2021 – an optimistic year for UK equities?
This is also an unusually positive time to be making the case for UK equities. The economy is ready to pick up strongly in 2021, and our forecasts are reinforced by positive trading updates we have seen from companies across our portfolios. The UK market remains attractive on valuations grounds, particularly when set in an international context.
As UK equity managers, we continue to believe that investors are well-served by UK-listed companies that are compounding their earnings and dividends, and which offer world-leading corporate governance, dependant contract and title law, and reliable access to company management teams.
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