Lex-in-depth: why is the UK stock market so cheap?
For traders, Britain isn’t just the sick man of Europe however of the world. Since voting to depart the EU in 2016, UK inventory market returns have lagged behind worldwide friends and a traditionally extensive valuation low cost has turn into ingrained. A lot in order that the UK has turn into a searching floor for overseas consumers looking for low cost offers such because the US consumers of grocery store chain Morrisons and of defence producer Meggitt.
This diminished place isn’t helped by comparisons to booming tech fuelled US markets. Web giants equivalent to Google, Microsoft and Apple have all achieved trillion greenback valuations at document excessive multiples. But Britain barely musters a mid-cap tech group. Software program group Aveva valued at £7.5bn is at present the most important tech group within the FTSE 100.
And whereas the US market is full of such racy development shares — firms which might be typically unprofitable however richly valued attributable to speedy income development — the UK market is populated with worthwhile money producing companies or worth shares which have reached maturity.
Paul Marshall, chair of hedge fund Marshall Wace, believes the state of affairs is now so dire that the UK dangers changing into a “Jurassic Park” market — solely match for dinosaurs.
An imminent check of that may come when SoftBank-owned chipmaker Arm decides on whether or not to listing in London or elsewhere after a $66bn deal to promote it to Nvidia was blocked by UK regulators. Broad estimates for the tech sector suggest a 30 per cent valuation elevate for Arm in New York.
If Arm had been to shock the markets and decide the UK it could supply some vindication of efforts to draw quicker rising firms to London. Separate critiques final 12 months by Jonathan Hill, the previous European Commissioner for monetary companies, and Ron Kalifa, the previous Worldpay chief govt, have led to extra relaxed guidelines on twin class share constructions and public share counts.
The tweaks, nevertheless, are unlikely to get to the guts of the issue: the UK inventory market is affordable on nearly each measure. Until that adjustments, the implications for funding and innovation within the nation might additional diminish Britain’s worldwide competitiveness.
For an economic system strongly tied to the monetary companies business, which accounts for about 10 per cent of gross home product, it’s embarrassing that the worth of UK equities has fallen thus far behind that of worldwide friends. And it isn’t simply investor returns which have lagged behind. The market as a complete and particular person sectors proceed to commerce at valuation reductions.
Whether or not utilizing the most important 100 firms within the FTSE or broader measures, the UK market has a considerable low cost with the remainder of the developed world. On the finish of 2021, the valuation hole between the UK and different developed markets — nearly 40 per cent on a ahead earnings foundation — was at its biggest in three many years, though it has since narrowed.
The explanations are various however the choice to depart the EU in 2016 spooked traders who frightened that commerce with the UK’s greatest accomplice would collapse. The interval after the vote is when valuations started to sharply diverge. The FTSE 100, valued at 16 occasions ahead earnings in Might 2016, was according to different developed world markets. A 12 months later a 14 per cent low cost had emerged. It widened to 25 per cent by the tip of 2019.
The vote’s affect is plain. However there’s extra to the story than simply heightened political and financial dangers. The construction of the UK market has been out of favour with traders for much longer.
“The notion is that the UK is a spot of outdated economic system companies,” says Andrew Millington, head of UK equities at asset supervisor Abrdn. Heavy on banks, insurers, oil and miners, this view is “bolstered by the FTSE 100 and is one thing that predates Brexit,” he provides.
A benchmark weighted in favour of worth or dividend paying companies has constrained returns. These shares are usually regular state enterprises that generate dependable money returns for shareholders however supply little development. Even so, traders have restricted curiosity. Shares in Barclays financial institution and vitality group BP, as an example, stay caught at 2016 ranges.
As an alternative, traders need companies they assume will produce excessive income development and the potential to dominate the markets of tomorrow. Most of those are expertise companies the place income may be non-existent. In actual fact many, equivalent to electrical carmaker Tesla, have required fixed funding by shareholders to progress. Bets on the distant future are sometimes simpler to justify when rates of interest are low and cash is affordable.
A part of the UK’s underperformance is the underlying skeleton of the market. Know-how teams dominate world development as companies compete to be the subsequent Google, Apple or Alibaba.
The UK is barely in that race. The expertise sector accounts for lower than 5 per cent of the UK’s whole market capitalisation. In Germany, it’s 11 per cent. Within the US, it’s nearly one-third. Traders fascination with development has been fuelled by a document interval of low rates of interest. However as these begin to rise the worth of future money flows fall as they’re discounted to current worth.
The UK started to path different world markets, on a complete return foundation, at the least two years earlier than the Brexit vote attributable to this worth bias when it comes to the composition of shares. And even if you happen to alter for that bias, the valuation low cost shrinks however remains to be about 10 per cent, calculates Simon French, economist at Panmure Gordon.
UK listed firms need to subsequently work tougher and enhance earnings quicker to attain the identical inventory scores as friends elsewhere. “Failure to embrace a growth-oriented mindset is unnecessarily elevating the price of fairness capital [in the UK],” says French.
Utilizing price-to-earnings to development (PEG) ratios, a metric that mixes a inventory’s valuation and its anticipated development, French discovered the UK at 1.3 occasions was considerably under the EU at 1.7 occasions and the US at 1.9 occasions. “Eight out of 11 industrial teams [surveyed] throughout each Europe and the US have increased PEG ratios than their UK equivalents,” says French.
Software program group Blue Prism typifies a few of these failings. The maker of robotic course of automation instruments will depart the UK’s junior AIM market in a £1.24bn take care of SS&C of the US. That takeover worth is properly under the place its shares had been buying and selling as not too long ago as the start of 2021.
Blue Prism isn’t the one UK listed enterprise that went to overseas homeowners at a perceived knockdown worth. Takeover makes an attempt had been at a 14-year excessive final 12 months and bids from personal fairness had been at a document. Markets are telling traders that UK property are a cut price however many consumers are merely not listening. In the event that they had been, valuations could be increased.
In search of somebody responsible
The findings from the Panmure Gordon evaluation lend weight to Marshall’s criticism that UK cash managers have turn into a part of the issue. Revenue funds put money into the lower-risk, regular return, cash-generative companies that make up a lot of the FTSE 100.
Such earnings funds solely make up 5 per cent of the £1tn UK managed fairness property, in keeping with the Funding Affiliation. However, says Marshall, this earnings focus is extra widespread than simply these formally designated funds. He argues that the entire UK fund administration business has deep seated earnings bias that has turn into ingrained in funding mandates from pensions to insurance coverage and different funds.
That creates a cycle of detrimental suggestions that’s reducing off the lifeline of recent development and maintaining the UK market down. This thesis is simply partially true. Whereas the UK market is underweight in expertise it has nonetheless created some robust performing companies over the previous decade.
“It has been attainable to construct good outperforming portfolios of development shares within the UK utilizing an energetic technique,” provides Millington. “The FTSE 250 index has some very thrilling mid-cap development companies.” Share costs for retailer JD Sports activities and gear rent group Ashtead have each risen greater than 15 occasions over that interval. Data group Relx has risen fourfold and is now valued at £43bn.
The shift from outlined profit, or remaining wage, to outlined contribution pensions has been one other key consider decrease valuations. “Systematic promoting by DB funds has pushed valuations for UK shares decrease,” says Professor David Blake, director of the Pensions Institute at Bayes Enterprise Faculty.
DB pension schemes within the UK have been huge web sellers of equities globally up to now twenty years. That is largely attributable to demographics as members age and financial savings are transformed into extra secure money bearing property equivalent to bonds.
And though 80 per cent of the UK’s pension property stay tied up in DB schemes, the majority of those investments are actually in bonds and different cash-generating options equivalent to property and infrastructure. The extent of UK equities held inside DB schemes has fallen from about half of whole property within the early 2000s to lower than 5 per cent at present.
“As schemes have closed to new members, allocations have shifted away from development investments like equities in the direction of earnings investments, like bonds,” says Matthew Graham, head of UK and multinational DB pensions at Aviva Traders, the asset administration firm.
Only a quarter of whole UK pension property — each DB and DC — are actually in equities in comparison with about half within the US, in keeping with advisory group Towers Watson. Not solely are there fewer youthful savers to step in for these whose pensions are shifting into maturity. However allocations to UK equities for these new savers is much under historic ranges. Any residence bias that after favoured fairness markets in saver’s personal nations has largely been eradicated because of cheaper prices equivalent to foreign money hedging.
Altering demographics imply that not solely is the whole quantity of recent savers’ pensions decrease however the share allotted in the direction of the UK market can also be smaller. Newer UK pension schemes are selecting as a substitute to speculate throughout equities globally. “In contrast to DB schemes, our members carry everything of the chance. That offers us a higher incentive to maximise returns,” says Liz Fernando, deputy chief funding officer on the Nationwide Employment Financial savings Belief, which manages £23bn of office pensions.
Regardless of nearly 60 per cent of NEST’s allocations being held in equities, roughly solely 4.5 per cent is within the UK inventory market. A alternative that’s tough to argue with given the UK market’s underperformance in recent times.
Whereas many developed nations face the identical demographic and pension pressures, the UK seems to be struggling worse. “Weak productiveness development shouldn’t be neglected as an element that’s holding the UK again,” says Blake.
Fixing the issues
Consciousness of the issues is rising. The UK’s lack of publicity to expertise shares was distinguished within the Hill and Khalifa critiques. Modifications to guidelines round twin class shares would possibly encourage extra listings. But, they’re unlikely to be an element for giant companies looking for the perfect valuation equivalent to SoftBank’s Arm, for which the US presents a transparent benefit.
That doesn’t imply the state of affairs is hopeless. In actual fact, the UK market has achieved higher than most others thus far in 2022. The FTSE All-Share index remains to be down however losses are much less extreme, particularly in contrast with the steepest within the tech heavy US market.
The identical elements which have depressed UK shares for a decade are actually working in its favour as a world rotation into worth accelerates alongside the prospect of upper rates of interest. These needs to be significantly useful to the banks and different monetary companies which might be over-represented in UK indices.
Rising rates of interest will increase banking revenues as curiosity margins increase. Greater charges additionally usually imply future money flows are extra closely discounted by traders decreasing the value of development shares, that are valued on long term horizons.
It’s too quickly to have a good time. There have been a number of durations of latest outperformance for worth shares: on the finish of 2016 and 2018, and most not too long ago firstly of 2021. All of which fizzled as development reasserted its dominance. Is it completely different this time?
What has modified is inflation. That is now at a 40-year excessive within the US and the quickest for 3 many years within the UK. Predictions for the variety of Federal Reserve charge rises in 2022, which set the tone for world markets, have risen from one or two on the finish of final 12 months to 2 or three in January, to 5 or seven now. However any charge rises could possibly be slowed by the affect on the worldwide economic system of the conflict in Ukraine.
“Inflation will likely be materially increased within the subsequent 12 months and central banks will likely be pressured to behave. In some unspecified time in the future the change from development [stocks] into worth [ones] will likely be actual,” says Millington.
The flexibility of the UK market to reap the benefits of that relies upon not solely on a beneficial composition of worth shares. However can also be proof that these shares are in a position to do what earnings traders are on the lookout for, pay out money dividends.
UK public firms paid out £100bn to shareholders in 2019. Progress in dividends had outstripped earnings pushing protection ratios, which measure how properly earnings help dividends, to document low ranges. The pandemic pressured many to reset. Shell, for instance, reduce its dividend on the finish of 2020 for the primary time for the reason that second world conflict. That helped increase dividend protection, which this 12 months will likely be nearer to 2 occasions earnings for the FTSE 100 than it has been since 2014, says AJ Bell.
The previous decade has examined the resilience of the UK economic system and its traders. A scarcity of huge globally aggressive tech companies is a symptom of deeper issues that can’t be solved just by fast fixes to itemizing guidelines. Issues which have been additional uncovered by the extraordinary efficiency of tech companies within the US, China and elsewhere. However as that tech cycle subsides, so ought to criticism relating to the UK deficiencies.