UK stocks are cheap: is this an opportunity or a threat?

Global stocks have rallied hard since the crunch following the Covid-19 outbreak in Europe. However, UK investors noticed that their portfolios were following at a slower pace, even after the UK became the quickest vaccinated country amongst the G7. Since February 2020 the MSCI World, the global equity benchmark, has risen 27% in Sterling while the FTSE 100 trailed gaining just 2.3%. As a result, global stocks now trade at roughly 26% above their long-term average while UK stocks trade 1% below theirs.

Portfolio managers across the UK began to wonder:  Is that 27% discount an opportunity or a threat?

For our portfolios, we decided to treat it more as an opportunity and less as a threat.

The first question we asked ourselves is: Is Brexit the obvious culprit? The answer is surprisingly straight: ‘No’. The Pound has been trading at the highest post-Brexit level for the better part of the year, which means that markets are moving beyond the subject, especially in the wake of significant fiscal stimulus announced by the UK government for the next year.

We believe that the reason is probably a confluence of two factors: better earnings revisions for the UK and an aversion for income stocks.

1. Better earnings

The forward Price/ Expected Earnings ratio (forward P/E), the most popular valuation metric, is based on assumptions about future earnings in the denominator. These assumptions change, sometimes dramatically, at the turn of the year. For the MSCI world analysts suggested a 20% earnings upgrade for 2021. For the UK the upgrade was double, at 40%. Prices, however, didn’t rise as much in the UK as they did for the MSCI world, which is more influenced by US high growth tech stocks.

This means that the numerator (price) moved higher for global stocks, and the denominator (expected earnings), moved higher for UK stocks. This dynamic explains most of the resultant differential in valuations.

The difference was mainly due to more optimistic earnings assumptions for the financial sector, which still weighs heavily on the FTSE 100, and industrials.

The simple truth is that the market is not yet pricing in what analysts predict for those UK sectors. If and when it does, relative performance for the UK should improve.

2. Income

The other reason for the lower valuations is simply a global aversion for income stocks. For many global asset allocators, UK stocks are a proxy for equity income in a diversified portfolio. They feature a dividend of 3.85%, more than double the dividend yield of 1.91% for global stocks.

Taking the high-dividend portion of the largest equity indices outside the UK, we see that valuations are much lower, and much closer to British valuations.

This means that when income returns to vogue, UK large cap indices could also perform better on a relative basis than their global counterparts.

Conclusions

By our way of thinking, earnings optimisms and income aversion in a low yield world are not significant threats to our UK portfolio holdings.

We believe that income stocks will not necessarily remain in the doldrums forever. During the Covid-19 crisis, many companies which received government money and /or saw a significant drop in earnings cut dividends. So far, earnings in 2021 have been convincingly bouncing back and often beat expectations. Therefore, some dividends should be reinstated this year and things would probably further improve in 2022.

The main risk to this thesis is not so much significant earnings misses, as we don’t expect markets to overreact to these since the optimism has not fed into the prices in the first place. It is rather waiting for a long time for income stocks popularity to return. However, we feel that our portfolios have taken a sufficiently long view to wait.

This justifies a 5% overweight in UK equities, the largest regional overweight currently in our asset allocation which we maintained in our latest investment committee in late June.