We bring together members of our UK equities team to discuss the key opportunities and risks in the market.
Read this article to understand:
- The current state of the UK equity market and where the opportunities are
- The role activist investors are playing in UK companies
- How ESG is changing the overall market dynamic
The UK equity market has been unloved by global allocators, and many domestic investors for that matter, for much of the past decade. The UK ‘discount’ to global stocks that tentatively appeared in late 2012 has grown into a chasm, accelerated by Brexit concerns in the lead up to and post the EU referendum in 2016.
By the end of January 2022, the discount (measured by the forward price/earnings ratio) was just over 33 per cent.1 This is despite the large proportion of revenues generated internationally by UK-listed companies (around 80 per cent in the case of FTSE 100 names2), clarity on the UK’s relationship with the EU, and a faster lifting of COVID-19 restrictions than many other developed markets.
So, will this year be the moment the UK discount starts to narrow again? To find out, and assess the impact of inflation, political risk, activist investors and ESG on the market, we brought together our UK equities team – James Balfour (JB), Henry Flockhart (HF), Trevor Green (TG), Charlotte Meyrick (C. Meyrick) and Chris Murphy (C. Murphy).
What’s your assessment of the current state of the UK equity market?
HF: The headline is that the UK market is cheaper than other global markets on current valuation multiples, particularly compared to the US, which has been expensive for a significant period. Some of this has been attributed to challenges with our index; we have a higher proportion of oil and gas companies, mining companies and financial companies, all of which have been stressed for one reason or another, and we have also had headwinds from Brexit and COVID-19.
But if you look beneath the headlines, things are rattling along quite nicely. Corporate governance tends to be strong and lots of companies have strong management teams. The Brexit headwind is easing, and our COVID-19 experience might turn into a relative tailwind as restrictions ease earlier than many other countries. For the first time in a very long while, our GDP growth rate might be ahead of other G7 nations, so the backdrop is improving.
C. Meyrick: Just to expand on what Henry said, even if you adjust for the materials, energy and financial sectors, the UK still looks cheap relative to other developed markets. That’s a key point.
Since the onset of the pandemic, performance has been polarised and to a large extent driven by whether you were perceived as a COVID-19 winner or loser. If you take the FTSE 250, the top performing two decile stocks have performed so well and carried the headline multiple for the index higher. We shouldn't be fooled by that as there's still a large proportion of stocks trading below their February 2020 levels, so plenty of opportunities remain at the stock level.
TG: Another interesting dynamic is the number of activists in UK companies and the fact they are going for large caps. I think it's for various reasons – the valuation discount to global peers, liquidity and a belief they'll get a voice in the UK.
JB: One of the biggest concerns economically is around the cost of living and what that does to domestic spending, but this is a global issue. But in terms of the UK specifically, across a lot of sectors, names that are similar to international peers are trading at discounts; from an equity income perspective, we’ve also seen levels recover quickly from COVID-19. The biggest positive is that we’re seeing improved growth across the board, especially in mid-cap names.
C. Murphy: There is still a misconception surrounding UK equities among many international investors; the reality is that you are getting exposure to truly global businesses, even with many of the mid-cap names.
Investors should be looking at individual companies when they invest rather than the overall index
Investors should be looking at individual companies when they invest rather than the overall index. If you look at the US and global indices, a lot of the returns in recent years have been driven by a handful of names; the UK has global leaders in every sector, but for a variety of reasons they have been ignored. To Trevor’s point, activists have returned to the UK because they recognise a lot of our businesses are very good at what they do. Sometimes, we undersell ourselves in the UK.
That discount has been evident since before the EU referendum. You’ve all highlighted the opportunities, but when is this going to start showing in the valuations?
C. Murphy: A lot of asset allocators have a simple way of looking at markets – they look at the price of the overall index and growth and allocate that way. Meanwhile, if you look at retail flows, there has been a massive focus on global funds because they think that’s where the money is. But if history tells us anything, it is that retail flows tend to be a good indicator of where bubbles are. As I said, a lot of the returns in the global index have been driven by a handful of US names – up until this year, when those same names have been hit hard.
At some point, things start to flip, people will begin to look elsewhere and may start to see the UK and Europe in a different light. In all honesty, we can’t second guess when that will happen; all I will say is there comes a time when value gets realised. The increased presence of activists could be a sign that time is coming.
From a global allocation perspective, investors may be looking to reduce their US exposure
C. Meyrick: Various ‘clouds’ have kept investors on the sidelines from increasing allocations to the UK; Brexit took us from 2016 through to 2019 and then the global pandemic took centre stage from early 2020. The uncertainty over Brexit is no longer there and we're hopefully closer to the end of the pandemic, so 2022 could be the year investors re-appraise their longstanding underweight positions to the UK.
At the same time, the US has a number of headwinds, so from a global allocation perspective, investors may be looking to reduce their US exposure.
While there is more clarity on Brexit, there is still a fair amount of political noise in the UK. Is that having any impact on sentiment?
HF: It is exactly that – noise, rather than a big driver. It’s not something businesses are talking about; they are more focused on global issues around supply chains and inflation. We have to remember UK companies are largely global businesses – at the margins, some industries would prefer easier access to European workers, but most are relatively unaffected by the post-Brexit world or domestic politics. They have the same issues as other global companies, but happen to be trading at a cheaper price, which is where the opportunity is for investors.
So, fears about the long-term impact of Brexit have been overplayed?
TG: Companies have prepared for it and service companies aren’t really talking about it anymore. Many of the companies we invest in have global manufacturing, facilities, and distribution chains; where we are looking at more UK-focused businesses, there is a positive underlying growth story and they've got their supply chains and everything else sorted. Furthermore, the bids we're seeing for UK companies are a clear sign Brexit is not an issue for overseas money.
Will activists lead the lead the way for other allocators?
HF: Activists and private equity are driven by returns. Ultimately, everyone else will be as well. The early involvement of activists and private equity is a clear sign the UK is an attractive place to invest. They aren’t here because it’s a nice thing to do.
Are activists a force for good or bad in trying to instigate change?
C. Murphy: It depends how you define activist. Some of these investors, particularly from the US, are not activists in the truest sense of the word. They're not engaging with companies because they want to improve long-term strategies. They're here to make a short-term return. They own less than long-term investors, make a lot of noise and move on. I personally don't understand why we give them so much time and space in the press because they're not trying to improve our businesses or society.
The involvement of activists and private equity is a clear sign the UK is an attractive place to invest
JB: A lot of activists have come in to try and accelerate a potential split in a business to make a quick return. That isn’t accelerating change; it’s more about accelerating turnover and getting the share price up quickly than fundamentally wanting to improve a business.
What’s the knock-on effect on long-term investors?
JB: The noise created by activists has pros and cons. On the one hand, it forces management to be clear around their strategy and vision for a business. On the flip side, it means every single question for the next number of years is about when they’ll be doing something the activists have called for.
SSE is a good example. It already had a plan to shift its focus towards renewables. It was coming under pressure [from activists] to separate that part of the business on the basis it could trade at much higher multiples than European competitors. SSE didn’t want to go down that route because it thinks it has the ability and cash to run both its traditional business and gradually scale-up in renewables.
As a long-term investor, we’re in the middle of that debate – while we want to see it accelerate its plan to expand in renewables, it’s far too early in that part of the business’ lifecycle to be spun off. The noise around it has been a big distraction for management trying to defend itself instead of getting on with running the business. Let’s see whether the investors calling for a split will stay around or exit the stock now they’ve seen a decent return.
Where are some of the best opportunities right now?
C. Meyrick: Looking at the consumer sector, there is potential for a shift in wallet share from retail into leisure with COVID-19 restrictions set to be phased out and overseas travel restrictions easing. We’ve been looking for ways to play pent-up demand for overseas travel and holidays.
HF: There are two key dynamics influencing the way we view companies. With respect to COVID-19, we’re getting a clearer picture of those companies that, because of their business model or the damage inflicted on competitors, have been able to accelerate their advantage and should be able to reap the rewards from here.
Wage inflation is influencing the way we view companies
Second, in stark contrast to what we saw after the financial crisis, inflation – particularly wage inflation – is a feature in this cycle. That wage inflation should feed through into sectors like recruitment, but also consumer confidence. That’s beneficial for companies across the supply chain in construction as people are more willing to invest in their homes, highlighting confidence in the rebound.
TG: Just adding to Henry’s point on companies who have been able to accelerate their advantage during COVID-19, there are names like Compass and Greggs in the catering sector who have emerged stronger and have a good growth story to tell.
C. Murphy: I continue to see opportunities in financial services, from platforms like St James Place through to discretionary fund managers. The average investor is still looking for good advice or the right platform to help them build a long-term savings plan, and I believe those businesses will continue to grow. They shouldn’t be ignored.
Defence and areas like cyber security are also interesting given the geopolitical situation, which is part of the reason we’ve seen a lot of bids for companies in the sector. While recognising some ESG investors say you shouldn't invest in defence companies, it’s more complex than that – we’re not talking about companies selling arms to terrorists. The need for a strong defence sector is clear; it’s a multi-decade trend.
How is the increased focus on ESG changing the dynamics of the market?
C. Murphy: There are certainly a lot more companies claiming to be at the forefront of the green agenda who weren’t a few years ago and a lot of that is down to pressure from investors. When the UK equivalent of Article Eight SFDR fund classifications come in, I think we’ll see some investors decide they can’t hold certain stocks, particularly heavy polluters, in the same way we saw with tobacco a few years ago. The cost of equity for these companies should go up, but that is not fully reflected in the share prices today because many investors are quite slow to move, particularly oil companies.
We’ll start to see a lot more scrutiny on companies’ roadmaps to get to net zero
TG: We saw a lot of net-zero pledges by companies at COP26 and there will be more this year. But we’ll start to also see a lot more scrutiny on companies’ roadmaps to get there. Dealing with Scope 3 emissions (indirect emissions across a company’s value chain) is particularly hard, when you consider they can account for up to 80 per cent of a company’s emissions. There isn't consistent reporting and companies have run into quite a roadblock on this. Of course, we want to see better articulation of net-zero strategies, but also understand it’s difficult and will hold balanced discussions with the management teams.
C. Meyrick: I've been surprised by how quickly some stocks perceived as ESG beneficiaries have re-rated. In the last 18 months, some stocks, in areas like renewables and air ventilation, have entered a new valuation paradigm they’ve not seen before.
C. Murphy: There is a lot of attention on whether a bubble is building; but through various factors, including regulation, these kinds of bubbles can go on for a long time.
If we look at renewables, what progress are the traditional energy names making in diversifying their businesses towards that area?
C. Murphy: I personally think they are phenomenal PR machines. But it is only very recently they've started talking about investing in hydrogen, biofuels and windfarms. In some cases we are talking about people with big toys who like drilling big holes – they haven’t suddenly had a Road to Damascus moment.
The time for radical action was when Al Gore presented An inconvenient truth, which is more than 15 years ago, instead of spending billions lobbying against him. And he was right! There are leaders and laggards in the transition; the latter are changing because they’ve got no choice, but they are not running as quickly as they could be.
HF: There's a green premium for the pure-play businesses, while those transitioning are hoping to capture some of that. You can see that in some share prices: Anglo American sold its coal business to facilitate its transition to become part of the electrification of the world and having higher copper content. The same is true for BP; it is also trying to capture some of that green premium, but the returns it is achieving for renewables are currently lower than for its traditional business, which is why it still perceives the latter to be a good allocation of capital at this time.
The risk is that at some point, the green premium goes, away and investors get caught in the middle. But right now, it pays to transition because the multiples available [on those activities] are that much higher.
We are talking about people who like drilling big holes – they haven’t suddenly had a Road to Damascus moment
JB: We’ve seen acceleration in some businesses where they are making good investments to help with the transition, which will put them in a stronger position longer term. But I agree with Trevor’s point on net-zero targets; we’ll need a significant advancement in technology to get there and it will take time for change to filter through the supply chain. We have to be careful not to penalise companies indiscriminately for missing targets who are doing as much as they can, but who are finding the supply-chain impact is not happening as quickly as they would like.
Policy change is critical – we need policies that incentivise individuals and companies to fully commit.
HF: We need to be mindful there could be significant malinvestment in the greening of the economy, in the same way companies over built fibre in the tech bubble or railways in the 19th century. It is incumbent on us as investors to not see every green pound spent as the same and keep looking ahead at what could happen within the green economy and green technology.
Where do you see the biggest potential for malinvestment; how do you avoid this?
HF: I do not own any pure-play green businesses which, as Charlotte mentioned, is where the highest premium is. For example, there is a lot of money going into areas like battery technology and electric vehicles, and those investors need to be sure they know what they're doing.
For me, it’s about finding businesses I think can benefit from transitioning their products or business models to be more aligned to net zero than others believe.
C. Murphy: In a sense, it’s understandable why valuations in these areas are so high – that’s how capitalism works. The fact they are trading at such high multiples should theoretically encourage more capital to invest in these areas, which should improve innovation and make the world greener.
We need to be mindful there could be significant malinvestment in the greening of the economy
But as Henry said, we have to avoid being pulled into businesses. Look at Johnson Matthey: there was a time when everyone was getting excited about the potential for its battery materials business and how it was going to tap into Asian growth. Last year, it exited that market altogether because it realised it could not compete and its valuation has been badly hit.
It’s not so exciting, perhaps, but we’re going to see huge investment in the electricity grid as we move towards net zero, and we have to look for the main beneficiaries, which is those with a strong business and commercial story who can deliver solid returns. Many utility bosses are excited about potential growth over the next two-to-three decades for precisely that reason.
Do you have any concerns rising interest rates will hit UK companies?
HF: I don't think the cost of debt is the issue; it’s more the absolute level of debt that companies – particularly weaker ones – have been able to take on. They could feel the squeeze and investors will be less keen to allocate to highly indebted businesses.
C. Murphy: I think the balance sheets of UK companies are generally healthy and shouldn’t be badly hit by rising rates. It’s actually a philosophical question on inflation I can't get my head around.
In a world where we don't want carbon, the carbon price has to go up; there has to be petrochemical and carbon inflation, which has impacts on the beneficiaries of the last few decades. There's also been the consumer trend towards cheap food and travel, neither of which are particularly good for a green environment.
Governments want us to be greener but don't want inflation
Governments want us to be greener, not use hydrocarbons, but don't want inflation. I don't know how they and central banks are going to solve this unless they have subsidies to protect lower income and poorer families.