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With UK Equities At Their Cheapest In 40 Years Is Now The Time To Invest Or Is It Better To Wait?

written by Bella Palmer
uk-equities

Fund manager Columbia Threadneedle has calculated that, judged against a global benchmark, UK equities are currently at their cheapest since records began over 40 years ago. But do valuations at an almost half-century low mean it’s time for a UK stock market investment? Or is there good reason why investors are shunning London-listed companies that we should be paying close attention to and heeding the warning by putting our money elsewhere?

UK Equities At Their Lowest Valuations In Almost Half A Century

Thanks to a combination of the economic impact of the Covid-19 pandemic and fears Brexit will hit an unprepared UK-in-denial hard, UK equities are currently being valued more modestly than at any point since 1988. That’s the message fund manager Colombia Threadneedle has delivered, with its calculation London-listed share currently trade at a 42% discount to other developed international stock markets, compared to an historical average of 17.5%.

Morgan Stanley has created a chart that represents the historical valuation of UK equities relative to global stocks. Its methodology was based on combining the price-to-earnings ratio of stocks, with their price to book value (valuation divided by net tangible assets) and dividend yield.

That showed previous lows for UK equities were in 1988, as the economic growth achieved under Margaret Thatcher’s government began to lose steam before the UK fell into recession in the early 90s. In 1988, UK equities were, according to Morgan Stanley’s methodology, valued at 30% less than the global benchmark. By the early 1990s, that discount had extended to a little under 40%.

However, within a couple of years, the gap between UK equities and international peers had dropped to less than 10%, thanks to a return to economic growth. That small gap held until the 2000 bursting of the dot.com bubble, when it grew to around 30% again. UK equities again strengthened before the 2008 financial crash briefly widened the disparity to 25% again. By 2012, it had again contracted to around 10%.

Since then, the gap has gradually widened to a yawning chasm, which has reached the current 42% value difference between UK equities and the international benchmark.

Source: The Times

Are British and international investors right to value companies listed on the London Stock Exchange more conservatively than peers domiciled elsewhere? Or are current valuations simply a ‘Brexit uncertainty’ and ‘poor government handling of Covid-19’ tax that fails to reflect the fundamentals and underlying performance of companies?

For investors, the question could also be formed as “have UK equities hit or are near to a bottom”? If the answer to that question is ‘yes’, that would mean now is potentially the best moment in decades to make a UK stock market investment. But if it’s ‘no’, the bet is that UK equities could fall by a significant amount more before returning to health.

It’s an important question because in the first scenario, it would make sense to invest as much as possible in UK equities now. And in the second, it would make sense to consider cashing in UK stock market assets and either reinvesting the capital elsewhere in the world, or holding onto the cash to put back into UK equities at a later date, when valuations are ready to rise again.

Why Are UK Equities Currently So Cheap?

What is dragging on UK equities valuations? To answer the question, it makes sense to look at the UK stock market within a global context. Across the world, the equities markets to head into the last stage of the year sporting a positive return for 2020 are those that either, like the USA, have a heavy weighting towards the few sectors to benefit from the Covi-19 pandemic, like tech.

Specifically, tech sectors such as digital entertainment, online retail, electronic payments or software companies whose products have seen greater demand as a result of work-from-home regimes such as productivity and video-conferencing apps. Or they are in countries and regions that have had most success in getting the virus under control. Like New Zealand and China.

Is The Modest Valuation Of UK Equities Justified?

The UK has neither managed to keep the Covid-19 pandemic under relative control, nor does it boast much in the way of large technology stocks. Quite the opposite – the FTSE 100 has a heavy weighting towards energy, travel & tourism sector and financial stocks – among those worst hit by the economic consequences of the pandemic. Throw Brexit uncertainty into the mix and investors just don’t seem to see a strong argument as to why they should take a risk on London-listed companies in favour of international alternatives not facing the same drags.

Some analysts believe the months ahead will be even worse for UK equities. There are fears Brexit may have more painful economic consequences than many of those who voted for it, and even those who didn’t, are currently bargaining for. Combined with the repercussions of Covid-19, there are concerns Britain’s unemployment levels could rise to levels last seen in the 1980s.

Are UK Equities Primed To Rise In Value?

One factor that could well spark the beginning of a revival for UK equities valuations is the resumption of dividend payments from the host of companies that either cancelled or cut back on them this year. Dividend yields are, however, not that bad at the moment despite the fact that some of the historically biggest payers like BP, Shell and big banks, have turned off the taps in 2020. The UK stock market still yields around 4% on dividends, which suggests valuations already seem to have priced in most of the bad news.

That means when companies in traditionally big dividend sectors such as financial services, oil and gas, industrials and tobacco, do up their dividends again, there could be plenty of upside. Some may not survive the next few years, or at least not in their present form. But many have strong balance sheets and enough cash in reserve to allow them to bounce back strongly, especially if they invest in restructuring and innovation in the meanwhile.

The big question is how long it might take some of these sectors to recover. Aerospace and travel and leisure are down by almost 40% as sectors this year. But with a sustained recovery in air travel not forecast until 2024, it might be wise to hold off on stocks in these sectors for a while yet.

Oil and gas stocks such as BP and Shell have been hit even harder, with the sector down 56% in the UK. They could recover more quickly than those in aerospace and travel and leisure, but the sectors are linked. Oil demand will be lower until travel returns to pre-pandemic levels and the industry is also entering a fraught transition period towards a cleaner energy future, which is likely to hit revenues and especially profits over the medium term.

Banks are also down around 50%, but they also face a tough period ahead with interest rates currently at historic lows and unlikely to rise significantly any time soon, squeezing lending margins.

However, there are other sectors where stocks are likely to shake off the ‘London tax’ on their valuations more quickly. Pharmaceuticals is an obvious one, and consumer goods companies should also be boosted by a wider global economic recovery.

There is a broad consensus among analysts that the internationally-focused FTSE 100 is likely to see pre-tax profits leap to £174 billion next year from £122 billion this year. However, of that growth in profits, 30% is tipped to come from the oil and gas sector, and there are concerns about the sector’s long-term sustainability in a lower carbon future.

Some will manage to evolve as low carbon energy companies, Shell and BP have both committed to reaching carbon neutrality over the next 3 decades, but others will fall by the wayside. Investors will have to risk picking those who will manage the transition but still accept there may be rocky years along the way.

25% of profits growth will come from financial services and 10% from industrial goods and mining. Stocks in all of these sectors face a fight to remain relevant in future years and decades.

The UK is light on the sectors currently doing best – IT and non-essential consumer goods. They make up just 8% of the UK equities market compared to 40% of the USA’s.

London-listed stocks could make up ground in coming years and prove a wise investment at today’s valuations. But there is plenty of uncertainty, with recovery likely to hinge on the UK’s success in signing working trade deals with first the EU and then other regions and countries. A no deal Brexit, which is looking ever more likely, would almost certainly both delay any narrowing of the value gap and quite possibly extend it further over at least the short term.

However, on the historically-based presumption that it is a matter of time before the valuation gap narrows, with the only real question being ‘a matter of how much time?’, long term investors might worry less about the next few years and start investing now. The long-term view would be that even if valuations do fall further, they are already low enough that they will eventually improve compared to the global benchmark.

That would negate the desire to try to time the market and mean current valuations look like a bargain. Even if the bargain’s value may take some time to come good.

Disclaimer:

The opinions expressed by our writers are their own and do not represent the views of UK Investment Guides. The information provided on UK Investment Guides is intended for informational purposes only. UK Investment Guides is not liable for any financial losses incurred. Conduct your own research by contacting financial experts before making any investment decisions.

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