An unloved laggard – but will the UK bounce back in 2021?

If the job of stockpickers is to work out when the market is “mispricing” shares, then there is plenty for those with a focus on the UK to get their teeth into right now.

As investors look beyond events over which they have no control – such as Covid-19 and Brexit – opportunities abound at an individual stock level. Indeed, in terms of potential, today’s market for stock picking is comparable to the one that followed the Global Financial Crisis (GFC).

This is at a time when many companies are looking to the future again and increasing investment. There has been some sensible bolt-on merger and acquisition (M&A) activity and many dividends are being reinstated. Plenty of companies have surplus cash to grow their businesses and reward their shareholders.

Investor confidence in the UK dropped away amid the pandemic. Having briefly re-engaged in late 2019/early 2020, global fund managers retreated back to the side-lines, according to regular investor polls by Bank of America Merrill Lynch. As a result, UK shares lagged other regions for yet another year in 2020 – even though the gap closed a little following positive vaccine news.

The possible reasons for not owning UK shares have been extremely well-publicised, with Brexit and the devastating Covid-19 crisis at the top of the list. The reasons for owning UK shares, on the other hand, are frequently overlooked. It seems that the bad news is crowding out the good, explaining why there are so many mispriced opportunities at present.

The resumption of “inward” M&A activity suggests our optimism is shared by other large and experienced long-term investors. The trend of inward M&A had begun to gather pace prior to the global pandemic. We see many indications that it is starting to regain momentum.

Recently announced deals include a recommended bid for RSA Insurance by a consortium of overseas rivals. Meanwhile, the eponymous owner of Las Vegas’s iconic casino Caesars is to acquire gaming group William Hill. This comes as two North American rivals vie for control of security group G4S.

This bid interest underlines the unloved status of many UK shares. A large number of companies are trading on very depressed price-to-earnings ratios (a commonly-used valuation metric), similar to the situation we saw in the wake of the GFC.

Covid-19 sell-off has left UK companies as cheap as in the GFC

^{JP Morgan Marketing Intelligence team, data from August 2000 to August 2020.}

Companies back on track

Since peak Covid-19 uncertainty in early March, we have seen many companies get back on track. Even before the positive news on vaccines, many companies we follow were looking ahead again. They were feeling sufficiently confident to give some guidance on their likely future financial performance. A number of these companies have also paid, or indicated plans to resume, dividends that were deferred last spring.

Many in the market had judged these dividends more vulnerable than they have transpired to be. Their reinstatement is a really good signal of corporate confidence, which may have been obscured by 2020’s high profile dividend cuts.

These cuts have been concentrated in the hardest hit sectors of banks, oil & gas, travel & leisure and other areas within the wider consumer services industry. Some dividends have been “rebased” to a lower level, as may also happen with the banks when they resume distributions.

Many companies outside these sectors have been less impacted by the pandemic. As a result, confidence - and dividend payments - have been able to resume more swiftly than many had previously assumed possible or likely.

Quintessential “exogenous” shock

Having said that, Covid-19 is the quintessential “exogenous” shock, one which arises from outside the economic system, such as an extreme weather event. These shocks are less quantifiable than those which come from within, like the global financial imbalances which set the scene for the GFC.

The acceleration of technological trends, changing consumer behaviours and the loss of demand as a result of the crisis will also have long-lasting impacts.

In some instances, these impacts may become permanent if it takes longer than expected to resolve the pandemic due to the many challenges faced by vaccination programmes. These include manufacturing, storing and distributing vaccines as well as levels of public uptake.

This increases the risks around some of the worst-hit sub sectors, and underlines why valuations need to be scrutinised in the context of company fundamentals. For this reason, I am avoiding some apparently cheap property companies (traditional retail/office), airlines and cruise operators within the travel & leisure sector.

More broadly, markets could fall if expectations around vaccination programmes prove too optimistic, especially as global stock markets have recovered quickly since news of the vaccine progress. 

If it does take longer than expected to resolve the pandemic, the strongest companies with the strongest balance sheets should outperform. It’s worth noting this scenario would not necessarily preclude UK shares in the broad performing relatively well. There are country-specific factors at play here as well. Should, for instance, uncertainty around Brexit subside, it could create space for the UK stock market’s positives to come into focus.

Strongest consolidate their positions

The degree of negativity towards UK shares remains really quite entrenched. This is reflected in the extreme positioning of global fund managers. However, many of the companies we follow have unveiled promising new investment plans. We are also seeing some sensible “bolt-on” M&A proposals to accelerate growth. In summary, many of the strongest companies have been able to consolidate their positions and are adjusting well to recent changes.