With valuations at extreme levels, Sue Noffke and Andy Brough explain how they’re looking at the UK stock market heading into 2020.
The UK equity (stock) market is trading at a 30% valuation discount to global peers, close to a 30-year low.
For a detailed explanation of the valuation metrics which are used to calculate this discount please see Three reasons why the UK stock market looks compelling.
While domestically focussed UK stocks are particularly out of favour, other areas of the market are very expensive – extremes exist at both ends of the spectrum.
The UK has a lot of "quality growth” stocks, many of which have performed very well over the past few years. Growth stocks have revenues that are expected to increase at a faster rate than the average company. Quality stocks are those with consistent profitability, market-leading positions and low debt. In all equity markets investors are paying large, many would say unsustainable, premiums for such safety or growth.
Against this backdrop, two of our fund managers who cover different areas of UK equities explain how they’re looking at the UK stock market heading into 2020.
UK equities are global in nature. International developments often set the tone, and in this regard the ongoing US-China trade discussions and the state of the world economy are key considerations. They could be as important market drivers in 2020 as any domestic factors, such as UK political or Brexit uncertainty.
Market participants and policymakers are becoming increasingly concerned that we are reaching the limits of quantitative easing (QE) to support economic growth.
QE is a form of monetary policy and effectively involves central banks injecting money directly into the financial system by way of asset purchases (buying mainly bonds) to encourage additional investment and incentivise people to consume more.
There is a growing body of opinion that national governments should now be doing more to counter the slowdown with increased spending in areas such as infrastructure to take advantage of ultra-low borrowing rates. This is known as fiscal policy and, like monetary policy, is a means by which policymakers attempt to manage economic fluctuations.
In the UK we have seen both the Conservatives and Labour make significant spending pledges as part of their election campaigns.
One particular equity market distortion resulting from the loose monetary policy of the last decade has been the outperformance of growth stocks versus "value" stocks. Growth has become an increasingly sought-after commodity and as a result more highly priced.
The below chart shows the huge valuation premium that such stocks trade on in the UK, relative to value stocks. Value stocks tend to trade at a lower price relative to their fundamentals such as earnings or revenues.
A group of shares can rise simply because investors view them more favourably, without any corresponding change in near-term prospects. Collectively, investors ascribe a higher value to the group.
The chart illustrates how UK growth stocks are being ascribed a high value relative to value stocks. It compares the price-to-earnings ratio (a commonly-used valuation metric) of these two groups. On this basis, growth stocks are being valued almost twice as highly as value stocks, which is significantly above the average valuation premium shown by the green line.
However, these distortions will not last forever. If monetary policy has indeed been stretched to its limits, then fiscal policy and economic restructuring will likely be turned to in order to lift economic activity.
Financial markets may see this as a trigger for rising inflation and higher interest rates. This would likely be supportive to the outperformance of lowly-valued value stocks over their growth counterparts.
A resolution of the Brexit stalemate may also be positive for UK value stocks. These include domestic banks, property companies, housebuilders, consumer discretionary areas (general retailers and leisure companies), food retailers, media agencies and utilities.
Accordingly, we have a slight bias towards more lowly-valued stocks at the moment, where we can still find equities that are not priced for perfection.
It is not certain that the UK general election on 12 December will help break the Brexit stalemate. But in any event, as a stock picker I embrace mispriced opportunities which arise during such periods of uncertainty (for details, see Why as an investor I’m looking through Brexit fears).
Private equity (PE) and PE-backed buyers are finding a disproportionate amount of opportunities in the UK. There has also been an ongoing stream of bids from overseas businesses for UK-quoted companies. For a detailed explanation of these trends see: Who’s buying UK shares and what does it tell us?).
At a time when the majority of the market is uninterested in UK equities, we share the opinion of these other large and experienced long-term investors and recognise the valuation opportunities.
UK small and mid-cap (SMID) shares have outperformed other areas of the stock market over the long term. We expect this trend to continue.
The recent pick-up in UK mergers and acquisitions (M&A, the buying, selling or combining of companies) is particularly focussed on SMID companies. In the past they have attracted a relatively greater part of the M&A pie, a trend that shows little signs of changing (see chart below).
In a rapidly-evolving world, SMID companies are generally better able to capitalise on new opportunities as they tend to be more dynamic, and have a smaller base than their large counterparts have from which to achieve growth. M&A activity helps make room for the next tranche of exciting small company shares to emerge.
This dynamism is perhaps best underlined by the ever-changing constituent list of the FTSE 250, which we refer to internally as the “Heineken index” given its potential to “refresh” a portfolio in a way large cap companies struggle to do.
Often referred to as the market’s “second tier”, the FTSE 250 is the next most established group of shares quoted on the London Stock Exchange outside of the FTSE 100. It has returned 520% over the past 20 years versus 136% from the FTSE 100 (total returns 31/10/1999 – 31/10/2019, source: Thomson Reuters Datastream).
The FTSE Small Cap index, home to some of the smallest companies, has returned an equivalent 253%.
The pick-up in M&A this year is also telling on another level. A number of SMID companies on the receiving end of bids have been domestically focussed. These include UK pub operators Greene King and EI Group plus smaller peer Fuller Smith & Turner, which sold its brewery (of London Pride acclaim) to Asahi of Japan.
Other examples include Dairy Crest (snapped up by a Canadian peer), Telford Homes (bought by American real estate firm CBRE) and Hull broadband provider KCOM, acquired by Australian investment business Macquarie.
This suggests that the value which can be found in spurned UK domestic quoted stocks relative to an equity market which has reached historic highs has not gone unnoticed by all market participants.
October’s “Brexit bounce” gave a taste of what might happen should sentiment improve – the share price recoveries of investment trusts invested in UK SMID companies were particularly pronounced. Such trusts tend to have a greater exposure to UK domestically focussed shares than their large cap equivalents do.
During periods of market stress, sentiment towards UK domestically focussed shares is prone to becoming excessively negative. This happened last winter (for details see Death of the High Street? Why we’re still backing UK retail). Backers of shares such as petcare specialist Pets At Home, homewares retailer Dunelm and athleisure leader JD Sports (since promoted to the FTSE 100) have done well in 2019.
We take comfort that the UK economy is not in dire shape. Recently released data from the Office for National Statistics show that growth in household spend (three quarters of all spending in the economy) has continued in 2019. It would also appear to us this growth is reasonably sustainable, underpinned by a strong jobs market, real wage growth and lower taxes.
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