Even before the Ukraine crisis, expectations of higher inflation and interest rates were giving some equity investors the jitters. Rory Bateman and Uzo Ekwue assess whether this is justified.
Rory Bateman: The Bank of England recently raised interest rates to 0.5% and the hawkish tone of recent Federal Open Market Committee meetings suggests US interest rates should also rise this year. In addition, the Fed plans to reduce the size of its balance sheet, which means it want so reduce the number of assets it holds, such as bonds. This implies there will be reduced support for financial asset prices.
Such a backdrop of tighter monetary conditions has negatively affected stock markets so far this year and may continue to do so. However, performance so far across sectors has been mixed. Broadly speaking, ‘value’ stocks, such as banks, energy and commodity firms have done well. Meanwhile, growth stocks - particularly those that are unprofitable - have done poorly.
Uzo Ekwue: The UK’s FTSE 100 index has a large representation of those kinds of value stocks. The consequence of being more of a value-oriented index has seen the FTSE 100 perform relatively better compared to international stock market indices so far this year.
We expect the value investment style to continue leading the way in the interim. However, the discount for ‘value’ stocks in recent years has been a function of falling real yields – the return bond investors can expect once inflation is taken into account. Ultra-low yields made shares of faster-growing companies more attractive. But the discount should narrow as real yields rise, making value shares less appealing over time.
Rory: Investors should remember that a sizeable valuation discount has existed between the FTSE 100 and MSCI World indices for close to two decades. As at the end of January 2022, the FTSE 100 index traded at a c.30% discount to the MSCI World index (as measured by the aggregate price-to-earnings ratio of companies in the respective indices).
However, although there is a value tilt, the FTSE 100 is not just cheap because of the presence of ‘old economy’ sectors like energy and mining. Rather, there are numerous sectors within the index that are actually cheaper than their US and European peers. And there is no reason we can see for this other than that the UK market is out of favour.
On the size front, meanwhile, the FTSE 250 index of small and medium sized companies (also known as small and mid caps) continues to trade at a price-to-earnings premium to the FTSE 100 large cap index. This is because of the higher relative growth among these smaller companies. However, it still trades at a discount to its global equivalent index. UK large caps may well continue their outperformance for now versus small caps, due to the value-oriented composition of the index.
Uzo: But we still believe there is scope to invest opportunistically in small- and mid-sized companies. Many smaller companies’ share prices have fallen disproportionately due to the recent flight from riskier assets, despite no change to their fundamentals.
An example is small and mid-sized companies in the healthcare sector, whose share price declines have been further perpetuated by technical factors such as wide bid-ask spreads and low trading volumes. (The bid–ask spread is the difference between the prices quoted for a sale – ask - and a purchase – bid - of a stock).
Uzo: While UK stocks are lowly valued compared to global peers, they are also highly cash generative. At the end of January this year, the FTSE 100’s forward free cash flow yield stood at 6.8%, which was the highest amongst all developed markets. (Free cash flow is the money a firm has left over after paying its operating and capital expenses. The yield is calculated as free cash flow divided by market value).
Meanwhile, research from Goldman Sachs suggests that UK companies have the highest levels of cash on their balance sheets relative to their total assets.
We believe that this combination of valuation support and cash generation presents a very compelling investment opportunity.
Uzo: The value of share buybacks rose rapidly in the UK in 2021, and this could continue in 2022. UK companies have a cash pile and the recent stock market selloff could make buying back their own shares an attractive option. However, more than ever, boardrooms will have to weigh up the capital allocation decision and where to obtain the best return on equity for shareholders – by either buying back their own shares at deeply discounted prices or by pursuing opportunistic mergers or acquisitions.
Rory: The recent market volatility has led to a slowdown in the pace of initial public offerings (companies going public by listing their shares on the stock market). We expect this to continue until valuations settle. With interest rates in the UK expected to continue rising, highly indebted public companies are likely to need injections of fresh equity capital due to rising financing costs.
Meanwhile, we expect private equity firms to use falling valuations as fuel to further deploy capital into making bids for listed (and unlisted) companies.
Rory: As we navigate the rest of the year, opportunities to buy attractive stocks at bargain prices may well appear. While we are aware of the macroeconomic environment, we are focusing our attention on stock and sector diversification, as well as investing in businesses with strong supportive balance sheets and good growth prospects.
A version of this article first appeared in Investment Week on 9 February 2022.
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