Why UK equities are back in favour

Rebecca Tomes
August 31, 2021
(IFA Magazine)

 

Thomas Moore, senior investment director at Aberdeen Standard Investments, shares his views on why UK equities are back in favour.

It’s now a little over five years since the Brexit referendum and over that period UK equities have found themselves decidedly unloved on account of a number of factors, including:

  • Substantial political uncertainty regarding the shape of UK’s relationship with Europe
  • Index being composed of sectors deemed to be “old economy”
  • The UK suffering one of the most severe downturns in developed markets in the immediate aftermath of COVID

However, times of uncertainty can create opportunity and if we consider a long term, evidence-based approach to asset allocation, UK equities currently offer a great deal of interest.

Attractive valuations and a healthy yield

Regional equities have followed different paths in recent years. US equities, powered by some of the world’s most important technology stocks, have outperformed other regions by a large margin. As a consequence, US Large Cap valuations have moved sharply above their long term averages over the last five years with a cyclically-adjusted P/E ratio currently around 32.5x. By contrast, the UK equity market is just below its long term average with a cyclically-adjusted P/E ratio of 17.6x. This is a great starting point for investors because, over longer periods, the starting valuation you pay has been a key determinant of future returns.

“2020 was a particularly challenging year for UK dividends given the market’s concentrated pay-out profile and the enormous impact COVID had on economic activity, commodity prices, and companies’ willingness or regulatory ability to pay dividends. Those companies that were at risk of cutting their dividends have now done so. Dividends are now growing again as the cyclical backdrop improves. Today, the FTSE All Share yields around 3.5%, which remains attractive relative to other equity markets and asset classes.”

A number of catalysts

Over the last seven years, UK Equities have been firmly on the back burner, with BofAML’s Global Fund Manager surveys showing that investors have been materially underweight. For much of this period, Brexit has been a major overhang, followed on by the severe impacts created by COVID on the UK economy and stock market. However, with much more certainty on the UK’s relationship with Europe, the release of vaccines in the fight against Covid-19 and continued monetary and fiscal policy support, risk appetite towards the asset class is starting to inflect.

 

“From a political and economic perspective, headwinds that have faced the UK equity market have started to change into tailwinds. With the clouds of Brexit led uncertainty now cleared, combined with the more cyclical, value orientated composition of the UK market, investors are re-engaging with the market. Furthermore, lockdown has created huge, pent up demand with people much less able to spend their money, allowing for the highest and second highest level of net savings on record.

“Estimates put the scale of current savings at around £190bn. As restrictions continue to ease, the potential is therefore there for significant growth in spending, driving the domestic economy forward. So considering UK plc, the economic backdrop is strengthening supported by rapid vaccination, growing business and consumer confidence, a falling unemployment rate and a likely material boost in consumer spending in the coming months. It appears these dynamics have supported global investors’ moves in the last few months to reduce the underweight to UK equities.”

Record levels of M&A

2021 has seen a record in UK M&A activity in terms of the value of deals conducted in H1. A total of 124 takeovers and purchases of minority stakes have been conducted worth around £41.5bn. Attractive valuations, Brexit resolution, the pace of the Covid-19 vaccination programme and the rich seam of opportunities in the UK have all underscored this activity.

What is particularly interesting here is that 47% of European private equity deals in 2021 targeted UK companies – almost half of the deals done. With the FTSE All Share trading at a material valuation discount to global equity markets, we are heading for biggest year for UK private equity takeouts since 2007. A clear conclusion is that while public markets have left the UK equity market to one side, private equity is capitalising on the opportunity for global growth.

A recent example of this can be found in Tencent’s acquisition of Sumo, a UK based video games developer, which saw a 43% premium paid to shareholders. This only one of a significant number of deals in the last 12 months with deal pipelines indicating no sign of a slowdown into year end. Evidence suggests that the depth of opportunity for stock pickers willing and able to take a forward looking view remains strong in a market that has been overlooked for some time.

Final thoughts

In summary, there are numerous factors that support an increase in longer term UK equity allocations. The UK equity market is currently trading around the steepest valuation discount to global equity markets in 20 years. There is clear evidence that investors are re-engaging with the asset class with the UK economy set to continue to recover strongly. World class governance standards support investors looking to generate returns from global opportunities. And record M&A activity highlights the latent value that forward-looking stock pickers can currently find in UK equities.

 


Story originally appeared on fca.org.uk

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