Investors used to be accused of a home bias; portfolios were often over-represented in the UK companies. As a result, investors would often miss out on major sectors that could only be found overseas. That accusation could hardly be made today. Instead, the question is whether investors are missing out on real value among UK companies.
At the recent Square Mile Investment Conference, Richard Buxton, head of UK equities at Merian Global Investors, was clear that the pendulum had swung too far in favour of global equities: “It used to be that everyone would over-index to their home market. However, more recently everyone has rushed to go global at the expense of the UK, just as the US has outperformed significantly.”
As an instinctive contrarian, he believes this should give investors pause for thought.
Currency has played a significant role in supporting the price of global funds and UK-listed international companies for UK investors. The weakness of sterling has buoyed returns, but it is increasingly clear that it may have gone as low as it can go. Sterling’s response to the news of Boris Johnson’s Brexit deal with Brussels showed that a ‘no deal’ scenario was largely reflected in the price. If Johnson’s Brexit deal doesn’t fly, currency movements are unlikely to be as supportive from here. “Even if you are very successful investing in international stocks, it could be more than offset by a reversal in the currency,” says Buxton.
Mark Barnett spies discounts in domestics
Investors deciding on their allocation to the UK versus global companies also need to take into account current valuations. Mark Barnett, head of UK equities at Invesco, points out that UK domestic companies are now trading at a 25% discount to their international peers. This compares to an historic range of -10% to +10%.
He looked at whether there was a correlation between how the stock market values businesses and the situation in the real economy. He says: “If the stock market is right about applying this big discount to UK domestic companies, what’s the GDP outcome that’s being factored in?” His calculations suggest that the current valuations imply a 4% drop in GDP – a very sharp recessionary impact.
Is this likely? Barnett believes not: “I don’t see a recession in the UK, even though many have been forecasting it for the last three years since the Referendum.”
Buxton also agrees that the outcome for the UK economy may be better than some are expecting, particularly if there is some sort of resolution on Brexit. At the moment, it appears jobs and the consumer are holding up and inflation remains benign.
Barnett also looked at UK-sourced revenues compared to elsewhere in the world. His analysis suggests that a dollar of revenue generated in the US is currently valued 3x as highly as a pound of revenue generated in the UK. It is a clear anomaly, he argues, and appears to be sentiment-driven.
Private equity to the rescue?
What might change this? Assuming Brexit remains unresolved, merger and acquisition activity could make a difference. It has picked up materially as private equity investors, flush with cash, are looking at the prices they need to pay for quality listed companies and deciding that it’s time to buy. Barnett says private equity groups are buying stocks in the UK irrespective of the political risk, because they want to take advantage of lower prices today.
Buxton says that some companies will also be taken private: “The UK market is myopically focused on short-term earnings momentum and some shares are de-rating to the point where companies are saying ‘if you’re not going to value us properly, we might as well take ourselves private’. It is sad to be losing those opportunities.”
With that in mind, Barnett is firmly focused on domestic value. That means insurance, telecoms, specialist food manufacturers and real estate plus selected retailers. He adds: “The oil companies are as good as any time I’ve seen in my career and yet they’re being valued as lowly as I can remember.”
Although marginally less domestic in his focus, Buxton is holding the banks, believing that many of the risks have diminished and the sector looks cheap. Barnett is more focused on ‘non-correlated’ financials. This may be less familiar names – AJ Bell, Burford or Biopharma Credit. For him, these offer income diversification and are less dependent on traditional business cycles.
Both suggest that it shouldn’t take much to turn sentiment towards the UK. Fund flows have been so weak that any reversal should shift share prices quickly. Brexit remains the elephant in the room, but with the EU ruling out an extension and a new deal on the table, it feels like the UK might be nearing the end game. The UK has value: the question is whether investors will be brave enough to take advantage today.
