A compelling reason to own undervalued UK shares

The contrarian case for UK equities has been aired by a City bank after it said that valuations were the most attractive in the G10 group of leading industrialised nations.

In particular, UBS said financial stocks traded at their steepest discount to European peers in 30 years and that the median UK company in every sector apart from healthcare and utilities generated a higher return on investment than its European counterpart.

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In his opinion piece for yesterday’s Financial Times, Michel Lerner, UBS’ head of HOLT, an independent research product within the Swiss bank, described UK shares as “a haven in a more uncertain world”.

He added: “The London market is smaller than it has been in the past and the macro environment remains challenging but UK stocks often reflect a lot of pessimism. Increasingly, this creates opportunities to buy resilient businesses at attractive valuations.”

Lerner’s comments echoed a note published last week by the bank’s Global Wealth Management division, which told clients of the supportive backdrop for UK equities.

It pointed out that valuations were reasonable at 12 times forecast earnings, versus the median since 1990 of 12.8 times. The earnings backdrop is also improving, with profit set to rise by 16% this year and then by 9% in 2027 as commodity price tailwinds begin to fade.

The bank’s base case forecast for the level of the FTSE 100 index by next June is 11,500, which represents an upside of 8% on today’s 10,654.

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An upside scenario, where global growth improves more rapidly and a weaker pound supports higher local currency returns, leads to a target of 12,300. The downside estimate is 7,700.

While higher interest rates are a near-term risk, UBS said what matters most for equities is the reason why rates are rising.

It said: “When tighter policy also reflects resilient economic activity, earnings growth can more than offset the effect of higher discount rates.

“This is especially true for the UK market this cycle given the role of higher energy prices in the shift in outlook for global central banks.”

The FT piece by Lerner, who leads UBS’ HOLT corporate performance and valuation framework, also made some interesting observations about the shrinking of the UK equity universe.

At its peak in 2015, he said the UK had 180 “best-in-class” companies with high profitability sustained through the cycle. This number has since halved.

And many of these high-quality UK stocks no longer command their previous valuation premiums, despite resilient and improving economic returns.

With takeovers and delistings, the UK now accounts for 10% of Europe’s stock-market capitalisation compared with a quarter in 2012.

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Lerner said: “UK equities have become easy to dismiss given the numerous issues they had to contend with.

“Capital investment has weakened since Brexit, inflation expectations are higher than in other developed markets, and few listed companies provide exposure to the AI theme.

“More recently, fiscal uncertainty and concerns over the national debt load have added to the UK woes.”

However, Lerner said the valuation and profitability picture told a different story.

He said UK valuations are now the most attractive in the G10, with the market trading at a lower price/earnings (PE) multiple than France despite a lower level of economic uncertainty.

Technology accounts for less than 1% of the profitability of UK-listed companies, versus 6% in Europe and 25% for the US. Historically, the UK has been the best-performing region when technology underperforms but as tech rebounds the UK tends to lag.

Lerner wrote: “The UK’s low exposure to the technology sector has been a source of weakness until now.

“Yet it now makes UK equities a compelling hedge for investors concerned about their exposure to increasingly volatile global tech stocks as the market increasingly questions the economics of some of the large AI infrastructure investments.”