Interactive Investor

UK equity market valuations at ‘embarrassing’ levels

30th June 2023 09:45

by Kyle Caldwell from interactive investor

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While it is a prudent investment strategy to avoid overpaying for any asset, investors are continuing to stay away from the UK equity market. 

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At the risk of sounding like a broken record, the fact remains that the UK market is cheap versus its own history and compared to international markets.

However, while it is a prudent investment strategy to avoid overpaying for any asset, investors are continuing to shy away from the lower price tags in the UK equity discount aisle.

The lack of love for the UK market is leaving many pros perplexed. They point out that the UK market has plenty of bargain opportunities given that the FTSE 100’s new all-time high, achieved earlier this year, was driven by a small number of stocks – energy and miners – which have benefited from rising energy prices.

The fund statistics, however, reflect that investors have not yet been persuaded. Figures from the Investment Association (IA) show that March and April were two bumper months for fund sales, with inflows at £3.8 billion. However, UK equity funds saw £2 billion withdrawn across its three sectors – UK all companies, UK equity income, and UK smaller companies.

Overall, UK funds have been out in the cold since the Brexit vote, which created a huge amount of uncertainty.

Seven years on from the referendum, Brexit is still par of the negative sentiment towards UK equities, according to James Henderson, who manages Lowland (LSE:LWI)Henderson Opportunities (LSE:HOT), and Law Debenture Corporation (LSE:LWDB).

Speaking at a recent investment conference, Henderson said that international investors pulled money out of the UK market following the Brexit vote, and have not yet returned.

He argued that trying to reverse the tide of negative sentiment towards the UK market “is like pushing water up a hill like I’ve never known it”.

Henderson says that Lowland is at a valuation discount to its history, with the price to earnings (P/E) valuation of its portfolio 9.0x compared to 12.7x for its 10-year average.

Lowland's three new holdings over the past six months to take advantage of cheap share prices are property developer Hammerson (LSE:HMSO), insurer and asset manager Legal & General Group (LSE:LGEN), and Strix Group (LSE:KETL), which produces kettle safety controls.

In addition, in the second half of 2022 Henderson initiated new positions in housebuilder Bellway (LSE:BWY), building material supplier Marshalls (LSE:MSLH), and Conduit Holdings (LSE:CRE), a global re-insurer.

He added: “Sentiment is dreadful at the moment, but I’ve been here before. When I started my career 35 years ago, UK equities were considered a basket case. Then, six months later, a recovery started, and then the following decade was a fine period.”

In particular, Henderson is finding value opportunities in UK domestic stocks. He added that he is not alone, as private equity groups and other corporates are recognising the value on offer in the UK market. However, he says that at such cheap valuations a pick-up in M&A bids will result in the UK market “losing good companies, at the wrong valuations”.

At a separate event, Clive Beagles, fund manager of JOHCM UK Equity Income, described the low valuations attached to the UK market as “embarrassing”.

He said: “Compared to international peers the UK valuation is embarrassing. BP (LSE:BP.) and Exxon Mobil (NYSE:XOM) are very similar companies, yet the former is on half the valuation of the latter. Being listed in the UK used to be a badge of honour, but now it is embarrassing.”

Beagles points out that the UK market and value stocks have underperformed over the past 15 years. The fund manager named a number of stocks that he thinks look attractive in terms of their low valuations, but highlighted three in more detail: Standard Chartered (LSE:STAN), easyJet (LSE:EZJ) and Keller (LSE:KLR).

Beagles noted that on two valuation measures, price to forward earnings and price to book, Standard Chartered is trading close to all-time lows. He says the stock is a beneficiary of interest rate rises, as this increases its net interest income.

With easyJet, the fund manager says the valuation is compelling due to the firm currently under-earning on fares and ancillary revenues. He notes that if margins improve, which he expects to happen, there’s plenty of upside potential.  

In the case of Keller, the world’s largest geotechnical specialist contractor, Beagles thinks the share price could triple from current levels due to the firm being well placed to benefit from an uptick in infrastructure spending.

A demonstration of overall value, points out Beagles, is that the fund he manages has its second-highest ever dividend yield, of 5.7%. The only other time the yield was higher was following the global financial crisis.

He added: “The valuation opportunity for the UK equity market is stark. Equities’ earnings and dividends provide natural protection against inflation.”

Since we launched the fund 20 years ago, we’ve grown the dividend stream by 9% per annum on average. It’s fair to say a starting yield of 5.7%, growing at the rate of high single digits, ought to provide better protection against inflation than a bond fund with a coupon which doesn’t grow at all.

Research from fund manager Schroders shows that on the P/E measure the UK equity market is cheaper than usual. Its data showed that, as of the end of May 2023, the UK market was 19% and 18% cheaper than over the past 15 years, on the forward P/E and trailing P/E measures.

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