Sometimes the best value is right on your doorstep – Invest in the UK

Date Published: 18 March 2018

Category: Uncategorized

Since SCM started, we have found considerable opportunities outside the UK by investing in stocks with either lower valuations or higher growth potential, or ideally a combination of the two; rather than in their UK alternative.

Since SCM started investing for clients on 8th June 2009, investors would have received 92% extra return in £ sterling from investing in global equities (MSCI World) compared to UK blue-chips (FTSE 100); as illustrated by the chart below. The relative ratio (shown in green) in terms of FTSE 100 relative to MSCI World is close to 71%, a recent low:

  Source: Bloomberg LP

Our asset allocation strategy has benefitted our portfolios returns, as we have progressively increased our overseas equities exposure compared to the UK since we started:

It understandable that some commentators think the recent trend of UK equities underperforming their international peers is part of a longer-term trend, but as with all investment decisions, it is vital to interrogate the fundamental data and see what the facts show.

Over the 20 years from the end of 1983 to the end of 2013, the total return of UK equities (FTSE 100) and world equities (MSCI World) was very similar in £ sterling:

Source: Bloomberg LP

It is the period since 2013 that has seen the great divergence in returns between the UK blue chips and world equities in sterling:

Source: Bloomberg LP

However, as the legendary economist John Maynard Keynes is reported to have said: “When the facts change, I change my mind. What do you do, sir?”.   I would point out that the American Nobel laureate, Paul Samuelson says Keynes’  actual words were “When my information changes, I alter my conclusions.”

Either way, some UK investment firms run or influenced by ideologically based politicians seemingly make investment decisions on the exact opposite principle, namely “when the facts change, I try and find new facts to support my previous view”.  In my view, this can be a recipe for disaster, for investors.

With my contrarian mindset, I think it is time to look at the UK afresh, especially as many investors appear to be very negative of UK equities, thereby creating an opportunity.  They seem to have forgotten that many of the largest quoted UK stocks are simply stocks that are quoted in London, but are in fact global organisations with 75% of their revenues derived from outside the UK.

The UK is currently the most unpopular developed country among international institutional investors, according to the latest monthly Bank of America Merrill Lynch survey of public market investors managing $510bn.  UK equities are the least popular since the 2008 financial crisis and even bonds are currently hated less than UK stocks.

 

Research Affiliates, a respected firm that conducts impartial research, produces an estimate of future 10-year returns for different asset classes based on a valuation methodology.

Ideally, investors should be seeking the highest expected, with the lowest volatility i.e. as far into the top left corner as possible in the chart below.  Research Affiliates have found that the UK market has one of the most attractive expected return (8.2% pa) / expected volatility (13.7%) combinations in the world.

 

You might think the reason for this low valuation is low growth, and you would be partially correct.  Next year’s consensus growth rate in profits (in terms of earnings per share growth) or cashflow (in terms of EBITDA per share growth) from these UK blue chips is much less than their global peers.

However, this gap narrows substantially in the following year.  Also, the valuation discount of UK stocks is typically about 25% over both time periods, so the market is already factoring in much lower growth into these stock prices:

 

FTSE 100 MSCI World FTSE 100 MSCI World
Valuation Measure Y+1 Est Y+1 Est UK Discount Y+2 Est Y+2 Est UK Discount
Price/EPS 12.9 15.1 15% 11.9 13.8 14%
Price/Cash Flow 7.4 10.1 26% 7.9 9.6 17%
Dividend Yield 4.6 2.6 75% 5.4 2.8 94%
Price/Book 1.7 2.2 23% 1.6 2.0 20%
Price/Sales 1.1 1.6 28% 1.2 1.6 25%
Price/EBITDA 6.1 8.2 25% 5.8 7.7 24%
EV/EBITDA 7.5 9.8 23% 7.2 9.2 22%
Net Debt/EBITDA 1.3 1.7 24% 1.2 1.6 23%
Average 30% Average 30%
FTSE 100 MSCI World FTSE 100 MSCI World
Y+1 Est Y+1 Est Y+1 Est Y+1 Est
Measure Growth Growth Growth Growth
Earnings Per Share 5.4% 8.8% 8.3% 9.6%
EBITDA Per Share 3.4% 6.9% 5.1% 6.7%

Source: SCM Direct utilising Bloomberg data as at 12 March 2018

 

At SCM, we recently increased our asset allocation UK exposure (on the 20th February 2018), for the first time in a long time, via an additional allocation to the FTSE 100.  We are seeking to continue to add to this position as the risk/reward of these UK blue chips looks attractive.

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