UK equities look attractive across various valuation measures
UK stocks have underperformed other major developed markets so far in 2018, extending a pattern that has been in place since the June 2016 vote to leave the EU. A longer-term analysis also suggests Brexit isn’t the only thing weighing on UK companies, so why should investors be interested in UK equities now? We think investors are pricing in a fairly negative Brexit scenario, and see UK shares as offering fundamental value and opportunity in differing economic outlooks.
UK shares have underperformed the MSCI World Index significantly since the end of 2011. This has been due to a number of factors: the UK’s high exposure to sectors such as banking, oil and mining which have experienced periods of challenging trading; a relative lack of exposure to higher-growth areas such as technology; and more latterly concerns about the potential for Brexit to impact the UK economy.
On the day of the EU referendum, 23 June 2016, the closing price of the FTSE 100 was 14.4 times the expected earnings for the index over the next year (a ‘forward price/earnings’ or ‘PE’ of 14.4), compared with the S&P 500’s forward PE of 17.8. Since then, despite good growth in the FTSE 100’s earnings, its forward PE has fallen to 13.4. The S&P 500’s forward PE has meanwhile been fairly steady, and recently it was at 17.4, especially as technology giants like Amazon have prospered. This has widened the discount that UK shares trade on to 22% (figure 7).
Figure 7: Relative attraction
The average price-earnings ratio of companies in the FTSE 100 has been falling steadily relative to the S&P 500 since the Brexit referendum.
Source: Datastream and Rathbones.
Another good valuation measure is what is called projected free cash flow yield, which takes the amount of cash flow a business produces for its shareholders and divides it by the value of its shares. On this measure, the FTSE 100 has also become more attractive — rising from 4.8% at the time of the referendum to 6.6% today. Having been 4% less attractive than the S&P 500, it is now 28% more attractive.
Even if we adjust for the S&P 500’s skew toward faster-growth and higher-valued technology shares, the FTSE 100 still looks relatively cheap. And this is true across sectors: in personal care and household goods, Unilever trades on a forward PE of 17.7 versus US peer Colgate-Palmolive on 21.3, and in energy Royal Dutch Shell is on 13 compared to 16.2 for US rival ExxonMobil.
The UK was already less expensive on some measures prior to the referendum, and has now become even cheaper to reflect uncertainty over Brexit. Overseas investors may also be put off by the prospect of hard-left UK government with Labour leader Jeremy Corbyn climbing in the polls (see our recent report Oh! Jeremy Corbyn).
If the UK exits the EU with no free-trade deal and there is a hit to trade and to economic growth overall, we think the adjustment mechanism will be the value of sterling. In this scenario, it would be very likely to fall. The FTSE 100 derives approximately 76% of its revenue (according to estimates by FTSE Russell) from outside the UK, so depreciation of sterling would boost foreign earners’ sterling profits and, therefore, their sterling share prices would improve.
The FTSE 100 looks cheap — but it is only attractive if we can be fairly sure its long-term investment returns will be good. Our research suggests that sterling is significantly undervalued versus other currencies, and we expect that over the long term it will normalise, which should boost long-term returns to global investors from sterling-denominated equities.
The FTSE 100 should also deliver decent long-term earnings growth. Significant weightings to energy, mining and consumer staples give it the best exposure among Western markets to higher growth regions of the world, chiefly Asian emerging markets. Even though the domestic economic outlook is currently uncertain, we continue to see UK equities, and in particular the more outward-looking FTSE 100 index, as reasonably attractive.