As UK equity investors we often allude to the attractions of the UK equity market for long term investors. The universe is well represented by many market leading global companies spread across many different industries, meaning that investors can gain exposure to a broad range of themes, and outcomes are certainly not dictated by the UK economy. Meanwhile, high standards of corporate governance, strong accounting standards and consistent rule of law makes the UK a natural choice for investors looking for transparency into the Environmental, Social and Governance approaches of the companies that they are investing in. UK companies have also historically been early adopters of positive ESG practices, therefore as sustainability factors continue to grow in importance, the UK equity market should see further interest from investors. Despite the key attractions discussed above, the UK market has certainly faced its fair share of challenges over recent years, and has underperformed global equity markets more broadly. But we believe that now could be the time for investors to seriously consider the opportunity offered by the UK.
Why now? Firstly let’s look at Brexit… Quite possibly the greatest headwind to UK equities in recent years. Uncertainty around the UK’s future relationship with the EU has seen high levels of pessimism towards UK equities and global investors have continued to shun the asset class, resulting in the market being unloved, under owned and undervalued, with the UK market trading at a 45% discount to global equities. However, on 24 December 2020, investors were delivered the early Christmas present that we had all been waiting for… a Brexit trade deal! This we believe lifts the huge cloud that has been hanging over the UK market for the last 4 years, removing the Brexit ‘no deal’ risk premium attached to UK equities. While the deal covers the goods-trade only, clarity around Brexit is far more important than the actual terms, and this could see money once again flow into the UK as investors reappraise the value of UK plc, with a rising tide lifting all boats. Furthermore, there are many global, market leading businesses listed in London that are trading at a significant discount to globally listed peers for no other reason than the fact that they are listed in the UK. Ferguson, distributor of plumbing and heating products, for example has rerated by c.15% in 2020, while its US peers have re-rated by more than 30%, despite the US market accounting for more than 80% of Ferguson’s revenue during the year. This is one of many examples of opportunities that have been created for investors looking at the UK in recent years, and one thing that we are sure of is that these opportunities won’t last forever. While UK equities remain widely unloved and undervalued relative to history and other asset classes, the recent pickup in inbound M&A activity from overseas investors confirms that there are buyers willing to take advantage of such opportunities.
In addition to the positives a Brexit deal provides for investors in the UK market, it also provides clarity for corporates. We see potential for more UK businesses to accelerate investment now that they have clarity over the new rules of engagement, which many have been waiting for. Differentiated companies investing in their businesses should lead to higher UK corporate profit growth.
While Brexit has been a great headwind for the UK market, we must not forget the impact that Covid-19 has also had on this asset class. The UK stock market has a higher proportion of consumer and leisure facing companies than most markets, which have been most negatively affected by the Covid related restrictions and this has disproportionately impacted the UK stock market. However, even if lockdowns persist, companies are already innovating to find workarounds – such as increased investment in digital processes or simply adapting employee practices to meet social distancing requirements. Meanwhile the UK is leading the charge on rolling out its vaccine programme, which provides light at the end of the tunnel for policymakers, households and companies. Therefore, the UK could see a faster return to normality and importantly this would pave the way for companies to grow profits again. Over the mid to long term we think there is a fantastic opportunity for investors in UK equities, with risk to the upside. We expect interest in the market to increase as political uncertainty reduces, businesses return to a new normal and investors look to capitalise on the attractive valuations offered in this market.
Along with the opportunity for strong returns, the dividend outlook of the UK market also looks encouraging. Whilst the coronavirus pandemic has meant that we have saw a swathe of dividend cuts last year with an estimated 50% cut to the FTSE All Share, going forward we view the dividend outlook for the UK market with renewed optimism. We expect dividends, in aggregate, to be more resilient and to grow faster in the future. We have long believed that dividend payouts in parts of the UK equity market were unsustainable. We expect the majority of the dividend cuts inflicted by this crisis to be temporary, however some businesses will use this crisis as an opportunity to reset dividend policies for the long-term. This means that whilst overall market dividends are likely to be lower, they will be more sustainable, with higher growth in the future and gives us confidence that UK equities offer an attractive source of yield in an income-starved global context.
While we are positive on the outlook for the UK market as a whole, we are also strongly of the opinion that this is a market, and now is the time, when it pays to be active. Despite the factors discussed above that we feel will provide an attractive backdrop for the UK market, there are a number of companies which make up a large proportion of the market, which operate in industries facing long-term structural challenges, for example Banks, Oil & Gas, Tobacco and Telecomms. While many of these companies might screen as ‘value’ on a P/E ratio, the fundamentals of the businesses tell a different story. Whether it is the prospect of lower for longer interest rates impacting the earnings of banks, the uncertain path to transition away from oil production to a carbon free future for the oil majors, or the emergence of an alternative to traditional cigarettes for the tobacco industry, these long-term challenges are severely impacting the outlook for profits and cashflows of these businesses. Therefore, the ability of active managers to avoid these challenged areas of the market can significantly improve investor returns over the long term. Outside of these large “zombie” companies, the UK market is home to many exciting, market leading businesses, with defendable competitive advantages, and long-runways of growth ahead of them. Auto Trader, Rightmove, Spirax-Sarco, Hargreaves Lansdown, and Next, to name a few, have delivered impressive compound earnings growth over a number of years and seen their share prices multiply over that time. The market serially undervalues both the magnitude and the duration of this type of long-term, sustainable growth, and as active investors we have the unique opportunity to exploit this opportunity for our clients.
Please note that this article has been submitted by representations of BlackRock, and does not necessarily reflect the views of Embark Group.
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