UK equities: and now for something completely different

UK equities have been out of favour for many years. Underperformance relative to global markets – whether coincidentally or not - started around the time of the Brexit referendum in 2016. There was a partial rebound in 2022, however this has faded somewhat in 2023 as a result of euphoria around a narrow cohort of US tech stocks, spurred on by a frenzy around Artificial Intelligence.

Although UK equities have long been overlooked, we argue that the asset class should not be ignored – not by UK, nor by international asset allocators. It offers something that is as different as it is attractive. And both these qualities are important

The Invesco UK Opportunities Fund (UK) and Invesco UK Equity Fund stand out among their peer groups. The funds have been consistently managed as large-cap, core value funds. The strategy has shown an ability to add value to investors, even in challenging markets. Over the past ten years, against a tough backdrop for ‘Value’, the funds have still outperformed the FTSE All-Share Index as a result of strong stock selection.
 

Background – Value at the point of purchase really does matter

Since the time of the GFC, ‘Growth’ has been the dominant style in global equities, fuelled by loose monetary policy, against a backdrop of low inflation. 

But by historical standards these have not been ‘normal’ conditions.

Figure 2. below illustrates almost 100 years of performance in the US, of stocks valued in the lowest quintile, compared to those in the highest.  The dominance of ‘Expensive’ since the GFC mirrors the recent dominance of ‘Growth’ in the UK. But the lesson from history is clear: in the long run, value at the point of purchase really does matter. 

We believe that the next 10 years in markets will look very different to the past 10 years, characterised by (on average) higher inflation and higher interest rates than we have experienced since the GFC. In such an environment, nominal earnings growth will become less special, and the consequent increased cost-of-capital will weigh more on the present value of growth in outer years of projections. The obverse is also true – cash generated today will be increasingly important compared to the hopes of reward tomorrow. Focus on valuation at the point of purchase will re-assert itself as a key discipline.

We don’t expect that Value will out-perform Growth all the time. There will be volatility on the way. But we believe that Value will outperform more often than not.  

At the very least, in a world in which US 10-year yields are 4.0% (1 August 2023) - not high relative to a 50-year average of 6.0%, but fundamentally changed from the average of 2.3% over the past 3 years - why would you now not want at least some exposure to Value as a factor?  

An environment that is different, calls for exposure to something that is different.

UK Equities offer exposure to the Value factor through a very different mix of companies, that are in many cases lowly valued relative to their global peers.

Quite how different the mix of companies is, is illustrated in Figure 3 below.

The chart compares the weightings of each of the major sectors in the S&P 500, the MSCI Europe ex-UK Index and the FTSE All-Share Index, along with weightings in the Invesco UK Opportunities Fund (UK).

After an extended period in which Growth has been the dominant factor driving equity markets, there is now a significant skew in the sector weighting of the S&P 500 to the Technology sector. Almost 1/3^rd of the entire index is comprised of Tech stocks, which are valued (across a range of measures) at over 2x standard deviations above their 20-year sector average. We make no judgement other than to observe that this is consistent with the concentration of absolute risk in the S&P Index.

The sector weights mapped for the MSCI Europe ex-UK Index, show there to be more moderate exposure in Europe to Tech, but otherwise display a similar shape of sector exposures to the S&P 500.

The overall shape of the FTSE All-Share Index is however very different. There is minimal exposure to Tech, but greater exposure to Consumer Staples, Energy, Basic Materials and Financials. The Invesco UK Opportunities Fund (UK) offers still greater exposure to global Energy, to large cap Consumer Staples, and to diverse stock specific drivers among cash generative Utilities.

So much for structure. The correlation data in Figure 4 quantifies how this translates in terms of actual performance.

It is evident from the data that total returns from the FTSE All-share are less correlated with the S&P 500 and MSCI Japan, than is the MSCI Europe ex-UK. For an asset allocator with significant equity exposure to the US, the UK therefore offers greater diversification than does Europe. 

The Invesco UK Opportunities Fund has a particularly low correlation with the S&P 500 and MSCI Japan: it offers something completely different. Furthermore, the Fund has significantly outperformed each of the indices over the 3-year period, at notably lower levels of volatility (i.e. realised risk) than US, Europe, Japan or China based indices.¹

A concern of some is that the UK equity market might be a small pool in which to fish. The MSCI World Index is indeed dominated by US companies which comprise 72.7% of the Index, but of the remaining countries, the size of the UK at 4.0% is second only to Japan (6.1%) and is significantly larger than either France (3.4%) or Germany (2.4%). The size of the UK market provides both breadth and liquidity in many world class companies listed in the UK that are global in their activities. The FTSE All-Share Index is not the same as the UK economy. Less than ¼ of the revenues of the FTSE All share index are derived from the UK. There are more revenues in the Index derived in US-dollars than in Sterling.
 

Back to Valuation

When analysing the current valuation of UK equities we have used a returns adjusted valuation model.  Our model has helped us assess whether UK equities are offering fair value by:

• Showing how price-to-book has varied with returns, globally, over a 20-year history, and
• Comparing the latest price, against the ‘fair value’ implied by the model, given latest forecasts.

The model implies that there is a much as 27% upside to the current valuation of UK Equities and by contrast, the S&P 500 is now trading at a 22% premium to its own implied valuation, despite negative revision to earnings since the beginning of 2022 (full chart of this model is available in the pdf version of this article).

The difference in the implied valuation premium / discount represents a returns-adjusted valuation differential, illustrated in the chart below.

Over the past 20 years, the average valuation differential has been 20%. So even returning to the median (and not to fair value equivalence, last seen around the time of the EU Referendum in June 2016) implies significant valuation upside potential.

The exponential shape of the fair value frontier in our returns adjusted valuation model (Figure 5) implicitly recognises the value of higher returns being reinvested for higher growth in earnings. It recognises that the prospect of higher growth in earnings merits a higher PE multiple.

But here again the ‘quality’ of earnings growth in the US is perhaps not all that it might seem.

Post tax returns are affected by tax policy, and whilst change in policy does translate over time into cash, the rate of change in earnings due to tax policy is not sustainable. Earnings growth due to tax policy should therefore not merit an increased multiple.

Figure 6 illustrates how the effective rate of taxation borne by companies listed in different jurisdictions, has changed from the pre-pandemic era to the post-pandemic era.

The analysis shows the effect of taxation policy response, in the wake of the pandemic, has been to increase the burden of tax on UK listed companies, bringing the effective tax rate more into line with European levels, but at the cost of reducing earnings. By contrast, effective tax rates have fallen in the US and China, providing a boost to corporate earnings.

Analysis of consensus earnings expectations shows that the annualised growth in EPS in the US is expected to be 9.5% over the 8-year period, compared to 5.5% in UK. However, half of this EPS growth differential is explained by taxation, and the underlying difference in rate of growth in pre-tax income less than 2%.

Against this backdrop, earnings multiples have in the US expanded from 16.8x consensus expectations for the next 12 months (in January 2017) to 19.6x (31 July 2023). By contrast in the UK, they have contracted from 14.3x to 11.0x, over the same period.

This seems both anomalous and excessive.
 

Risks to equity returns

From a top-down perspective, there are a number of macro factors at play that we believe will continue to challenge global equities over the medium term.

We believe inflation is likely to remain stronger for longer in developed markets. In some cases, central bank models of how inflationary pressures are transmitted through the economic system have also been proven to be out of touch. The precise mix in the inflationary cocktail varies from market to market. But it remains potent whatever form.

With inflation set to remain higher for longer, we also expect interest rates to remain higher for longer. Such is the likely persistence of inflation, we have become increasingly concerned at the possibility of policy error by central banks.

Added into the mix, we sense there is a degree of complacency in energy markets. These muddled through last winter through a combination of mild weather, reduced economic activity in China (still largely shut because of Covid), and a physical and financial destocking of oil (especially, of strategic petroleum reserves).

As we look out to the rest of the year and beyond, we are not calling for a recession in any particular market, but the risks of a slowdown of GDP in national economies and of earnings momentum in individual businesses are there to see.

Despite the caution engendered by macro views, we remain optimistic at the medium to long-term outlook for UK equities, particularly on a relative basis.

The bottom line is that UK equities are an attractive source of value. The opportunity set includes many world-class, internationally orientated companies with good earnings momentum. They are undervalued versus their own history and versus the US, and sterling is undervalued too.

UK equities are also an attractive source of real income. Higher inflation and volatility are both likely to continue, but dividends should keep pace with inflation over time. Equity income will be attractive in challenging markets.

Attractive, different, … and available through Invesco Funds which form a consistently managed large-cap, core-value strategy, that has demonstrated an ability to add value to investors over the long term, even in challenging markets.