This article was taken from the
August issue of Market Insight. To subscribe to our investment publications, please visit
www.redmayne.co.uk/publications.
It would be fair to say that the UK stock market has faced its fair share of challenges over recent years. Economic fragility, political turbulence, and market volatility have cast shadows over the landscape of UK equities. Consequently, domestic institutional investors have chosen to reduce their exposure to this segment of the market, seeking more promising growth opportunities with less political and economic volatility on foreign shores. This shift in investor sentiment over a prolonged period has triggered significant outflows from UK companies, exerting influence on liquidity, share price performance, and company valuations. Given the scale of migration away from British companies, the door of opportunity looks evermore enticing for value-seeking investors looking for a bargain as the UK trades on its most significant valuation discount to global peers in over a decade. Highlighting sentiment, valuations, and buyback activity as three key areas to watch over the next year could provide some insight into how UK companies might come back into favour over the long term.
Firstly, it is important to understand why UK companies have been so out of favour in recent years. The uncertainty which followed Britain’s decision by referendum to leave the European Union in 2016 cast a long and dark shadow over UK businesses. The prolonged negotiations, coupled with the threat of a “no-deal” scenario, left investors anxious about the potential disruptions to trade, supply chains, and access to the vast European market. This uncertainty led many investors to reduce their exposure to UK assets and seek less volatile investment destinations overseas. Political instability has further exacerbated the gloomy sentiment with four different prime ministers at the helm since 2016. This revolving door of leadership has hindered the government’s ability to provide clear and consistent economic policies. Most notably, this was seen through September 2022’s mini budget as ‘Trussonomic’ theory created chaos within financial markets with equities, real assets and bonds all falling considerably. Of course, these events have been reflected in real investment behaviour for some time now, but investors are still waiting to see a material change in the UK economy before reconsidering their strategic UK equity allocations.
As sentiment continues to sour around UK stocks, the value of companies listed on the London Stock Exchange (LSE) has also faced a sustained downturn. Historically, the United Kingdom has maintained an average valuation discount of approximately 18% compared to its global peers. However, at the start of 2023, this discount had widened significantly, hitting 40%. This notable disparity underscores that UK companies are presently trading at their most attractive price levels in over a decade. While this deep discount may suggest a bearish outlook, it’s essential to examine the factors contributing to this situation, including misconceptions regarding the international exposure of these companies. Many investors often mistake UK companies for being domestic-focused in terms of their revenue sources and are thus vulnerable to domestic economic downturns. Contrary to this belief, the reality is quite different. Approximately 75% of the revenues generated by companies listed on the LSE originate from international markets, positioning them as truly global players in the business world.
Take Unilever, for instance. While it is a UK-listed company, only 4% of its total revenue is generated domestically. The remaining 96% comes from a diverse range of markets including the United States, Asia, Europe, and various emerging markets. Although this international revenue diversification better insulates companies like Unilever from the potential adverse effects of a recession in the UK, the company has still been tarred with the same brush as the wider market. By using the price-to-earnings multiple as a way of valuing the company, measuring its current share price relative to its earnings per share (EPS), it is quite apparent to see a drop in the company’s value since 2016. In fact, Unilever is currently trading at a valuation approximately eight times cheaper than in 2016. This striking divergence between performance and valuation underscores the profound impact that weak sentiment has had on company valuations in the UK market.
Beyond the compelling valuation discount, there are other factors contributing to why UK equities are potentially being overlooked by equity investors. Notably, the prevalence of share buybacks. This strategy involves companies repurchasing their own shares from the market and, assuming that it is done correctly, it will improve shareholder value. This is because, as the share count decreases, the value of shareholder ownership rises, leading to an improved earnings per share and dividends per share (DPS) value. In many cases, a business will do this is if they believe the market has discounted their shares too steeply, suggesting that they are currently undervalued, and inferring that the management team have confidence in the business over the long run.
In recent years, UK companies have embarked on a spree of equity retirements. The numbers speak volumes, with over £51bn allocated to share repurchases in 2022 alone, translating to a noteworthy buyback yield of nearly 3% on the FTSE 100 index. More recently, this summer’s earnings season featured over seven major buyback announcements, primarily within the banking sector as these companies are beneficiaries of a higher rate environment. Although concerns similar to those impacting US regional banks spread into the UK economy, a closer examination reveals that the quality of British bank loan books, their diversified client base, and better source of funding would suggest that the issues seen in the US don’t necessarily read across to the UK. In response, many banks opted to repurchase their own shares, signalling their belief that the market had undervalued their stock. NatWest Group, for instance, announced a £500m share buyback program, while HSBC unveiled a $2bn return to shareholders through its buyback scheme.
The power of buybacks, when executed effectively, could be massive. Beyond the immediate impact of reducing outstanding shares and boosting metrics like earnings per share and dividends per share in the short term, it also possesses the remarkable ability to compound returns over the long term. Through a combination of increased ownership stakes, higher stock prices, reinvestment opportunities, and potential dividend growth, the power of compounding share buyback returns can deliver substantial benefits to both companies and their investors. Given the extent of buybacks we are currently seeing, it is quite apparent that many UK companies are realising how undervalued their equity is currently trading at, raising questions around whether investors should be reading from the same book.
Of course, not every UK company is a long-term bargain. Some companies appear to be value traps, meaning that while the companies look like a value opportunity, the discounts they trade at continue to widen over time with no real upside. However, there is potential for investors who can identify companies currently out of favour, but with the potential to generate robust free cash flows in the future. While it may seem like things could deteriorate before improving, as long as these companies maintain strong and growing returns while managing their debt levels, investors who see the current discount as an opportunity for long-term gains may be well-positioned to reap returns when market sentiment eventually improves.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.