Value Perspective Quarterly Letter – Q2 2023 – UK

Our quarterly note covering the UK market

20/07/2023
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Authors

The Value Perspective team

“The worst course an investor can take is to follow the prevailing sentiment about economic activity. The reason is that it will lead the investor to buy at high prices when times are good, and everyone is optimistic and sell at the low when the recessions near its trough and pessimism prevails.” Jeremy Siegel

UK Equities: Cheap (and getting cheaper)

The UK equity market has been cheap for some time. And it’s getting cheaper. Here are a few statistics:

  • On a median 12-month forward P/E basis, FTSE 350 trades close to one standard deviation below its long-run average.
  • More than 10% of FTSE 350 stocks trade with a dividend yield higher than their P/E; this has been a buy signal for UK equities in the last 20 years.
  • UK equities trade at a c.30% discount to global equities, and have not been this cheap in 30 years. Relative to the US, the UK is historically cheap on a broad range of valuation metrics.
  • The valuation of UK equities and UK credit in the context of 33 broad asset classes dating back over the last 20 years (see chart 1).

Chart 1 - UK valuations vs. peers

Chart 1 - UK valuations vs. peers

Source: Morgan Stanley

We could go on …

While historical valuation comparisons for equity indices are by no means perfect, whichever way you look at it there is a strong case to be made that the UK stock market is cheap today. The gloomy sentiment reflected in valuations is also reflected in fund flows. So far, so depressing.

So the question is, is the market, and are fund investors, right? Is the UK cheap for a reason?

The bad news is the market appears to be increasingly concerned about runaway inflation, and the Bank of England needing to break the economy to bring inflation under control. The good news though, is this is already priced in.

What about underlying corporate health?

Investors are rightly concerned about earnings in the near-term and they should be; companies are going through tougher times. However, in most cases these businesses are well prepared. Aggregate surplus free-cash-flow yields for UK companies are towards the top of their post-GFC range and corporate balance sheets are generally robust.

As active stock pickers, we sincerely hope that we can do better than the market average. The average health of companies in the portfolio is higher than the market average.

The stress tests that we put all businesses in the portfolio through, which of course includes the retailers, housebuilders, and other cyclical companies added to the portfolio last year, are far more severe that what companies are going through today. Stress testing balance sheets for recessions is core part of our investment process; it’s where we stare into the abyss and ask, what would it take to break this business?  Balance sheet strength combined with low valuations is vital to limiting the longer-term impact on portfolios if the global economy does head south. We are comfortable that the companies we own, while not immune to the effects of an economic rout (if indeed one comes), are well placed to weather the a storm, allowing us to profit from future recovery. We believe there is positive time arbitrage in many of the cyclicals we hold and we believe patience (and some bravery in buying more when attractive opportunities present themselves) will be handsomely rewarded.

Good operational performance isn’t being reflected in share prices … yet

If there is a source of short-term frustration, it is that the UK market remains ignored by investors (see chart 1, again). Even when companies do well (beating consensus estimates) their share prices are not moving significantly. 150 years of stock market history tells us that this cannot last forever, and that undervaluation is the only reliable catalyst for outperformance in the long-run. We are confident that our focus on cheap stocks (within a cheap market) and minimising fundamental risks will be rewarded with significant outperformance. Counterintuitively, the pervading malaise gives us confidence that the risk/reward equation is favourable for patient long-term investors such as ourselves.

Value’s lost decade was all about interest rates … or was it?

The most common argument for value’s underperformance prior to the global pandemic was low interest rates. We would concede there is an undeniable kernel of truth to the idea lower discount rates theoretically justify a higher spread between the multiples you can justifiably apply to low growth and high growth businesses. Anyone can build a simple Discounted-Cash-Flow model and illustrate why that maths works.

So after the pandemic had past, inflation returned, rates were rising and Value started to outperform Growth. Markets had stuck to the script. But no longer. In 2023 this relationship has broken down, spectacularly. Interest rates have continued to rise but value has performed poorly. In the first half of the year Growth has outperformed Value by an incredible margin in all developed markets. MSCI World is up 15.1%. Growth is up 27.1% and Value is up just 4%. A 23% performance delta between Growth and Value in a 6 month period!

While all irrational market bubbles start with a kernel of truth, the recent evidence blows a sizable hole in the argument that the direction of interest rates and the fortunes of value strategies inextricably linked, or indeed, strongly correlated.

To explore this further, let’s assume central banks are making a policy mistake and rates can’t sustainably return to pre-GFC levels ever. Does that mean value will underperform forever? We don’t think so – because even permanently low interest rates should only really have a one-time impact on valuations; i.e. once you’ve adjusted your valuation model / cost of capital to account for cost of debt being stuck on the floor into perpetuity, that dynamic can be fully reflected in the fair value you apply to shares. At that point, rock bottom rates are fully discounted in market prices. Low interest rates might move the goal posts on the kind of multiples one might be willing to apply to businesses vs. history, but it doesn’t justify a belief that fundamental valuation as a concept no longer applies. Permanently low rates therefore can’t be a logical argument for perpetual growth outperformance of value shares.

Chart 2 shows UK 2-year bond yields and the performance of value versus the market. On the right-hand side you can see the 2 lines diverge meaningfully. Bond yields head north while value heads south. Perhaps most importantly of all, history shows that the link between value returns and changes in bond yields is unstable at best; drawing conclusions about the fate of value based on interest rate forecasts is best avoided.

CHART 2

CHART 2

Source: Source: SG Cross Asset Research/SG Quant Data

Banks, again …

We discussed  banks at some length in last quarter’s letter following the turmoil in the US regional banking sector and the collapse of Credit Suisse. The market seems to have moved on, but three months later banks are back in the limelight as concerns of higher interest rates and the potential impact on loans (particularly mortgages) worries investors.

Before heading into the detail, there are two things to mention:

  1. After years and years of complaints that banks are un-investable because of low interest rates, it is amazing how quickly the narrative has swung to banks being un-investable because of high interest rates!

 

  1. the key risk for banks and why we spend a great deal of time focused on asset quality and strength of capital ratios. This should not be a new or unexpected risk to anyone.

The headline-grabbing commentary around rising mortgage rates is certainly alarming. Those people rolling off fixed-rate mortgages today and reverting to a variable rate will see a marked increase in monthly payments – sometimes a rise of up to 300%. With inflation to be found in most corners of the economy, from groceries, to transport to childcare, headline writers can revel in some scary statistics. However, when we look at the data behind the headlines, it tends to paint a less alarming picture.

A surprisingly low number – just one third – of households have a mortgage, and those households tend to have a higher than average household income (in excess of £85k per year) and therefore are more able to absorb higher interest rates. When breaking down the household income for those households with mortgages, mortgage payments make up 10% of gross income on average, and of the remaining expenditure there is sufficient room to absorb the higher payments (albeit with a squeeze on disposable income). Moreover, half of all mortgages are fixed over five years. This means there is not a cliff-edge; the rise in interest rates will be felt gradually over time, and in fact a third of all mortgages have already repriced to higher rates. Lastly, whilst mortgage payments are undoubtedly increasing, energy bills have started to decline as wholesale energy prices subside; for the average household, these factors largely offset each other. In terms of asset risk, average loan-to-values are lower today than they were going into the financial crisis, so there is room to absorb lower house prices without households going into negative equity (approximately 5% of mortgages have a loan-to-value above 90% today). This combination of factors doesn’t make the situation go away, nor does it overlook that some households will suffer a significant squeeze on their disposable incomes, while there will inevitably be some individual examples of people forced to sell their properties. However, we focus on numbers, not the narrative, and the numbers paint a far less negative picture than the headlines.

The key question for us as investors is, are we being compensated for taking on these risks by sufficient upside to a conservative estimate of fair value?  We believe we are. P/E multiples remain in the mid-single digit range across the sector, and most banks trade at a discount to their tangible book value. And these attractive valuations are in spite of the marked improvements in capital ratios, profitability, dividend pay-outs, and share buybacks.

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Authors

The Value Perspective team

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