Why you should consider a contrarian play within a contrarian play

In the school playground of global markets, UK equities can be found sitting forlorn and friendless at one end of a seesaw. According to Investment Association numbers, retail investors withdrew almost £13bn from UK equity funds over the four years to the end of June 2020. Morningstar data meanwhile tells us the UK All Companies grouping of funds experienced a further £1.3bn of net outflows in August alone.

You do not have to think too hard to find reasons why UK equities might be so unloved. The uncertainty of Brexit has been compounded by the relatively severe impact of the pandemic on the UK. A further headwind is the composition of the UK market, with its high concentration of dividend-paying larger companies – most of which have now cut their dividends, as we flagged in An inevitable side-effect of Covid-19.

Whatever the reason for millions of individual investors’ decisions, however, the outcome is plain. On cyclically-adjusted valuation measures, the UK is among the cheapest developed markets in the world. In absolute terms, the UK market is now trading at a valuation that is significantly cheaper than the average since 1980, and in line with its very long-term history.

Depressed valuations

On a relative basis, meanwhile, valuations for the UK are incredibly depressed. It currently trades on a 44% discount versus the MSCI World index across a blend of price-earnings, dividend yield and price-to-book value – versus a long-run median discount of 18%. Even within unloved Europe, the UK is shunned: the same metric reveals a 28% discount versus the MSCI Europe ex UK index, compared with just 3% in the long run.

Clearly UK equities are quite the contrarian play so far as most investors are concerned – and, within UK equities, most investors feel similarly about value. As the following chart shows, UK value is extremely depressed from a long run perspective with performance relative to growth now close to an all-time low on data going all the way back to 1975.

Relative valuations for value continue to look extremely undemanding too. Across a blend of price-earnings, dividend yield and price-to-book value, UK value trades close to an all-time valuation low, again relative to growth. As value investors, here on The Value Perspective, these statistics make for difficult reading and there is no doubt we have been humbled by the style’s deep and protracted period of underperformance.

Not to put too fine a point on it, the experience has been extremely painful – both professionally and personally. And yet, looked at the other way, this same data also indicates a once-in-a-generation opportunity for value investors in the UK today. History suggests investors in UK value funds stand to make stellar returns – in both absolute and relative terms – over the coming decade.

Cashflow generation

As we aim to take full advantage of that on behalf of our investors, we will continue to seek out companies that are generating cashflows, and those with the potential to grow those cashflows over time. We do take comfort in the fact that, operationally, value stocks are performing as expected. The trouble is, they are not being re-rated as much as they usually would be.

Our next chart shows the total return of the UK stockmarket over the past decade, as well as the returns of value and growth broken down into the core constituents of dividend yield, earnings growth and valuation change. Focusing in on the most recent period – from 2016 to 2019 – you can see value has de-rated despite superior contributions from dividend yield and earnings.

And yet, the longer the market declines to reward operational improvement, the greater the outperformance being stored up for the future. In articles such as Risks the market is ignoring – Valuation risk, we have referred to a metaphorical elastic band that stretches between market valuations and their long-term average, between value stocks and their growth counterparts, and between fundamentals and valuations.

The further it stretches, the greater the opportunity – and the long-term opportunity for patient value investors in the UK today really is enormous. This is what underpins a favourite adage we have noted already this year in Why an indiscriminate sell-off means opportunity for discerning investors and Five rules for navigating a market crisis: “You make most of your money in a bear market, you just do not realise it at the time.”