How the UK now offers attractive options for discerning investors

Some parts of the UK market may be bouncing back to their pre-pandemic valuations but other sectors are now genuinely cheap, offering selective investors the potential for significant increases

28/07/2020

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

In 2020 vision – Part 1, we took the unusual step of running a macroeconomic chart, which showed how current GDP forecasts indicate 2020 will be the worst year for the global economy since the 1930s. The key word there, though, is ‘forecasts’ – in reality, here on The Value Perspective, we have no idea what is going to happen to GDP nor what shape any recovery will take. Then again, nobody else does either.

How then should investors look to get a handle on the market opportunity that faces them today? We made a similar tongue-in-cheek point in The long-term opportunity for patient value investors but, as of the start of this year, the UK market stood at a higher level than it has in 99% of all months since Crazy Horse beat General Custer’s 7th Cavalry at the Battle of Little Bighorn in 1876.

This is a deliberately silly way to make an important point: focusing on market levels is the wrong way to look at things. Inflation is such a powerful phenomenon that of course the market is going to be higher now than it was the best part of 150 years ago. Mind you, while we may have taken things to extremes here, comparing market levels over time – even over a five-year period – is a mistake we see lots of people make.

Intelligent alternative

Debating absolute levels – whether 7,000 or 7,500, say, represents ‘fair value’ – is not a sensible way to think about whether a market is attractive or not. A more intelligent alternative is to adjust for inflation and yet, as you can see from the following chart, that still put the UK market’s level in the 95th percentile as we came into 2020. Not quite as extreme as the unadjusted example, then, but hardly cause for celebration.

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An even better way to size up the opportunity now facing investors is to consider valuations. Here on The Value Perspective, our view on whether or not a market is attractive is predicated on the valuations of that market – and with good reason. From a purely statistical perspective, this has proved the best guide for patient investors as to a market’s direction.

Long-term average

As this year began, then, the UK market was trading at a premium to its long-term average – though in line with its post-1980s average, as you can see from the next chart. In other words, valuations in aggregate were OK – if nothing to get too excited about. When the pandemic hit, the market did not drop to 2009 levels but it did briefly trade in line with the long-term average. The bounce seen since then has closed half that gap.

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From here, history suggests market returns from the UK as a whole over the next three to five years ought to be decent – not to the extent you should mortgage your house but significantly better than may be expected from many asset classes. Here on The Value Perspective, however, we do not invest in the UK market as a whole but in good businesses with solid balance sheets and cheap valuations.

Low valuations

Much of the UK’s attraction as a market comes from its large weightings in miners, oil companies and banks, which are all trading on low valuations. To underline the point, take a look at the following chart, which shows the valuations of the different industry groupings within the UK market at three points in time: the trough of the financial crisis in 2009 (dark blue); the end of last year (green); and the end of May (light blue).

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As you can see, when the credit crunch was at its worst, valuation spreads were relatively compressed, with most sectors trading in a range of 10x to 15x on a cyclically adjusted price/earnings basis. In contrast, at the start of 2020, as the green bars show, intra-sector valuation dispersion was much higher, highlighting the opportunity set for valuation-based investors and naturally tilting us towards the left of the chart.

Following the market fall and rally in the first half of the year, the blue bars are where we are now. And while some parts of the UK market – most obviously technology – have not seen sufficient valuation change to make them attractive buying opportunities, in our view, other sectors are genuinely cheap and offer the potential for some very significant increases for patient long-term investors.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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