Value Perspective Quarterly Letter – Q3 2020
The UK equity market is unloved. New data from the Investment Association shows that retail investors have withdrawn almost £13 billion from UK equity funds over the 4 years from 2016 to end-June 2020. According to Morningstar, the Investment Association (IA) UK All Companies sector experienced another £1.3 billion of net outflows in August. Market commentators will tell you that this is a result of three headwinds: Brexit, the relatively severe impact of the pandemic on the UK, and the composition of the UK market with its high concentration of dividend-paying mega caps (most of which have now cut their dividends). Whatever the reason for millions of individual investors’ decisions, the outcome is evident.
On cyclically-adjusted valuation measures the UK is among the cheapest developed markets in the world. In absolute terms, the UK stock 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. On a relative basis, valuations for the UK are incredibly depressed. The UK currently trades on a 44% discount versus MSCI World across a blend of price-earning (p/e), dividend yield and price-to-book value. This compares with a long run median discount of 18%. Even within unloved Europe, the UK is shunned. The UK currently trades on a 28% discount versus MSCI Europe ex UK across a blend of p/e, dividend yield and price-to-book value. This compares with a long run median discount of just 3%.
So, UK equities are a contrarian investment today, but what about investment styles within this unloved market? Where are investors likely to benefit from the greatest future returns?
UK value is extremely depressed from a long run perspective with relative performance (vs growth) close to an all-time low on data back to 1975. Relative valuations for value continue to look extremely undemanding too. Across a blend of p/e, dividend yield and price-to-book value, UK value trades close to an all-time valuation low relative to growth.
As value investors these statistics make for difficult reading. There is no doubt that we have been humbled by the value style’s deep and protracted period of underperformance. It has been extremely painful, both professionally and personally. On the other hand, however, these data mean there is a once-in-a-generation opportunity for value investors in the UK today. History suggests that investors in UK value funds stand to make stellar returns, in both absolute and relative terms, over the coming decade.
A focus on company fundamentals will be rewarded in the long term
We look for companies that are generating cash-flows, and those with the potential to grow those cash-flows over time. We take comfort in the fact that operationally, value stocks are performing as expected. These stocks, however, are not being re-rated as much as they usually would be. The chart below shows the total return of the UK stock market over the past decade and the returns of value and growth broken down into dividend yield, earnings growth and valuation change.
If we focus on the most recent period, from 2016 to 2019, we can see that value has de-rated despite superior contributions from dividend yield and earnings. The longer the market doesn’t reward operational improvement, the more outperformance is being stored-up for the future.
In previous letters we have referred to this as the metaphorical elastic band. It stretches between market valuations and their long-term average, between value stocks and their growth counterparts, and fundamentals and valuations. The further it stretches, the greater the opportunity. The long-term opportunity for patient value investors in the UK today is enormous.
As the saying goes, “you make most of your money in a bear market, you just don’t realise it at the time.”
A focus on income
The market falls that followed the global spread of the Covid-19 pandemic have thrown up some particular challenges for income-focused investors.
We wrote at length about dividends in our last quarterly report, and have set out to provide regular communication on UK dividends given their importance and the unfolding situation. Calculating dividends themselves can be a surprisingly contentious issue. Should you factor in special payments? No? Well, what about those ‘specials’ that are paid at the same level year after year? And what period do you use for your calculations? The ex-dividend date or pay date? And what exchange rate do you use to translate, say, dollar or euro dividends? That alone can be a significant consideration for UK investors.
In short, there are many, many ways to calculate dividends, but one thing that we touched on in our last quarterly report that is not contentious is that no matter how you do the maths, 2020 is going to see a very large cut in the UK market dividend.
What we know for sure is this cut will be impossible for professional investors to offset without ‘pushing the envelope’ and skewing portfolios in an unacceptable way. Indeed, as we wrote last quarter, the Investment Association has explicitly recognised this by relaxing the constraints on UK equity income funds to ensure end-investors are not negatively impacted by desperate attempts to chase yield in the few areas that have maintained their dividends.
At the end of June, we said that forecasts as to exactly how this is going to play out within the UK market are hard, but was no doubt companies themselves have been struggling to decide on an appropriate plan of action. Many UK businesses have a December year-end, which means the end of June saw them finish their half-year. There had been little in the way of clarity on the economic impact of Covid-19 and businesses are desperate not to look foolish by paying a dividend only to discover they need the cash they have just paid out. That said, they currently have the cash and they want to pay a dividend, which goes some way to explaining the wide variations in 2020 estimates of a cut to market dividends of anything between 30% and 50%.
As we write this in late September, having worked our way through companies’ half-year reports over the summer months, it is clear that that market-wide dividend cut is likely to be towards the upper end of that range.
While we are working hard to offset the inevitable decline in dividends for our clients, outperforming that decline will be extremely difficult – especially given the concentration of value within the UK stock market and our unwillingness to sacrifice that value exposure. More positively, the level of yield currently available from the UK market remains reasonably attractive – particularly versus other asset classes and geographies – and, as companies rapidly return to the dividend register, growth from the new base should be significant.
Why Schroders for income?
The current picture is far from rosy, but as fund managers we have faced severe reductions in income from the UK stock market before, in the aftermath of the 2008/09 financial crisis. Back then we made the very difficult decision to cut the fund’s pay out.
We are acutely aware of the consequences of this, as many retirees and investors rely on equity income to cover their costs of living. While the cut in the fund’s distribution was disappointing, the compound growth of 9% per annum over the subsequent decade led to the highest all-time pay-out from the fund. Moreover, that growth means that the inevitable cut this year will re-base the fund’s dividend at a level that will still be high in the context of the fund’s long-term history. Importantly for our unit holders, it should provide a solid base upon which to build and grow the fund’s distribution over the next three to five years.
The Value Perspective team
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.
This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.