Perspective

Like Monty Python’s parrot, are UK equities dead or just resting?

Like many people, I have found myself down a few YouTube rabbit holes recently.

One of these ended up at the famous “dead parrot” sketch from the British comedy troupe Monty Python. In it, a customer debates with a pet shop owner whether or not his recently purchased “Norwegian blue” parrot is dead, or just resting.

I thought it seemed to have a lot of parallels with the UK equity market. Like the parrot, the UK stock market has shown few signs of life lately but can we claim it is resting and not dead? Let’s look at the evidence.

The Bank of America fund manager survey shows just how poor sentiment towards UK equities has been. Fund managers have had a net underweight to the region since 2014.

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In recent years that has been a fairly good call. A glance at the performance of the UK market relative to others over the last three and five years in particular would lead many to give up hope. 2020 was no exception, as the chart below shows.  

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But as investors, we know that the past is not necessarily an indicator of future performance.

So instead of looking back, let’s start to look forward.

The level of disinterest in UK equities has left the market trading at a c.40% discount to global equities, around a 30-year low.

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I don’t want to get dragged into a value vs growth debate, as I am fully aware that it is not the case that every stock with a low ‘price-to-earnings’ ratio is destined to outperform.

In the Prime UK Equity team here at Schroders, we are also not committed to any particular style. We are not ‘growth’ investors, nor ‘value’ investors. We spend our days looking for ‘mis-pricings’- stocks where the characteristics of a business are not reflected in the share price.

But this aggregate de-rating of the market has led to many mis-pricings across the sector and style spectrum.  

Let’s look at the opportunity and address a few of the misconceptions about UK equities.

Misconception 1: Even with a Brexit trade deal, the UK economy is worse off than before - so it can’t be an attractive place to invest.

Firstly, while economists and market strategists like to discuss stock markets as if they are economies, they are not. The below chart shows the long-term (lack of) correlation between the stock market and GDP growth.

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Why is this the case? Businesses listed on the UK stock market do not generate all of their revenues in the UK. In fact, over 70% of the sales from UK businesses come from overseas.

While the UK stock market does host some purely domestic businesses, it is much more heavily weighted towards international franchises that generate sales across the globe. `

Misconception 2: There’s no growth! All the businesses in the UK are old economy duds whose best days are behind them.

Are they? Excluding investment trusts there are over 400 companies in the FTSE All Share index. Can they really all be busted flushes?

Admittedly, some of the larger constituents of the market have been poorly performing, ‘value’ stocks, such as those in oil & gas, banking, tobacco and telecommunications. It is fair to say that these have weighed on the performance of the market overall in recent years.

But remember that active managers are not investing in the overall market. When we look beyond these large laggards, we find many global, market-leading businesses with good long-term growth potential, often trading at big discounts to their global peers.

Sometimes world leading tech giants are languishing in plain sight, masquerading as failing food retailers. Take Ocado. For years its investment in online grocery technology was dismissed as a valiant effort, doomed to eventually go up in a puff of cash-consuming smoke. But in June 2017, Amazon acquired Whole Foods, and the whole picture changed.

Suddenly, the food retail industry, which for years had dismissed the prospect of online food delivery, had to wake up to the realisation that it may not be a ‘fad’ after all. Cue a scrum of traditional food retailers around the world looking to catch up by licensing Ocado’s world-leading technology.

Instead of being viewed as a cash-guzzling project doomed to failure, Ocado now is viewed as a global leading online grocery technology business. And in share price terms, the rest is history.

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In addition, with the stock market constantly being refreshed through initial public offerings, new opportunities regularly present themselves. Given the cash that has been pouring into venture capital start-ups in the UK in the last few years, we are likely to see some of these list on the stock market as they mature.

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Recently there has been a healthy pipeline of businesses looking to list in the UK, many of them technology-enabled market leaders, such as Trainline, the world’s leading independent rail and coach digital travel platform. We have also seen Hut Group, Trustpilot, Moonpig, but also ‘old economy’ businesses thriving in the current economic conditions, such as Dr Martens.

Misconception 3: The UK is a sustainability pariah

The presence of large oil & gas and tobacco businesses can lead people looking for sustainable investments to write off the UK stock market. In fact, the UK’s expertise in science and engineering may actually position the market well in the development of some key sustainability themes.

The market is arguably underrated when it comes to environmental technology leaders. There is a great deal of investment being made today by UK PLCs that will contribute to hitting net zero targets.

The below map looks at just a few of the renewable energy projects going on in the UK, and illustrates the contribution UK-listed businesses are making to these.

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Source: Schroders, March 2021

Crucial to the ZeroCarbon Humber project is carbon capture and storage technology from Drax. Similarly, HyNet North West relies on Johnson Matthey’s expertise in hydrogen and the Oxford Energy Superhub is deploying vanadium redox flow batteries from Invinity Energy Systems.

More generally, the climate in Scotland positions it well as a source of onshore wind energy. This creates opportunities for companies in this value chain to construct, own and operate the infrastructure involved.

Another interesting aspect is that many decarbonisation solutions require mined resources. Copper, for instance, is a crucial component in the renewable energy supply chain, used in everything from wind turbines to electricity grid infrastructure. In addition, critical components of the batteries in electric vehicles contain ‘energy transition metals’ such as cobalt, lithium, platinum group metals (PGMs) and nickel.

This means the mining industry has a leading role to play in the energy transition. Mining is a significant component of the FTSE All Share, representing 9% of the index. The key constituents are four of the world’s leading franchises with international assets, low cost operations, strong balance sheets and attractive growth prospects given their exposure to these metals.

Anglo American, for instance, has exposure to copper, PGMs and nickel while over half of Glencore’s earnings come from copper, cobalt, zinc and nickel. Rio Tinto and BHP Group are significant players in copper and battery materials, despite iron ore being their main source of earnings today. Over 90% of Rio Tinto’s growth capital expenditure is directed towards ‘low carbon’ metals.

These companies have healthy pipelines of projects coming on stream to underpin growth in future years. Finally, their strong cash generation allows them to return cash to shareholders in the form of dividends. BHP Group, for instance, has a very attractive 8% dividend yield, having recently announced a record $5 billion interim dividend.

Dare we say it, could the UK even be home to a hidden store of value for ESG investors?

Misconception 4: The UK market was only ever useful for income. Now the dividends have been cut due to Covid-19, even that angle has gone.

It is certainly true that the UK market has historically been seen as an attractive place to go for ‘income’ investors, looking for both income and capital growth. And while it is also true that many businesses cut their pay-outs during Covid to protect their balance sheets and franchises, we are now past the worst.

Despite the cuts (which were experienced across the world), the dividend yield of the UK market is still at a significant premium to global peers. Over the past 12 months, around two-thirds of businesses in the UK cut or suspended dividends.

However, with the improved outlook, we have already seen a significant number of companies return to paying. And as the above example of BHP Group shows, some companies are still able to offer healthy pay-outs.

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So, while the UK market may be unpopular, we believe there are reasons to look on the bright side.

If market participants don’t take advantage of these mis-pricings, in this era of zero interest rates and abundant liquidity, private equity and corporate buyers will. We have seen this recently in the uptick of incoming merger & acquisition activity.

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By the end of Monty Python’s sketch it becomes clear (spoiler alert) that the Norwegian blue parrot is indeed “bereft of life”. For UK equities, the debate goes on. Dead or resting? You decide….

Definitions - valuation metrics:

Forward P/E

A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number represents better value.

Trailing P/E

This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. 

Price-to-book

The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.

A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value.

Dividend yield

The dividend yield is the income paid to investors as a percentage of the price.