Many column inches and headlines have been dedicated to the decision by several high-profile UK investors to materially change their allocations to UK assets in favour of US assets.
Articles despairing the continued demise of London as a world leading financial centre to patriotic criticism for lack of support for 'our domestic market', continue to cause concern for investors. While all fascinating perspectives, we look at it from a slightly different angle.
The most enduring correlation in financial markets is the relationship between the price you pay for an asset and the longer term returns you get from it. A very common mistaken belief is that buying a great business automatically means that you will get great returns.
While it’s true that the US stock market gives investors access to world leading businesses, this comes at a price. Undoubtedly, it’s important to have meaningful exposure to the US, but we know we need to tread carefully.
Right now Microsoft is the most valuable company in the world and therefore arguably the 'best business', but had you bought it at its high in the TMT bubble in1999, you would have had to wait 17 long years to be up on your investment. Price matters.
We believe that the UK stock market could be sitting on the precipice of a re-rating. And rather than a single catalyst in the driving seat, we see a powerful combination of factors coming into play at the same time.
Valuations
Fundamentally, valuation matters. While the UK does not offer exposure to the big tech firms, there are other sectors that are just as important to get exposure to in a balanced portfolio. And they can be bought materially cheaper in the UK than the US.
Despite the strong recent performance of UK equities, the market remains cheap on both an absolute and relative basis. And crucially, the market is cheap against its own history.
US stocks demand a significant valuation premium to equivalent UK listed assets. The large energy firms are a fine example. Shell and BP are highly efficient energy businesses that are also at the forefront of the energy transition, investing heavily into renewables.
In contrast, US listed energy giants are a long way behind in this inevitable transition and still demand a significant valuation premium. UK businesses from this perspective are being unfairly penalised for investing in the future.
Buybacks and de-equitisation
The operational performance of UK PLCs has been strong, and the market in aggregate demonstrates robust cashflow generation while balance sheets are very healthy.
However, many firms have not seen this reflected in share price appreciation. This means that many are simply buying back and cancelling their stock, increasing both earnings and dividends per share.
A case in point are UK banks. They have been using their strong free cashflows to buy back stock well below book value, with a significant amount of their market capitalisation having been returned to shareholders in the past couple of years.
This has resulted in encouraging share price appreciation. In fact, around half of companies included in the MSCI UK Index have bought back shares in the past year, the highest percentage of any market in the world.
Macro
Inflation has been falling rapidly and it is probable that it will hit the 2% target again later this year. This may give the Bank of England wiggle room to cut rates and this cut may come before the Fed. This policy divergence will draw international attention back to the UK.
Furthermore, UK savings ratios remain elevated at circa 10% and the UK consumer could be in a position to drive a powerful cyclical recovery. This coupled with robust PMI data, the strongest in the G7, leads us to believe that only a small amount of monetary easing could increase consumer confidence and lead to a strong economic rebound.
UK politics
UK politics is no longer the tail risk that has plagued confidence since the Brexit vote. Indeed, the market barely registered the prime minister’s announcement of a 4 July election. This points to a less divisive contest than the US, especially with the opposition holding such a commanding poll lead.
Both Labour and the Conservatives appear relatively business friendly and understand the importance of functioning capital markets. In this sense we anticipate more market reform, with the British ISA likely to be just the starting gun.
Mergers and acquisitions
We’re all aware that overseas investors have started circling around the UK valuation opportunity and we have seen pick up in M&A from both private equity and corporates. Much of this is occurring in the cyclical part of the market, where valuations are particularly attractive, rather than the ‘fallen angels’.
This has largely gone unnoticed as the majority has occurred in the mid- and small-cap stocks. However, the bid for Anglo American is the kind of bell ringing M&A that really grabs attention.
UK firms have recently been generating strong returns and critically, from a risk-adjusted perspective, those returns are coming from different parts of the market to the US.
In an uncertain world, diversification and price remain paramount for investors and the valuation opportunity in the UK market is, we believe, too good to ignore.
Michael Toolan is co-chief investment officer at Brooks Macdonald. The views expressed above should not be taken as investment advice.