UK vs US: the FTSE 100's secret sauce

Breaking through 9,000 for the first time this week, the FTSE 100 is now running neck and neck with the S&P 500 over one year. With dividends reinvested, both have delivered a 13% return to shareholders over the past 12 months. It was only in April last year that the UK benchmark first hit 8,000. The Chancellor could hardly have picked a better time to be banging the drum for investing in shares generally, and London-listed ones in particular.

This is a dramatic improvement on the UK stock market’s historic underperformance of the US. Over ten years, on the same total return basis, £100 invested in British shares has grown to £200 while the same amount on Wall Street is worth £350 today. Over 20 years, American shares have done twice as well as our domestic market.

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The inclusion of reinvested dividends is important because it is one of the key differences between the US and UK stock markets. London has always been a good source of dividend income, with the yield on British shares typically around twice as high as that on more growth-focused US stocks.

That’s part of the secret sauce of British shares. Without the benefit of compounding that higher income, the FTSE 100 has grown by just 70% over 20 years, compared with over 400% for the S&P 500. With dividends rolled up, there’s a lot less in it. And it is not just the blue-chip shares that benefit. Over 25 years, the FTSE 250 index of middle-sized UK companies has performed bang in line with the US index in total return terms.

That hidden driver of investment performance goes a long way to explaining the perception of the UK stock market as a perennial disappointment. Another reason for that belief is the sequencing of returns. The US market’s gains have been concentrated in the past decade, and it is human nature to attach greater importance to what has just happened. The technology stocks that represent a third of the US market have taken off in the past ten years. That’s made it easy to outpace a British market which has almost no exposure to tech.

The headline numbers tell only half the story. Look beneath the bonnet of the UK market and you can start to understand why the past year has been so rewarding but the previous nine or 19 such a disappointment.

The first thing to note about the FTSE 100’s one year return is that it is an aggregation of very divergent performances. Twelve companies have enjoyed growth of more than 50% in their share prices since last summer, including five that have more than doubled. But over the same period, 11 have fallen by more than 25%.

The winners tell us almost nothing about the health of the UK economy, but quite a lot about what is going on, and going wrong, in the world. Top of the pile is Fresnillo, a Mexican gold and silver miner that has surged on the back of a doubling in the gold price over three years. The performance of gold is a reflection of growing concerns about inflation, uncertain geo-politics, and an explosion of debt around the world.

Three of the top performers in the UK market are cashing in on the realisation that Europe needs to spend a lot more to keep itself safe. Rolls Royce, BAE and Babcock are all riding high on expectations that significant sums must now be directed at boosting the region’s defence capabilities. Two other winners, Barclays and NatWest, have done well because interest rates have stayed higher for longer as inflation has remained stubbornly above target.

None of the other companies at the top of the one-year leaderboard can really attribute their success to the long-term growth potential of the UK. St James Place and BA-owner IAG are just bouncing back after years of underperformance. The London listings of Standard Chartered and Airtel Africa are flags of convenience for overseas businesses. BAT is an international, defensive sin stock.

These Footsie winners suggest that the UK market might just have found itself in the right place at the right time. The UK is turning out to be an unexpected safe haven, a value-focused market with a bias towards old-fashioned industries that look relatively attractive when people are nervous about what’s happening out there. Even Games Workshop, the last of the 12 stocks with a one-year gain of more than 50%, makes its money from people escaping reality.

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But there are some good reasons to think that the FTSE 100 needn’t stop at 9,000. One consequence of a weighting to tired and unglamorous sectors is the UK market’s big valuation discount. With the average FTSE 100 stock trading on a multiple of just 14 times expected earnings, the UK is significantly cheaper than the US - where shares are priced at more than 20 times earnings - and a bit better value than both Europe and Japan. It is no coincidence that American buyers are queuing up to buy British businesses. Even after this year’s drop in the value of the dollar, they look cheap when viewed from the other side of the pond.

The London market is also a beneficiary of an ongoing rotation out of the US as investors take advantage of the recent rally to rebalance their portfolios in the face of America’s fading exceptionalism. I suspect that process has a way to run given that funds continue to flow out of UK funds in aggregate, as they have for pretty much all of the past 10 years.

The silver lining of a pervasive lack of interest in the UK stock market in recent years has been the opportunity for stock pickers to find mis-priced bargains. With a stable political backdrop, a new-found desire to encourage risk averse savers to embrace the stock market, generous dividends and takeovers sweeping up the stragglers, there is no reason why the FTSE 100 should not continue its march towards 10,000.

This article originally appeared in The Telegraph

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