These numbers show UK shares are cheap - but should you buy?

BRITISH investors are now used to seeing shares from their home market in the bargain basement of global stock markets.

For several years UK shares have been getting cheaper and cheaper versus rival major markets in the US and Europe, according to commonly used valuation measures. Back in 2016, the price-to-earnings multiple for the UK market (explained below) was less than 10% below that of both the US and Europe but has now drifted to more than 20% below Europe and more than 40% below the US.¹

But just because UK shares are cheap, it doesn’t make them good value. Much depends on whether companies can deliver earnings and valuations can begin to recover.

What is the current valuation of the UK stock market - and does it represent an opportunity for investors?

Putting a value on UK shares

There are many ways to put a value on a company’s shares. Perhaps the most commonly used is the price-to-earnings ratio (p/e) - a comparison between a company’s price and the money it makes.

Most of the time investors don’t have to work this out for themselves because p/e ratios are widely published, but it can be determined by dividing the share price by the earnings-per-share for the company in question. The earnings figure you use can be either ‘trailing’ - those earnings booked in the past year - or ‘forward’ - those forecast to be made in the years ahead.

This allows you to make simple like-for-like comparisons between companies. As with any valuation, context is important. Some companies can have higher valuations because the markets see them as being in more attractive industries where lots of growth is expected, or because they have unique offerings that are valuable and can’t be replicated by others. That’s why companies of equal size and producing the same amount of earnings can still have very different valuations.

And just as it’s possible to put a value on individual companies, you can extrapolate out to put valuations on whole stock markets. So, there are p/e figures for the UK market as a whole that can be compared to other markets.

P/e ratios are useful, but they are influenced a great deal by short-term changes in company earnings. Economies can be expected to accelerate and decelerate in cycles, and this may greatly determine the short-term performance of some companies - and therefore their valuation as measured by p/e. To account for that, a related valuation is sometimes used - Cyclically-adjusted price-to-earnings, or CAPE.

CAPE uses a 10-year average of earnings, adjusted for inflation, to produce a valuation that should be more stable.

How does the UK stack up right now?

The table below shows valuations for the UK versus other major and emerging markets. On a CAPE basis, the UK is priced at 14 times its cyclically-adjusted earnings, making it the cheapest of the major stock markets - only emerging markets are cheaper.

The figures in brackets show the change in the reading versus a 15-year average. On that basis, CAPE for the UK has moved marginally higher, but by less than the increase in the US and Europe.

^{Source: Datastream Refinitiv, MSCI and Schroders Strategic Research Unit. Data to 31 May 2023}

Looking beyond the headline

Just as there can be reasons for different companies to be valued differently, the differences between stock markets can justify different valuations as well. The very high valuation on the US market is driven largely because that market contains several huge companies that are producing reliably growing earnings in high-growth sectors - such as technology. Those are things investors are happy to pay high valuations for.

The UK, by contrast, is dominated by some sectors that are less highly-prized, such as miners, energy companies and banks. These sectors have seen their valuations dip recently, contributing to the cheapness of the UK market overall. Separate numbers from Schroders show that valuations for companies in the UK materials sector are 22% below their 15-year average. Valuations on financials is 32% below and energy 33% below.²

Even a small reversion to the long-run valuations of these sectors could see the UK close the gap with rival markets.

Small versus big

The UK market may be lowly-valued overall, but some areas look particularly cheap versus the rest. In particular, there may be reason to think that Britain’s small and medium-sized companies represent a value opportunity for investors.

The p/e valuation for the FTSE 100 - the country’s largest companies - is currently around 10.2%. The readings for the FTSE 250 of medium sized companies and the FTSE Small Cap Index of small companies are similar - at 12.3 and 10.6 respectively.³

But other indicators show a divergence between these different areas of the market. Earnings per share for the FTSE 100 is forecast to fall 2.9% in the coming year, while it is expected to grow 7.9% for the FTSE 250 and 11.6% for the FTSE Small Cap. That could suggest that it is Britain’s smaller companies that have the best chance to raise their valuations from here.

Tempted by cheap Britain?

If an asset is trading on a low valuation it’s because the market in aggregate does not believe it deserves to be valued more highly - buying it means you are betting against that view.

The UK looks cheap right now but there’s no guarantee valuations will revert upwards. If you’re investing for long periods, however, your chances of success are improved if you are able to buy when prices are cheap - and that certainly applies to the UK right now.

Investors can get broad exposure to the UK stock market for low cost via an ETF (exchange traded fund) that tracks the UK market. The iShares FTSE 100 ETF and the Vanguard FTSE 250 ETF each target different segments of the UK market and both appear on our Select 50 list of favourite funds.

As does the Fidelity Special Situations Fund, which is actively managed with a bias towards undervalued stocks, and an overweight position in Britain’s medium sized companies.

Source:

¹ Chart 1&2 - Six charts that show how cheap UK equities are (schroders.com)

² Chart 4.1 Six charts that show how cheap UK equities are (schroders.com)

³ Peel Hunt, UK Market Valuations, 19 June 2023

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Select 50 is not a personal recommendation to buy or sell a fund. Tax treatment depends on individual circumstances and all tax rules may change in the future. There is no guarantee that the investment objective of any Index Tracking Sub-Fund will be achieved. The performance of a sub-fund may not match the performance of the index it tracks due to factors including, but not limited to, the investment strategy used, fees and expenses and taxes. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.