Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
It seems no-one can quite bring themselves to believe that this will be the UK’s year. Nearly five years on from the Brexit vote, talking down our domestic stock market has become almost second nature. And that, of course, is precisely the moment that contrarian investors should get interested.
The reasons why investors might want to give the UK a wide berth are well-known. The process and politics of Brexit may be less of a focus but they’ve only been replaced as a concern by the economic cost; the UK has almost no exposure to the tech sectors which have driven markets higher in recent years; and, for international investors, we’re just too small to warrant looking beyond these negative headlines.
But these are the intellectual short cuts - lazy thinking really - which create investment opportunities. Long-running neglect has laid the groundwork for a recovery in our local market’s fortunes. No-one has paid much of a price for ignoring the UK in recent years; this year they might.
First the facts. As we approach the one-year anniversary of the pre-pandemic peak, some markets will be forgiven for asking ‘crisis, what crisis?’. The S&P 500 index is 18% higher than it was a year ago. The Chinese market is more than 50% higher. The unloved FTSE All Share index, however, remains underwater, down 10% compared with this time last year. Please remember past performance is not a reliable indicator of future returns.
Go back to the pre-Brexit period and the comparable performances are even more striking. Since the beginning of June 2016, the FTSE All Share index has risen 9% compared with 87% for the S&P 500 and 79% for the CSI 300 index in Shanghai and Shenzhen.
But underperformance, by itself, is not a reason to invest. If there is a good reason why a market, or share, has lagged, then the shortfall might well persist. So, what is the case for the UK today?
The valuation argument
The first positive is a consequence of the underperformance. According to Goldman Sachs, UK shares are priced at a much lower multiple of their expected earnings than their counterparts in other markets. The forward-looking price-earnings multiple that measures the ratio of price to forecast earnings is 14 for the FTSE 100, 17 for the Stoxx Europe 600 (a broad measure of European shares), 18 for the Asia Pacific region excluding Japan, 19 for Japan itself and 23 for the US stock market.
That might make sense if the outlook for British company profits was particularly poor, but it is not. Goldman Sachs’s forecasts point to a 50% increase in earnings this year and 17% further growth in 2022. Now this follows a very difficult year, obviously, but it is indicative of a market which should bounce back sharply from the pandemic thanks in large part to the successful roll-out of vaccines.
The valuation discount is not just at the market average level. Delve down into individual sectors and you can see a clear preference for comparable shares in more popular markets. The valuations of oil & gas companies and basic materials businesses are roughly half what they are in the US today. In a globalised marketplace that seems like an anomaly.
Another important comparison is between shares and alternative asset classes such as bonds. On this measure, UK shares are as cheap as they have been in more than 100 years thanks to the historically low level of bond yields. The yield on the average FTSE 100 share is 3.9% today while that on a 10-year government bond (gilt) is just 0.46%. The UK stock market has a higher yield also than those in the US, Japan and Europe.
Other reasons to be positive
The second part of the case for the UK is the significant reduction in political risk that has hung like a cloud over the UK stock market for the past five years. This is not to say that there won’t be real negatives for the British economy from Brexit. We are hearing regular stories now of delays, red tape and additional costs. But we do at least know where we are vis a vis Europe and, for investors, that counts for a lot.
The third positive is the make-up of the UK stock market. For years the lack of tech stocks has been seen as a drawback for UK investors. Today the focus has shifted elsewhere towards more cyclical sectors that are expected to be beneficiaries of economic recovery. The most obvious of these is commodities, a sector which has suffered from a lack of demand and oversupply. Today, the reverse is true; demand is rising while investment in productive capacity has been inadequate for years. Result: prices are rising quickly.
The improving outlook is important because the UK has a heavy weighting towards the miners (companies like Rio Tinto, BHP Billiton and Antofagasta). Together basic materials companies make up 8.2% of the market capitalisation of the FTSE 350 index. Oil & gas adds another 7.4%. For context, technology represents just 1.1% of this index while telecommunications is just 2.3%.
Other more cyclical parts of the market, which stand to gain from the release of pent up demand and a more reflationary backdrop, are financials, banking and industrial goods and services. Banks, in particular, become more profitable as interest rates and bond yields rise. While this is not imminent, the direction of travel is clear. Banks represent 7.3% of the FTSE 350 index. Industrials, which are obvious beneficiaries of a pick-up in activity, account for 11.6% of the index.
So, valuations, the political backdrop and the composition of the UK market make a positive combined case. Has anyone actually noticed yet?
Investors do seem to be warming to the idea of a UK recovery. According to the latest Bank of America monthly fund manager survey, the proportion of investors claiming to be underweight UK shares has almost halved from 29% last June to just 15% today.
So, the case for investing in the UK is strong and investors are waking up to the opportunity. How might an investor get exposure to our home market?
One of the key themes underpinning my fund picks this year is the expected UK recovery and two of the five funds I chose at the end of last year are focused on the UK. The Fidelity Special Situations Fund is a contrarian, value-focused fund managed by Alex Wright. A more growth-oriented option is the Fidelity UK Select Fund, run by Aruna Karunathilake.
Five year performance
Past performance is not a reliable indicator of future returns
Source: Refinitiv, returns in local currency terms as at 10.02.21
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Select 50 is not a personal recommendation to buy or sell a fund. 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 an authorised financial adviser.
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