State of UK equities: time to back British again?

With a recently appointed new prime minister and government, the UK has been in the global spotlight the past couple of months. But how does Blighty stack up from an investment perspective?

Elections aside, there’s been a slew of negative news about the UK recently, further hitting investor confidence, which hasn’t picked up much since Brexit in 2016. In that time, the UK has dwindled to become the world’s fifth-largest stock market — its US$3.5trn dwarfed in comparison to the US at US$54.7trn and coming behind China, Japan and India. Will it shrink further? Maybe.

British companies have a reputation for being tenacious and innovative, and their valuations are currently compelling.

Accounting for the exodus

Coutts, banker to the King and the extremely wealthy, recently announced it’s slashing its UK exposure in its investment portfolios from 40% to a meagre 3.5% in some cases. The drop in confidence of institutional investors will likely creep to others and trickle down to private investors too.

And we’ve seen a plethora of delistings in recent years: UK companies fleeing the London Stock Exchange (LSE) to list in other places they consider much more profitable. One of the biggest delisting stories was Cambridge-based ARM Holdings, a microchip manufacturer, which left London for New York in March 2023. Another is Paddy Power’s owner Flutter, which will follow ARM this summer.

The Alternative Investment Market (AIM), the London Stock Exchange’s (LSE) market for small and medium-sized companies, has also seen a sharp increase in delistings, with 70 companies either moving to private ownership or relisting elsewhere. The LSE is on track to lose 30 or more £100m-plus companies this year alone. And rumour has it the NASDAQ is on the hunt to lure more firms from the beleaguered FTSE to New York.

Economic data not looking great

Economic news for the UK isn’t the best either. The Organisation for Economic Co-operation and Development earlier this year downgraded its British growth forecast from 0.7% to 0.4%, making the UK the worst performer in the G7.

The International Monetary Fund (IMF) has also recently released a report telling the UK government it faces a £30bn funding gap that can’t be filled with higher growth or extra borrowing. A blow for the new UK chancellor.

Searching for silver linings

So far, so depressing. But investors would do well to remember that it’s not all doom and gloom and to look beyond the headlines. The FTSE 100 is near an all-time high and still trading at attractive valuations.

It’s also a misnomer to think that a bleak economic outlook for the UK is reflected in the stock market. This is certainly not the case for the FTSE 100, where up to 80% of its earnings come from overseas and upwards of 50% for the FTSE 250, the oft-touted ‘domestic bellwether’.

The stock market is not the economy

Given the international earnings nature of the FTSE, it’s important not to confuse the stock market with the economy. Many UK smaller companies are international businesses, which are plugged into long-term structural growth trends, but they’re being valued as if they’re linked to the UK economy, or as if they’re in structural decline.

This is largely to do with valuations and investor perception. Market participants have long suggested that UK public limited companies (PLCs) deserve a lower valuation rating compared with international peers, specifically the US. This is usually due to investors pointing to profitability ratios such as return on equity and return on invested capital lagging behind the US, as well as our companies being prone to higher levels of cyclicality.

Where the valuations are most attractive

Like-for-like valuation comparisons (Unilever versus Proctor & Gamble or Shell versus ExxonMobil, for example) show that UK companies tend to trade at a discount to international peers – those with near identical business models, cash flow profiles and end markets.

Then there are other points of reference, such as investment trust discounts, which in October 2023 reached levels that had last been witnessed in 2008, although they have since recovered a bit from the lows. When you look beneath the surface at our small and medium-sized companies, you will find that valuations have reached extreme lows.

As of 31 October 2023, the Numis Smaller Companies index was trading at a Shiller price-to-earnings (P/E) ratio of 13x. This is close to its all-time troughs, seen on three occasions: the great financial crisis, the tech bubble aftermath and the early 1990s recession. After these troughs, smaller companies went on to produce significant returns over many years.

Of course, ‘smid’-cap (small and medium-sized companies) investing doesn’t come without risks (it tends to be significantly riskier than investing in larger companies) but it can have an important role to play in a diversified, well-balanced portfolio and we think there is currently an opportunity to buy UK equities at attractive prices.

Innovation isn’t limited to tech

Another important point for investors to remember is that innovation comes in many forms and not just US technological disruption. This might provide some comfort to investors who are worrying they have missed out on the magnificent seven boom (the mega-cap tech stocks, Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA and Tesla).

Longevity is a good signal of innovation — you need to stay innovative to succeed as a business. And there are some FTSE businesses that have been around for a long time. Diageo, which owns the best-selling whisky and vodka brands in the world, has been adapting to consumer tastes for hundreds of years. And RELX, the world’s largest publisher and exhibitions company, was formed from the merger of Reed International, a publisher with roots harking back to 1895, and the older-still Elsevier, a Dutch academic publisher.

Further down the market-cap spectrum, the UK can also boast about engineering brilliance, with the likes of Spirax-Sarco and its world-leading thermal and steam systems and Rotork, a global market leader in valve actuators.

Having cheap valuations is one thing, but investors are keen to know about catalysts, and those are already happening. There has been a surge in merger and acquisition activity, hitting the highest levels in decades. It’s a double-edged sword, as it means the UK is losing quality businesses to overseas buyers, but it’s also proof that we have something desirable and genuinely trading cheaply (not just optically cheap).

The ever-decreasing size of the stock market is also partly self-inflicted through record share buybacks and we expect more investors to take note and take part. The UK has a reputation for being tenacious, innovative and ahead of the curve in many respects.

So, although our markets will evolve and change and our economy will dip and thrive again, regardless of the broader macro-outlook, there will always be pockets of opportunity in the UK for investors.

For further information on any of the terms used in this article please see our glossary of investment terms.

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This is not a recommendation to invest or disinvest in any of the companies, themes or sectors mentioned. They are included for illustrative purposes only.

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