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Richard Buxton: For how long will UK equities remain this unloved?

Despite increasing numbers of corporate activists on company share registers, UK equities remain cheap relative to historic levels

News from the Bank of America Merrill Lynch global fund manager survey that global investors have never been so underweight UK equities comes as little surprise to this investor, given that the UK All Companies sector has seen persistent outflows for four years.

It may be the impression that the UK economy is set to be one of the slowest growing now that Europe is recovering and the United States is benefiting from fiscal stimulus. It may be a concern that the UK will suffer materially post-Brexit or the probability that at some point Britain votes in a redistributive and anti-business government set to raise corporate tax rates.

Or, more constructively, it may be that domestic investors are at last recognising the degree to which they are underexposed to US equities and addressing this in part through investing more in global equities. Maybe the concern that this post-financial crisis economic recovery is long in the tooth – and the accompanying bull market is similarly aged – is encouraging investors to bank profits.

Whatever the reason, it is clear that UK large-cap stocks are pretty unloved right now.

It is interesting, though, to note that this view appears to be at odds with the attractions that numerous corporates and activists can see in some UK shares. There are two bidders battling to win control of Sky, while Shire has just agreed a combination with Japan’s Takeda Pharmaceutical. Mid-cap engineer Fenner has agreed to be bought by France’s Michelin.

Meanwhile, activist investors have appeared on the share register of no fewer than three stocks I hold: Barclays, Micro Focus and Whitbread. These multimillion-pound investments have not been undertaken lightly and point to significant undervaluation of these companies in the eyes of the activists.

Even in very large companies the stockmarket can let share prices fall far from the intrinsic value of a business

The bull market may be nine years old, but it has certainly not reached extremes of valuation. With the FTSE All-Share index trading below its long-term average, at a little over 13 times forecast price/earnings multiple and a yield in excess of 4 per cent, this would hardly suggest that investor euphoria is at a peak.

It is true that the scale of M&A activity globally is reaching levels that have contrarians feeling nervous. Deals are rarely done at bear market lows when bargains are available – as bidders themselves feel cautious and lack highly valued equity with which to acquire. It is when confidence and share prices are high that the siren voices of investment banking advisors become irresistible to many boardrooms.

So a note of caution from the flurry of deal-making currently underway, but with an eye firmly on valuations the ground seems reasonably sound underfoot.

Investors often shun UK large-cap stocks as they perceive that mature, low-growth companies or industries such as banking or commodities can offer only low returns. But while there may be an element of truth to this, fortunately even in very large companies the stockmarket can let share prices fall far away from the intrinsic value of a business. You need to be patient and play a long game, but this does allow the investor to make considerable gains even in very large companies.

Two years ago, HSBC shares were trading not much above 400p, yielding over 7.5 per cent. Some brokers were forecasting a dividend cut, which to our analysis looked completely unrealistic. Sure enough, once the bank repatriated some capital from the US and started buying back shares, the market took comfort that the dividend was sustainable and the shares rose to almost 800p. Almost a doubling. From one of the UK’s biggest companies.

The chart shows the long-term price of Tesco. Some investors may know I sold my holding in Tesco in May 2010 at 425p, concerned over its expansion into the US. Several profit warnings, an accounting scandal, withdrawal from the US and a change of management later, I started to buy it back in 2015.

New management fully expected to take five years turning the business around. The market was persistently sceptical, enabling me to add to the holding as recently as a year ago at 178p. And it is only now, into the fourth year of its tenure, that the market appears to believe that it can actually reach its goals, judging by the reaction to the most recent set of results.

So UK economic growth may be subdued, the bull market may be ageing, but UK equity valuations are not stretched and the market will continue to provide opportunities for the patient investor, even in UK large-cap stocks.

Richard Buxton is head of UK equities and manager of the Old Mutual UK Alpha fund, Old Mutual Global Investors


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