Cheapness is one of the main selling points of UK equities, as they have been trading on ever lower valuations than their global peers.
For instance, the FTSE 100 is trading on a forward price-to-earnings (P/E) ratio of 10.8x for 2024 compared to 20.1x for the S&P 500, according to AJ Bell. The forward P/E ratio provides an indication of growth expectations for a stock but can also give an idea of whether a stock is over- or undervalued.
In theory, that means that investors can gain exposure to a range of strong businesses at half the cost. Yet, this argument is not convincing for global fund managers who argue that cheapness by itself is not enough.
For instance, FE fundinfo Alpha Manager James Thomson, manager of the Rathbone Global Opportunities Fund, who is a growth investor, does not believe that valuation alone is a reliable predictor of future performance.
He said: “For example, if you’re simply looking for cheap stocks then you would look at Russia which is on a P/E of 3x…..but it’s cheap for a reason. There are some very attractive opportunities in the UK but I don’t think that valuation is the catalyst.”
This is also the view of FE fundinfo Alpha Manager Alex Tedder, manager of the Schroder Global Equity fund, who has long had the view that UK equities are “fundamentally unattractive”.
He said: “Just because something is cheap doesn't mean it's good value and just because something is expensive doesn't mean it's bad value. Cheapness by itself is not enough. In that respect, the UK market has been cheap for a long time but, for us, that just hasn't been enough.”
Performance of indices over 10yrs
Source: FE Analytics
Dmitry Solomakhin, portfolio manager of Fidelity FAST Global, isn’t too sure either that UK equities present a once in a lifetime opportunity in absolute terms but finds some of them attractive as a contrarian investor. In fact, he’s been building out his UK allocation since the results of the Brexit referendum and his fund currently has a 27 percentage point overweight to UK equities compared to its benchmark.
He said: “The UK is very attractive from a contrarian point of view. A reflection of this is that the UK is the biggest country overweight in the fund by far. My largest position today is Rolls Royce, which I have owned for quite some time. The company has had a number of financial issues over the past 10 years, but I think it's fundamentally a very good, cash-generative business. The management team has done very good work on restructuring.”
While Tedder says UK equities are fundamentally unattractive, he also sees pockets of opportunities here as the market has become too pessimistic about the prospects of both the economy and the stock market.
He said: “The UK is quite interesting, because the market isn’t pricing in any growth for a lot of UK companies. I don’t think that’s correct.”
Tedder splits UK equities in three buckets, with two of them offering opportunities for growth and positive re-rating.
The first one is made of a handful of FTSE 100 constituents such as Diageo, AstraZeneca and the large oil companies. The second category is made of mid-caps that are expanding internationally or may even already have an international presence. The third group consists of more domestic-oriented firms, such as banks.
Tedder said: “The first two groups are not value traps. They have the potential to grow and to re-rate positively. Companies in the first group will get re-rated if they can show good progression on revenues and costs, and in particular on operating leverage going forward.
“Companies in the second group are slightly highly valued anyway, but they're significantly cheaper in a global context and actually do offer re-rating potential.”
Thomson also has a few UK stocks in his fund, such as Rightmove, which he has owned for more than a decade and has been one of his best performing stocks over the long term. He is confident that the company can continue to perform in a softening UK property market.
In recent weeks, he has added catering group Compass to the fund as the growth opportunity for external catering is still significant and cost/operational pressure on in-house solutions are increasing.
He added: “While there is not an abundance of ‘growth’ stocks in the UK market, and this market has underperformed some of the tech-heavy international peers, we are pleased that our UK holdings are all up between 10-30% this year.“
One thing that could help UK equities in the near-term is a fall in inflation, according to Thomson. He said this catalyst could lead to outperformance, especially as global investors have ignored this market for such a long time.
He added: “There have been outflows from equity funds and UK equity funds in particular but once that turns it will amplify the upside.”
On the long term, private equity bids could be the main catalyst for UK equities according to Christopher Mahon, manager of CT Dynamic Real Return.
He said: “The most obvious catalyst would be consistent bids from private equity firms who seem reliably interested in the UK, but we would caution this may be a longer-term support to the market rather than a shorter term immediate boost.”
For Tedder, wider and deeper changes are needed to give UK equities a new lease of life. That would include more support from the government and reforms in the business culture.
He said: “The government support for UK PLC is abysmal or patchy at best. If you look at the US, which is the ultimate laissez-faire economy, you have in many ways a lot of implicit and explicit government support for the corporate sector, for example the Inflation Reduction Act or the Chips Act. The UK is missing all that.
“The UK has an issue with its business culture, especially domestically oriented companies. They are very much geared towards cutting costs, paring back to the bone, not reinvesting and doing the minimum they can get away with. UK PLC needs to wake up to the fact that you need to invest to grow. That is starting to become apparent, but there's a long way to go."