The UK market is trading at cheap valuations relative to its own history with miners, pharmaceuticals and banks looking particularly good value, according to JP Morgan Asset Management’s James Illsley.
The manager of the £231m JPM UK Equity Core fund said on a straightforward price-to-earnings ratio (using a 12-month forward look-through) the market is fairly valued.
This is despite the market performing strongly in recent years, with the FTSE All Share index up 27.24 per cent, as the below shows, while the FTSE 100 remains at near-record highs.
Performance of index since Jan 2016
Source: FE Analytics
“When we look at the UK market in its own right rather than relative to other equity markets, currently we are running at around 14.5 times or so which is in-line with the longer term average since the turn of the century,” the manager said.
“But that ignores the fact that some of the areas of the market, whether its financials – particularly the banks – or possibly the miners and definitely the oil stocks are under earning and definitely not getting the full return on their capital.”
If you use cyclically adjust earnings over the last 10 years, rather than the earnings expectations over the next 12 months, the results are very different.
“This smooths out some of these sectors that are under earning on a cyclically-adjusted price/earnings [P/E] basis,” Illsley said.
“We can show the market as being 15 per cent below its longer term average going back to the early 1980s [on this basis],” he added.
“For us you can look at that P/E and say it is fair value but on cyclically adjusted price-earnings you can see it is below its long-term average.”
He added that this is at a time when most other assets, be it bonds or cash, have been re-rated in recent years thanks to the low interest rate environment.
“Gilts used to yield 10-12 per cent, now they yield just over 1 per cent while cash used to yield 10 per cent, it now yields zero,” the manager said.
“Yet the UK equity market hasn’t really re-rated over that period and if anything on a cyclically-adjusted basis it is actually cheaper than it was in the 80s.”
This lack of a re-rating has been reflected in the dividend yield, he noted, with the UK market currently yielding just under 4 per cent currently with dividends growing year-on-year.
Illsley said: “We are looking for mid-single digit dividend growth this year and next so as you are starting from just under a 4 per cent yield that looks quite attractive.
“We try to take all of those measures and come up with a balanced view and on balance, given an attractive starting and growing dividend yield, cyclically adjusted price earnings below its long-term average and – at worst – the forward price earnings in-line with its long-term average, that makes us think that the market is on the cheap side.”
As such, with a 4 per cent dividend yield, and inflation and GDP growth estimated around 2 per cent each this year, investors could reasonably expect to a total nominal return out of equities of 8 per cent or so.
“I think that is attractive in a low-return world,” said Illsley said.
However, the key for investors is the starting price, he noted: “One of the key drivers of your long-term return is the price that you pay for the asset at the starting point.”
As such, the first area the manager sees as being undervalued by the market is the miners, which despite a strong 2016 are on relatively attractive price-to-earnings multiples.
The sector is the only overweight position in his JPM UK Equity Core fund with a 6.8 per cent weighting to the area, 0.2 percentage points more than the benchmark.
“If you looked across the long-term averages you would be thinking about potentially some of the mining sector being cheap,” the manager said.
“We have seen a little bit of a de-rating in the first half of this year as worries over the outlook for China caused some short-term weakness at the beginning of the year.
“But we’ve seen two or three sets of data coming out of China recently that shows that the economy continues to grow.
“Most recently we saw some strong construction data out of China which underpins the demand for commodities so we have seen some recovery in the mining sector in the recent months.”
Performance of mining stocks over 5yrs
Source: FE Analytics
The mining sector has experienced much turbulence over the past five years, falling by 65.95 per cent from its peak in 2014 to its trough at the start of 2016 on fears of a slowdown in China.
However, it has rebounded strongly over the most recent 18 months and share prices have largely recovered to levels from before the fall.
Despite this, Illsley said the market is undervaluing companies in the sector as earnings have moved further than the share prices.
“Free cashflow yields are still very strong in the likes of Rio Tinto in particular, even with the iron ore price where it is today,” the manager noted.
“Rio is on a high single digit free cashflow yield of around 8 or 9 per cent – possibly even more given the recent rally in the iron ore price.
“So you have to have a view that commodity prices are going to weaken significantly from here to make those stocks look anything but cheap. For us commodities is still an area of value.”
Another area is the financials sector and in particular the UK banking sector, which has been on a slow and steady recovery over the last decade, as the below shows.
Performance of mining stocks over 10yrs
Source: FE Analytics
Indeed, the FTSE All Share Banks sector remains 35.84 per cent below its pre-financial crisis levels in 2007.
Illsley said: “We are still recovering from the financial crisis of 2008 so we are still on the recovery track in those areas.
“Now it will be a long haul – there is a long healing process – but there is still scope for those companies.”
The final area is the pharmaceuticals sector, though the manager noted that this is a more stock specific area than the previous two.
“When you look at GlaxoSmithKline it is cheap relative to its long-term history and again there is a lot of long-term value there,” he said.
The stock has had a volatile two years in which it has returned 19.34 per cent to investors, though Illsley said this has been weaker than he would have expected.
“It is a steady earner but at this point it is on a 13 times price to earnings multiple – one of the cheaper pharmaceuticals around the world,” he added.
Additionally, the business, which has a number of long-term franchises and a large intellectual pipeline of new products, is currently yielding around 5 per cent making it attractive.
Meanwhile, rival AstraZeneca is a special situation, according to the manager, given the proportion of its long-term sales that have yet to be launched if you like.
“If you look out to the early 2020’s something like 60 per cent of its sales forecast will be derived from new products that have only recently been launched or will be launched over the next three to four years.
“There’s always uncertainty and there is always dropouts along the way so with this we will have to see.”