Over last month global equity markets sold off; from 15 January to the end of February the MSCI AC World index has lost in sterling terms 2.8 per cent, the S&P 500 3.0 per cent and the Japanese Nikkei 3.46 per cent. The UK market similarly has tumbled with the FTSE 100 plummeting 6.29 per cent over the period.
With stocks cheaper compared to a few months man y see valuations as attractive, especially considering that strong equity performance had left valuations looking stretched. UK companies have lagged their American and European counterparts over the last year so this sell off has occurred from a lower zenith in the UK. British companies look cheap but are they a bargain?
What does the data say?
On a number of valuation metrics the UK market does indeed look like a good deal. FTSE 100 companies are global companies and source over two thirds of their revenue from abroad, so maybe this is a good opportunity to buy a global business at a cut price. The table below shows selected valuation metrics for the major world indices.
Source: Mazars, calculations as at 28/02/2018 in local terms
It is important to remember like-for-like comparisons between indices can be misleading as their compositions differ widely. For example, the IT sector, whose firms often sport higher valuations, accounts for 24.2 per cent of the S&P compared to 7.2 per cent of the Eurostoxx.
Despite the issues surrounding the comparison of indices, UK companies are being valued at a discount. UK energy and material stocks appear particularly cheap, trading with a price to earnings discount of over 30 per cent compared to 18 months ago.
A historic perspective
UK equities are now trading close to their 10-year average price-to-earnings multiple (P/E) but this still remains a premium to the five-year nadir. When we consider that pre-referendum the FTSE 100 was trading at a ratio of 16x many will argue this is a prime opportunity to bag a bargain.
If one believes that UK company fundamentals, in terms of future sales and earnings growth, is no different to 18 months ago, it is difficult not to agree the UK is attractively priced. That chart below shows how the price to forward earnings ratio for the FTSE 100 has moved over the last 10 years.
Source: Mazars
The Brexit premium
The UK’s cut price is widely recognised as a cost of Brexit uncertainty. The impact of Brexit for UK companies is unknown, the loss of tariff-free access to Europe and imposition of WTO rules is a real possibility. Companies in the FTSE 100 derive circa 20 per cent of sales from Europe, and Brexit may have lasting consequences for future earnings.
Moreover, the UK has tended to underperform when monetary policy is tightened, if the Bank of England has to hike interest rates to tackle imported inflation (from tariffs on goods and sterling depreciation) a difficult environment for UK stocks could occur.
This clearly is a big ‘if’, but stock pickers should remain cognisant that equity markets theoretically discount the future.
Uncertainties for the bargain hunter
It is entirely possible that UK companies are oversold and tarnishing the entire market with an uncertainty levy is unfair. Clearly there will be winners and losers from Brexit and many will point to how UK equities have rallied on the back of the pound weakening.
The UK’s multinationals originate circa 70 per cent of revenue abroad but report profits in sterling. When the value of the pound falls, the value of their profits automatically rises as does the share price. The Brexit outcome is far from binary and how the market will react to news flow on negotiations, transitions etc. is unpredictable.
The questions for those about to buy UK equities need to cover a few angles, with a focus on how the stock’s earnings are affected by new trade rules and moves in sterling. Both of these are inherently difficult to predict.
In January our investment committee decided to retain its underweight to UK equities in our portfolios. We feel that other geographies in comparison, such as North America and Japan, present better opportunities for equity returns. In the US we feel that the economic cycle has been extended by US president Donald Trump’s policies and in Japan, the re-election of Shinzo Abe has provided the prime minister further time to implement economic and corporate governance reforms.
Brexit uncertainty has unnerved both investors and CEOs, with many companies reconsidering investment and business plans. Uncertainty and inflation have had a significant impact on consumer sentiment and business confidence. Thus the investment committee remained negative on UK risk assets and ultimately the Brexit discount is not reflective of the risks posed for UK equities.
Daleep Singh Shahi is an investment analyst at Mazars. The views expressed above are his own and should not be taken as investment advice.