UK shareholders should resist the urge to make a quick buck from foreign takeover bids, according to Janus Henderson Investors’ Laura Foll, who says quality companies are frequently being sold for prices that underestimate the true value of the underlying business.
The FTSE All Share rallied on Friday following the Conservative landslide in the general election, yet Foll pointed out the UK market still needs to rise by about 30 per cent to catch up with global peers across an aggregate of valuation metrics.
Foll, who manages the Lowland Investment Company, said the dividend yield on the index is particularly puzzling.
The trust typically pays out less than the market, at 3 to 3.5 per cent. However, it is currently paying out closer to 4.5 per cent, having raised its dividend by about 10 per cent per annum over the past seven years.
“That is just unheard of,” Foll (pictured) said. “That 4.5 per cent yield is very unusual, it suggests either the dividend needs to be cut, or that valuations need to adjust upward.
“When I look at the portfolio, I don’t see any evidence that dividends in aggregate are going to be cut. There will always be one-off dividend cuts, but when I look at the market, the dividend cover is really quite comfortable.
“The FTSE All Share has a dividend cover of about 2x. I’ve started doing the dividend forecasting for next year and it doesn’t feel like dividends are stretched.”
Despite this strong yield, the UK remains one of the most out-of-favour sectors according to the Bank of America Merrill Lynch Fund Manager Survey, even though sentiment has softened more recently and is likely to improve further following the election result.
While international investors have been reluctant to take advantage of low valuations in the UK, it is a different story for international companies.
“That 4.5 per cent dividend doesn’t look sustainable, but it feels to me that valuations need to go up and that’s more likely than dividends to come down,” Foll added.
“And if we as the equity market are not willing to do that, that needs to come from more corporate activity, which is something that we’ve seen quite a lot of evidence of.
“We have seen the likes of Greene King go earlier on this year, Dairy Crest, and I expect to see more of that in 2020.”
However, while Foll obviously benefited from a boost in share prices after her portfolio holdings were taken over, she said it is not all good news.
“What I find slightly frustrating as a UK fund manager is we are being quite unambitious in some of the valuations that we as shareholders are accepting for good-quality companies,” she added.
“I put Consort Medical there as an example of a very good-quality company. That could get taken out at under 10x EBITDA, 15x earnings, which for that type of company is not a high multiple.
“It just feels like we are not putting the appropriate valuations on some of our good quality companies and if we are not going to do that, they’re going to get taken over.”
The value strategy used by Foll has been out-of-favour for a number of years now, which helps to explain the underperformance of Lowland – its gains of 13.5 per cent since the manager joined in November 2016 are well below the 24.23 per cent made by the IT UK Equity Income sector and 23.45 per cent from the FTSE All Share.
Performance of trust vs sector and index under manager tenure
Source: FE Analytics
When added to the visible structural decline of entire sectors such as physical retail, she said this has understandably led to clients asking if value investing is still relevant.
In response, she pointed to a chart showing the 10-year real return from Lowland versus the price-to-earnings (P/E) ratio in the starting year, with a strong negative correlation between the two.
“It shows the starting point matters for valuations,” she explained. “Be very careful of people telling you that valuations don’t matter.
“They do matter, history tells you they matter. Your starting point in terms of your P/E makes a big difference to your end return.”
Foll admitted there are some anomalies – for example, had you bought in 2008, you would have made a return closer to 8 per cent per annum, even though the average P/E back then was lower than average, at about 8x. However, she pointed out this was because the earnings in 2008 were “effectively illusionary – they weren’t real”.
She said that ignoring such outliers, the current 12x P/E ratio on the portfolio suggests anyone investing now can realistically expect to make 10 per cent a year per annum over the next decade.
Impact of starting P/E on 10-yr returns
“This chart suggests, yeah, value does matter,” she added. “Value will out in the end. And what we’re seeing at the moment is value is outing in corporate activity rather than the valuation that we are putting on things in the UK equity market.”
Lowland is currently on a discount of 6.72 per cent to net asset value (NAV) compared with 5.95 and 6.21 per cent from its one- and three-year averages.
It is 13 per cent geared, has ongoing charges of 0.63 per cent and is yielding 4.3 per cent.