Talking Themes : Finding Value in UK Assets
1.Prices of UK assets have suffered recently, a market reaction we consider overdone. We find opportunities in some areas of the UK market.
2.Short-dated UK government bonds (gilts) offer attractive yields in view of the weak currency.
3.The FTSE 100´s valuation is undemanding with a significant foreign revenues + earnings base.
4.Due to the currency devaluation, UK companies are even cheaper for non-sterling investors, making them a potentially attractive M&A target.
5.The theme is investable via dedicated funds and ETFs, but also single-line bonds and stocks.
UK asset prices have been dealt a blow by the new government after the latest budget proposal triggered a widespread sell-off in UK assets followed by an intervention by the Bank of England to calm the markets and avoid further damage to the UK pension system. However, in this paper we will not discuss the potential political and economic consequences of the proposed package. We prefer to focus on the impact that the announcement had on asset prices and where investors could find value in UK assets today.
More defensive investors could consider short-dated gilts. Indeed 2-year UK bonds are currently trading at a yield of more than 4%, over double the yield on 2-year German bunds. Clearly, we should not neglect the economic challenges facing the UK. Compared with other regional stock and bond markets, we feel that investors would be well rewarded for taking those risks. Some European government bonds offer only half the yield of gilts despite having substantially higher costs of insuring against default.
Obviously, non GBP-denominated investors are exposed to currency risk. As sterling has depreciated against the dollar by roughly 20% since May 2021, USD-investors would buy into a cheap currency. Sterling was more stable against the euro but we do not see material FX risk either. Our 12-month target (0.86/price of 1 euro to the pound) implies only minor changes to the current level.
More risk-tolerant investors may find investing in stocks, e.g. the FTSE 100 Index, an attractive opportunity. While the index is based in the UK, its constituents are truly global companies. The FTSE is home to some of the worlds leading pharmaceutical, telecoms, oil and mining companies. It is thus much more a representation of the global than the UK economy.
It is global and it is cheap
A strong US dollar may fuel M&A activity
Close to 75% of FTSE 100 companies’ revenues are generated outside the UK. More specifically, the USA and Europe are the main sources of revenue generation for the index constituents, thus making the index heavily dependent on currency moves. If sterling weakens – as it has recently - then foreign revenues, once converted back into sterling, are worth more. Thus, valuations are becoming more attractive which should eventually provide a boost to stock prices.
While the FTSE 100 is among the better performing indices in local currency terms over the year-to-date, there are few signs that the market is currently paying attention to the FX-driven revenue tailwind. The index is currently trading at a 12 month forward price/ earnings ratio of 8.8x which is the lowest level since 2011. Compared with the MSCI World ex UK, the valuation disparity looks even more extreme as the FTSE100 is trading at the biggest discount to global stocks for more than 20 years.
Equally interesting is the spread between pay-outs. The FTSE 100 is expected to provide a dividend yield of 4.5% over the next 12 months which is a premium to global peers of more than 200 bps. This measure stands at a 20-year high as well. While we feel that the combination of currency tailwinds, discounted valuations and above-average pay-outs would already make a compelling investment case for a truly global index, there is another angle to look at: takeovers from foreign companies.
For non-GBP based investors, the 20% drop in US dollar terms in UK large-cap stocks presents an excellent opportunity to buy already cheap UK stocks with an even higher discount. Since mid- January, the total market cap of UK stocks has dropped by roughly 17% in local currency. In USD though, UK stocks have lost by more than 30%, making the valuation case even more compelling.
Global financial conditions have became more restrictive over the last couple of months which is usually not a good sign for M&A activity as potential buyers may find it more difficult to secure funding for a deal at a reasonable price. Against this headwind we have seen signs that it still seems hard to resist tempting valuations. For example two British companies (Pendragon & Biffa) have already been taken over by foreign buyers in the last couple of weeks. If this trend goes on, this would be another argument in favour of investors building or increasing allocations in the FTSE 100 index.