19 December 2019
Investment 2020: Beat the Vultures
The UK market is strong for good reason.
By Frank O’Nomics.
Have we missed the boat? The 3% rally in the FTSE 100 since last Thursday’s election has been surprising in both its strength and intensity. While a “relief trade” might arguably be short-lived – and somewhat misplaced if one believes that a Tory majority had largely been discounted ahead of the event – there are some strong arguments for a more fundamental move towards UK assets. A number of measures point to the fact that UK stocks are cheap; both on a relative and absolute basis, and that the key trade for 2020 could be to “buy British”. Domestic investors may be focusing too much on what could go wrong rather than inherent value; and if they are not careful international vultures will beat them to it.
It is not hard to find evidence that the vultures have been circling for some time, with many having already committed in an effort to beat the rush. While sterling may have rallied, it is still well below the June 2016 level of $1.50, and over the last 3½ years a legion of UK companies valued over £100mn have been bought by foreign entities. The UK cyber security software company Sophos is one of the most recent victims – its purchase for $3.8bn comes hard on the heels of a Hong Kong company CKA buying the brewer Greene King for £2.7bn, and a pending £4bn takeover of the defence company Cobham by a US private equity group. These are big deals, but there are many that are potentially bigger. Analysts and investors are working very hard to try to assess who is next.
So why do UK stocks look cheap? The main reason is that, since the referendum in 2016 they have lagged the rest of the world significantly. Despite the recent rally the price earnings ratios of UK stocks remain well below those of other developed nations, with the discount of the order of 20%. In simple terms UK stocks were similarly valued against those in the US 3 years ago, yet they have returned 25% less since. This under performance leaves the UK as cheap, in relative terms, as it has been since 1990. In absolute terms there is also cause for hope. A FTSE yield of 4% is undoubtedly attractive when interest rates are very low.
Much of the under performance due to Brexit uncertainty could be eradicated over the next 12 months as we go beyond the withdrawal agreement and move towards a true trade deal. Business investment was pitifully low, even before the referendum, and one can hope for a degree of catch-up to develop, even if it may be a dribble rather than a torrent. Further, the government also has a part to play in generating investment. While manifesto pledges will inevitably be watered down by reality, the end to austerity, and a willingness to borrow to invest, can generate a proper economic multiplier. Consider also the state of the UK economy. Yes, growth has recently slowed to a standstill, but unemployment is near a record low, inflation is stable (at 1.5%) and interest rates look like remaining at very low levels for some time. Add this to the favourable corporate tax regime and a flexible labour market, and the case for overseas investors becomes still more compelling. The ratings agencies seem to agree, with both S&P and Fitch having taken the UK off negative watch this week.
Which sectors will be most favoured? Looking at FTSE overall it is important to note that stocks with a UK domestic focus have returned virtually nothing over the past 3 years, while those with an international focus have delivered closer to 40% – we recommended the “rotation” trade in these columns a few weeks ago. Clearly there is some catching up to do. The other area to bear in mind is smaller stocks, where the overall price–earning ratio, at around 11, looks very cheap. The FTSE small cap index is trading at around a 30% discount to its 20-year average and is near its 10 year low when compared to mid-cap stocks. Of course it may not be the cheapest stocks that get bought by overseas predators, and the attractiveness of gaining a bigger picture access to UK markets may be the greater incentive.
What could possibly go wrong? It is all very well to argue that UK stocks are 20% cheaper than those of Germany, France or the US, but if global economic growth slows significantly the possibility of UK shares falling by less than others will be scant consolation for a domestic investor. While UK markets may have lagged, we are still in the midst of an 11-year bull run, with the likes of the US equity market near record highs. US-China trade negotiations may be far more important than Brexit in the longer-term, and the UK election outcome coincided with a positive turn in those negotiations. A combination of a re-escalation of the trade war and a slip in the Brexit process could prove expensive for the bulls.
Overall, the faint-hearted amongst us need to be cognisant of the opportunity cost – if you don’t buy, an overseas investor might. The positive predictions are coming thick and fast from analysts, with Morgan Stanley, Goldman Sachs and Credit Suisse all coming out in favour of UK stocks. I am wary of advocating what might already be a crowded trade, but Morgan Stanley has described the UK shares as “potentially the best global equity opportunity for 2020” – and I am inclined to agree.