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The UK is a ‘no-brainer’: Why we’re bullish on UK equities

The UK is a ‘no-brainer’: Why we’re bullish on UK equities
Paloma Kubiak
Written By:
Paloma Kubiak
Posted:
14/05/2024
Updated:
14/05/2024

UK equities have suffered net withdrawals each month for nearly three years, but one managing director says “there’s money to be made” as he adds to holdings.

Investors have been net sellers of UK equities since August 2021, taking the cumulative withdrawal of capital to £30bn to March 2024, according to The Investment Association (IA).

It reports UK equity fund net retail sales at -£3.38bn in the first quarter of 2024, following withdrawals of £13.6bn in 2023 and £12bn in 2022.

As the UK market reached a record high in the last few weeks, UK equities have remained unloved for a considerable amount of time.

More recently, UK investors have embraced global diversification, according to Miranda Seath, director of market insight and fund sectors at The IA.

She explains that UK equities comprise a smaller portion of total equity funds under management (FUM), but they still hold a “significant weight”, accounting for 20% of the equity portion of industry FUM. This compares to the weighting to the UK of 3.8% in the MSCI World benchmark.

US tech boom and the Brexit effect

Seath says the UK’s reduction in percentage allocation has been driven by factors including the “allure of US stocks, with their robust performance”.

“The underperformance of the FTSE relative to other major indices, notably the US, can be attributed to the dominance of sectors that have thrived in low-interest-rate environments. For example, unlike their US counterparts, UK listings in the high-performing technology sector lag behind, with tech accounting for a mere 1% of the FTSE compared to a substantial 29% in the US-equivalent Russell 3000”, she says.

She adds: “Another factor affecting UK equity outflows has been the Brexit referendum. From 2016 to March 2024, UK equities have been in near constant outflow, amounting to a substantial £50.6bn. Leaving the EU introduced uncertainty about the economic outlook for the UK. During this, the challenging outlook for the UK economy has persisted and remains an issue affecting investor sentiment.”

UK is ‘unloved’ but ‘undervalued’

Despite the ongoing negative sentiment, Darius McDermott, managing director of independent fund research firm FundCalibre and Chelsea Financial Services, remains confident when it comes to the UK.

“We’re bullish on UK equities. If I had £1, I would invest it in UK equities”, he says.

McDermott says he’s been adding to his holdings in increments, taking the UK equity weighting up approximately 20% in the last year.

And this year alone, the UK market is already up 8.5%, with the FTSE 100 standing firm above 8,400 after beginning the year at 7,733.

While he likes the AI theme, consumer and energy space in the US, which has driven much of the growth of the S&P 500, he beams that “you can get that exposure in the UK”.

But here in the UK, the FTSE isn’t expensive. In fact, it has majorly underperformed the US and Europe in recent years, meaning it’s cheap. Meanwhile, the mid-caps are also trading at a discount.

McDermott says the UK market is “relatively undervalued from a historical perspective”, with the long-term average at about 12x PE – price to earnings ratio, which is a common method of valuing a company. It’s calculated by dividing a company’s market value per share by its earnings per share.

“In mid-March, it was around 9x PE”, he says, adding that the FTSE indices cover a wide range of sectors and industries, helping investors to diversify, though starting valuations are cheap.

Investors can gain exposure in healthcare, energy, commodities and financials, and while 70% of FTSE earnings are derived from overseas, “the UK market is trading at a discount to other global developed markets”.

Dividends, M&A activity and share buybacks

Another major factor adding to the allure of the domestic market boils down to dividends.

“The UK market is the most established dividend market in the world. The UK market offers one of the largest yields in the world. So a decent starting yield is part of the total return”, McDermott says.

According to Russ Mould, AJ Bell investment director, aggregate ordinary dividend estimates suggest the total payment in 2024 could come in at £79.1bn.

“That is slightly below 2018’s all-time high, but the forecast yield is still 3.6%”, Mould notes.

McDermott also points to the M&A activity and share buyback programmes – when companies repurchase their own shares – as “good reasons to own UK equities”.

He notes the recent BP announcement of $10bn share buyback over the next two years. This is a welcome move for investors as, if shares are undervalued, then when a company buys its own shares, it has the effect of shrinking the share count, which increases the earnings per share.

“In simple terms, if a company thinks it should be trading at £1 but your shares are trading at 75p, then you are buying assets cheaply too, which adds long-term value to existing shareholders”, McDermott explains.

Mould adds: “Buybacks are on track to at least match last year’s total of £52bn, another 2.5% of the FTSE 100’s market cap, and takeovers are running at a rate of 1-2% of the UK market cap as well.

“Add dividends, buybacks and takeovers together and the cash yield on the UK market is between 7% and 8%, a figure that easily beats inflation, returns on cash and the yields available on gilts.

“This matters because valuation is the ultimate arbiter of investment return: paying as low a price as possible both protects the downside, should anything unexpected go wrong, and maximises upside potential, if the investment thesis plays out as expected. Valuations tend to be at their lowest when pessimism is most pervasive, and there is no lack of pessimism regarding the UK’s economic, political and financial prospects right now.”

He adds that the “latest run of takeover bids for UK-listed firms suggests someone feels this presents an opportunity”. However, he warns “there are still clear risks to the UK equity story”.

“The buybacks could dry up quickly in the event of an unexpected event, just as they did in 2020 – and it is possible that the FTSE 100 is cheap because it deserves to be”, Mould says.

With a general election on the horizon, sticky inflation and mounting debt levels, this could change the narrative of the UK market story, he adds.