UK stocks are not all that cheap

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. The everything rally continues. But today Unhedged goes where no rally dares to tread: the UK stock market. Don’t worry, we’ll come running home to America, home of the free and of the Fed put, tomorrow. Email me: robert.armstrong@ft.com

UK stocks

While this newsletter is, by mandate, focused on US, we do take regular excursions abroad, either because international markets throw light on the US or simply because we’re interested. But we don’t write much about UK markets, despite being part of a UK-based news organisation; there are plenty of clever FT people in London doing it already. But some opportunities we can’t pass up. This is from a piece by my colleagues Stephanie Stacey and Costas Mourselas, entitled “UK’s ‘staggeringly cheap’ stocks trade at record discount to US,” and published on Saturday. 

UK stocks are trading close to a record discount relative to their Wall Street counterparts . . . 

London-listed equities have lagged behind peers in recent years as heavyweight sectors like banking and energy have failed to keep pace with the rapid growth of technology stocks, and political uncertainty following the 2016 vote to leave the EU weighed on the market …

“The thing that gets me excited about UK equities is just the amazing value that’s on offer within the market”, said Alex Wright, a portfolio manager at Fidelity International. He prefers value stocks, which could benefit as we “return to a more normal inflation and interest rate environment”, and said financials are the largest position in his portfolios.

The piece also contains this quite striking chart:

More evidence of UK stock unpopularity comes from the monthly Bank of America global fund manager survey. It finds that fund managers are, in aggregate, more underweight the UK than any other asset category the survey tracks: 

Unhedged loves cheap stocks, as painful as this love affair has been in recent years. Stacey and Mourselas put their finger on the key issue, however. Is the UK market cheap, or is it just concentrated in inexpensive sectors? This is part of the issue, but there is a broader way to look at what is going on. The UK is on the wrong end of at least two major market trends, and maybe three. 

First, investors have been paying more and more for growth rather than value. Below is a chart of the discount of the Russell value index to the Russell growth index. These are US indices, which I chose because I struggled to find good valuation data on global value and growth indices. But it is clear that something similar is going on in most markets: cheap stocks are very cheap right now.

Next, investors have shown themselves willing to pay more and more for American stocks relative to stocks from the rest of the world:

Finally, American companies tend to be much larger than UK ones. Even excluding the ten largest US companies, the average S&P 500 stock has more than twice the market capitalisation of the average FTSE 100 stock. And investors have been favouring large stocks lately. For example, the MSCI world large cap index has outperformed the MSCI world mid-cap index by almost five percentage points a year over the past five years. 

So the UK stock market — with smaller companies on average, more tilted to value sectors, and stuck outside the US — is facing a triple hex at the moment. The three curses overlap to an important degree (many of the biggest stocks are growth stocks, and so on), but not entirely. The interesting question is whether, once these factors are controlled for, a UK discount remains. The presumptive answer has to be no. Markets are pretty global and pretty efficient. Why would world investors decide to pick on the UK in particular? True, the UK’s economy is not growing much, but proper valuations adjust for growth.

Still, weird things happen. The discount may be there.

It’s worth noting that UK stocks might be a screaming buy even if there is no UK discount on UK companies in particular. Buying a UK index fund might be an efficient way to bet that mid-sized international value stocks are due for a comeback. Still, the question of a unique UK discount is intriguing. 

It is probably possible to answer the question in a scientific way, with a careful statistical analysis. I’m not going to do that, because of time constraints and laziness. But there is another, utterly unscientific but quite interesting way to look at this: one company at a time. Do any UK stocks look, on their face, like bargains, as compared to similar companies in the US?

Shell, for example, looks like a cheap UK stock. The oil producer trades at 10 times trailing earnings; the American super-major oil producers trade at 15 times. He’s how some basic numbers line up with Chevron (numbers from S&P CapitalIQ):

Shell has been getting smaller, Chevron larger. Chevron is expected to increase earnings more quickly over the next two years, too. And Chevron is less levered. Worth 5 turns of price/earnings ratio? Maybe. Now try consumer goods giant Unilever against its US rival Colgate:

Again, the UK company is cheaper, but grows more slowly (both retrospectively and prospectively), is more levered, and in this case has much lower returns on capital. It is hard to describe it unambiguously as “cheaper.” A better look for the UK is GSK in a head-to-head with Bristol-Myers:

This time, the UK company has stronger prospective earnings growth, due to Bristol’s patent expirations, as well as stronger returns, for about the same multiple of earnings. Worth a look?

These are just three examples. But, looking through a screen of UK stocks, the issues recur. UK stocks tend to be cheap relative to US stocks for good reasons. If the UK stock indices are so staggeringly cheap, where are the staggeringly cheap UK companies? Readers, send me your candidates.

One good read

Meat.