The UK - In from the naughty step

From the moment the Brexit referendum was decided, the UK stock market has been labelled as “too difficult” by many investors.

In the intervening five years, the UK has lost considerable ground against other global stock markets.

The political and economic uncertainty that prevailed for close to four years until the Brexit trade deal was agreed in December 2020, saw the UK move to a 50-year discount against global equities. It didn’t help that at this time many of the alternatives such as the US or China had a much more appealing exposure to the Technology sector.

The Brexit trade deal has meant that the outlook for sterling and for the UK economy is less uncertain than it has been for some time.  The UK stock market and currency have performed so poorly prior to this deal, there is now scope for the UK to recover some of its lost ground.

The other factor for global stock markets has been the economic impact of lock downs, necessitated by the COVID-19 virus.

The global stock market fall in Q1 2020 and subsequent recovery, against an economy that is only just recovering, is a conundrum for many. How should we value a collection of companies where we don’t really know the prospects for profits? 

How should we value a collection of companies where we don’t really know the prospects for profits?

One tried and tested way to do this is to use a 10-year average of profits for a market and divide it by today’s price level. This gives us an indication of the earnings power/potential of a market even if it is not quite firing on all cylinders. This measure is called the Shiller PE or cyclically-adjusted PE (CAPE).

Image of Collective Commentary 2

The graph in figure 1 shows that the UK is trading relatively cheaply against its long-term average, as opposed to the US market which has only been more expensive twice - in 1929 and 2000.

This indicator does not predict short-term movements in markets but is a good longer-term indicator and when the CAPE has been at similar levels previously in the UK, the market has delivered double digit percentage returns over the next ten years. This leads us to conclude that the UK is cheap longer-term. The US trading at nearly 3 times the valuation per pound of long-term profits is somewhat expensive.

However, as all shoppers know, sometimes low prices do not necessarily indicate a bargain. The UK, with its large positions in banks, insurance, oil, mining and tobacco companies, is certainly less glamorous than the US, with Facebook, Amazon, Netflix and Google. That said, even if we control for these factors by using global sector averages, then the UK is still cheaper than its US counterpart. The choice appears to be between the UK, which is cheaper with lower growth, and the US which is decidedly expensive but has better faster growth.

Can we find growth in the UK market but not pay a high price for it? What if we were to look in the UK for companies that offer some of the growth prospects of their transatlantic cousins? The answer is surprisingly interesting. The UK is home to a good number of interesting technology businesses and has some world leading healthcare companies.

While many of these may not be household names such as Microsoft or Oracle, these businesses are often growing faster, very well run and - after the Brexit sell off - far cheaper than the US majors.

Internet or cloud-based computer software companies have been particularly popular in the US and change hands for 12-15 times annual revenue. Similar companies in the UK will generally be c.3-4 times annual revenue for similar levels of growth. These UK companies are normally small or micro sized.  

The UK punches above its weight in life sciences having four of the World’s top 10 Universities for healthcare research. In the US there has been a huge boom in biotech and healthcare stocks related to gene and immuno-therapy. This is in marked contrast to the UK where such companies have been handed a much lower valuation. 

The UK punches above its weight in life sciences having four of the World’s top 10 Universities for healthcare research.

Many see the UK as an ‘old world’ value market with few growth companies. For those prepared to delve a bit deeper there are plenty of interesting smaller UK growth businesses available at discount prices. Perhaps in post-Brexit UK, we do not have to make a choice between business growth and low valuation.

Richard Penny, Fund Manager of CRUX UK Special Situations Fund

Views and opinions expressed in this article are those of the author and not of JM Finn. The information does not constitute advice or a recommendation. 

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Autumn Issue Thirty Six