The UK looks, on any measure, bizarrely cheap, particularly when compared with the US. The forward price-earnings ratio for the FTSE All-Share Index is about 10 times. It is the same for the FTSE 100, slightly lower for the FTSE SmallCap Index and only slightly higher for the FTSE 250. Compare the UK’s current forward P/E to its median over the last 15 years, says Duncan Lamont of Schroders, and you will see that it is on a discount of around 20%.
Look to the US and it’s a different story. The US market trades on around 18 times forward earnings and is trading at a 14% premium to the UK. The yield differential is huge too. You can get 4.5% here on a portfolio of reasonably valued equities. In the US, you can get less than 2% on a portfolio of still quite expensive ones.
It is true that the UK has long been a much higher-yielding market than the US, but as the analysts at Berenberg pointed out, this relative dividend yield is still very much “towards the top end of its 50 year history.” You may consider the differential to be completely normal: Most market participants will say that the US always trades at a premium. Always has, always will.
They are wrong. Go back 30 years and you will see the relationship only really kicked off in the late 1980s.
Still, the past is the past, and perhaps it seems obvious why the UK trades on a huge discount now. It’s bleak out there — there are strikes and high taxes as well as high state spending (though not enough to stop the strikes). Chuck in a global recession along with an overlay of Brexit, and clearly the hellhole that is modern Britain is cheap for a reason.
There’s also the fact the UK stock market is old, old, old — jammed not with the whizz bang tech of the US but with banks, insurers, oil, gas, coal and mining. Miserable politics, a miserable economy and no sign of a growth mindset anywhere. Who would want exposure to this mess of a market?
Yet there’s a problem with this easy explanation. All the awfulizing suggests that UK P/E ratios are low because one can expect little growth from the UK. However, look at the actual growth and it’s clear that this is valued differently to that in the rest of the world.
On to the valiant efforts of Panmure Gordon’s Simon French, who has spent much of the last few years delving into what he calls the “persistent undervaluation of UK listed companies.” Look at price-to-growth ratios, he says, and you will see they are consistently lower across most industrial sectors in the UK than in the US and the European Union. It isn’t so much that there is no growth, it’s that UK growth is valued less than growth elsewhere.
What might explain that? French has looked at two possibilities. The first is that UK companies suffer from a deficiency of do-goodery — and so our ESG ratings are lower in the round than those of other countries. There might be something in this: French finds that there is a small premium attached to companies with higher ESG scores for a given level of earnings growth. But this, at best, can only explain a tiny part of the discount.
One that explains more is liquidity. In the UK, it is “thin” relative to the US and Europe. French found the average daily volume across the UK’s largest companies over a 30-day period last year to be $11 million a day — with only one-third seeing more than $5 million a day. In the EU and US, those numbers were $95 million and $443 million a day, respectively.
This matters for the simple reason that lots of large institutional investors around the world work with self-imposed liquidity thresholds. If they aren’t sure they can get in and out of trades reasonably quickly, without moving the price too much, they won’t get in at all. So it might not matter how cheap or attractive UK stocks are or become, the big firms won’t be coming in to scoop their shares up.
Sure enough, French finds that the more liquid a company is, the more their earnings per share growth is valued. However, not even this explains the whole discount. There are, says French, no “clinching pieces of evidence that put the UK valuation story to bed.” What we have is “insufficient by some distance.”
This is fantastic news for investors. The stock market often does most of our work for us — things that are cheap are cheap for a reason, and we can see what that reason is. But sometimes, there is no reason that fully explains the cheapness. Then, and only then, as the late fund manager Ian Rushbrook put it, “the anomaly becomes an opportunity.”
Well, here we are. With an anomaly that is increasingly looking like a very good opportunity — and a particularly good one for retail investors. Why? Because retail investors don’t need to tick ESG and liquidity boxes before we buy (our trades don’t move markets); we have fewer time constraints; and as we are judged only by ourselves, we need not worry about what might trigger change. All we have to do is ask if what we are buying is too cheap, and if we are being paid enough in dividends to wait for that to change.
And here’s the answer: It is, and we are.
More from Bloomberg Opinion:
• Forget What You’ve Learned About Investing in the Last 20 Years: Merryn Somerset Webb
• Will UK Reforms Leave 800 Lords-a-Weeping?: Therese Raphael
• Bye-Bye, Big Bang: UK Reforms Are an Exercise in Political Theater: Paul J. Davies
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Merryn Somerset Webb is a senior columnist for Bloomberg Opinion covering personal finance and investment. Previously, she was editor-in-chief of MoneyWeek and a contributing editor at the Financial Times.
More stories like this are available on bloomberg.com/opinion
