Five years on from the launch of GAM Investments’ UK equity income strategy, managers Adrian Gosden and Chris Morrison outline the opportunity they see for UK equities to deliver on an absolute basis, despite the ongoing macroeconomic challenges the UK faces.
The last five years have been complex for investors in UK equities. Since the EU Referendum in June 2016, we have seen uncertainties stack up against interest – and confidence – in UK companies and the pain pile on for investors in UK equities. This is largely the result of a number of idiosyncratic events – the extended indecision over Brexit; the UK's poor record managing the Covid pandemic ahead of the vaccine rollout; the dividend bonfire of 2020; and more recently the war in Ukraine and the economic fallout from the mini-budget. Consequently, the UK equity market is today trading on a 40-year low on a price-to-earnings (P/E) basis against the MSCI World index.
Investors might justifiably ask what incentive there is to invest in the UK over other geographies at present. Crucially, we believe the UK market should be considered on an absolute rather than a relative basis. To illustrate this point, we selected six longstanding and well-known UK-listed firms from a range of sectors. As Figure 1 shows, each of these companies is currently on a single digit P/E. Crucially, if that P/E was to increase from five to six, for example, and that company paid its 5% dividend, this would result in a sizeable return.
Figure 1: UK companies trading on single digit P/Es
What could trigger such a move? The negativity that has surrounded the UK in recent years has been deafening and as a result, many UK companies have been traded based on macroeconomic developments in the UK. In our view, the move from a P/E of five to six would not require a dramatic turnaround in the UK’s fortunes, but rather an incremental change, such as recognition that the cost-of-living crisis in the UK is not quite as painful as initially expected. Aligned with this, when UK companies report, we are looking for evidence that their performance and outlook are not as negative as their share prices imply. Where this is the case, we see significant opportunity for them to deliver on an absolute basis.
The opportunity set in the mid-cap space, home to many of the more economically sensitive and more domestic stocks, which is down approximately 25% year-to-date, is even greater in our view, particularly as we gain greater clarity on the future trajectory for the UK in the weeks ahead.
Key pillars remain in place
The opportunity we have outlined above is supported by four key pillars which we have previously highlighted and which continue to hold – the return of dividends, a rise in corporate activity, the unprecedented amount of share buybacks and the composition of the UK market.
Beginning with dividends, they play a fundamental role in the UK, making up half of the return of UK equities over the last 100 years. Following the significant dividend cuts in 2020, we are now operating in a market where dividends are increasing. This not only benefits the shares themselves, but dividend growth is a very useful tool to help investors combat the current inflationary environment.
Secondly, the UK market continues to experience a significant amount of corporate activity. In recent years, we have seen a broad range of UK companies, including Euromoney and Morrisons, bid for at significant premiums by private equity firms. These are not anomalies. Rather, this is happening regularly in the UK market. This reflects both the fall in sterling and the undervalued nature of the UK market. Private equity firms are continuing to buy UK companies and taking them off-market – and they have the potential to make strong returns by doing so.
Further, we are continuing to see an unprecedented amount of share buybacks. UK companies, principally in the financial and energy sectors, having paid their dividends and with healthy balance sheets, are buying themselves. These businesses cannot make acquisitions in the wider market because it is too expensive and therefore, given the low price of their UK shares, they are choosing to buy themselves. We regard this as an attestation to the company’s value. Further, share buybacks matter to investors because they reduce the denominator on which dividend per share and earnings per share are calculated. As a result, earnings per share and dividend per share rise.
As well as these three key features – dividends, corporate activity and share buybacks – which represent strong tailwinds for UK equities, the composition of the UK market is also worthy of note. Specifically, 1% of the FTSE 100 is in technology, while technology accounts for almost 30% of the S&P 500.1 The UK market is instead dominated by financials, oil and gas and mining shares, all sectors which, in the current environment where we are seeing a rising yield curve, are likely to respond well.
Having invested in UK equities for the last 30 years, we believe today presents an opportunity akin to that we experienced in 2000, 2008 and 2020. That is, to stick to a robust investment process, adhere to cash flow principles, be nimble, put capital to work at the right time and crucially, be bold enough to make decisions in this investment environment with the aim of delivering on an absolute basis for clients.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.