10 December 2020
After a tough year for investors in UK equities, GAM Investments’ Adrian Gosden believes the sector offers a compelling investment case heading into 2021, helped by the return of dividends.
2020 has been a horrible year for investors in UK equities. As of 20 November, the FTSE 100 was down more than 15% year-to-date. This compares poorly with most other equity markets across the globe and looks quite wrong when compared to China CSI 300 which was up 28% (year-to-date in GBP) and the US Nasdaq which was up 33% (year-to-date in GBP) in the same period. The reasons for this huge underperformance are varied but can best be assigned to four key issues: Brexit, the Covid-19 pandemic, dividend cuts and a lack of technology in the UK index. Other considerations include the impact of low interest rates on banks and an ESG push against big oil stocks, both of which were important parts of the UK index. However, for the purpose of this article, we will focus on the four big issues mentioned above. Having acknowledged the terrible performance of the UK equity market in 2020 year-to-date, the question is whether UK equities might now present a good opportunity for investors. As Chart 1 shows, UK equities are at a 50-year valuation low compared to world markets. This is only of academic interest unless we can identify a reason why this might change - a reason linked to the UK market rather than assuming world markets fall.
Certainly corporates and private equity companies have noticed the valuation opportunity presented in UK equities. William Hill and Hastings Insurance, for example, have recently received offers. In the wider market stock market, bids have landed in house building, insurance and property. The variety of sectors involved is encouraging and suggests a wide undervaluation of UK equities. However, these corporate and private equity attentions are welcome but on their own, they will not propel the UK stock market back to more respectable levels.
Chart 1: UK versus MSCI World Average Valuation Premium
Considering the four key reasons for underperformance
Beginning with the composition of the FTSE 100, it is unlikely that the UK market will become populated with large technology companies in the near future, so we will have to do without the influence of this sector for now. A swift rollout of a vaccine and a quick, accurate mass testing system could help us to overcome many of the challenges posed by the Covid-19 pandemic, including being able to go about our business rather than staying at home. Certainly in Asia, we have seen the positive impact that combatting the virus has had on local stock markets. It now seems likely that a suite of vaccines will be available in 2021. Just as Asian economies have bounced back, it would not be unrealistic to expect European economies to also return to growth. Even the much forgotten about UK would see economic growth and that would usually result in a better performance from the UK stock market.
With regards to Brexit, UK stock market investors have hoped for progress ever since the vote to leave was received in 2016. Falling out with our biggest trading partner was always going to very unsettling for businesses. Could we have some clarity in 2021? Our hopes for this have significantly waned over time.
So that brings us to the final of those four key issues: dividend cuts. Here, we are far more optimistic. The dividend cuts in 2020 were severe. Between 40% and 50% of dividends were lost. Some dividend cuts were directly attributed to the economic downturn caused by the pandemic, some dividend cuts were companies taking the opportunity to rethink their dividends after years of over distributing and some companies were prevented from paying dividends by regulators. All in all, this was a heavy blow for investors. Dividends are an important source of returns, making up nearly half of all UK equity returns in the last century (Dimson, Marsh and Staunton – Triumph of the Optimists). To have such an important part of the investment case damaged, we believe, is the biggest reason for the UK market’s huge underperformance year-to-date.
Fortunately, as we approach the end of 2020, there is change in the air. Dividends are starting to return. Companies are returning to paying dividends from a wide variety of sectors. In our view, the biggest influence on the UK market by returning to dividend payments will come from the banks. As soon as the regulator permits this activity to recommence, we believe that investors will once again return to the UK market for the reasons they always used to - dividends. As we move into 2021, we believe UK equities offer a very compelling investment case.
This article was first published in Investment Week.
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 no indicator for the current or future development.