GAM Investments’ Adrian Gosden, Investment Director, UK Equities, outlines why the tide is turning for UK companies. He says the combination of a Brexit resolution, the vaccine rollouts and the return to dividend payments has created a unique opportunity for investors.
The UK has been a woeful place to invest in recent years, with the UK equity market currently on a 50-year low compared with global equity markets. In our view, this has been driven by four main factors: Brexit, Covid-19, the absence of large-cap technology in the UK market and dividend cuts. In recent months, however, we have seen some of these obstacles begin to weaken and the investment case for the UK become increasingly compelling.
Why have UK equities underperformed?
First, Brexit led to a great deal of uncertainty, most visible in sterling. We saw multiple withdrawal agreements fail to pass in parliament as the devaluation of UK equities versus overseas markets simultaneously accelerated. Simultaneously, as the uncertainty around Brexit began to ease, the pandemic hit. Covid-19 is a global problem, but in the early days of the pandemic, the consensus was that the UK was handling it very badly. The UK had higher mortality, with a particular problem in care homes. The strict lockdowns implemented in the UK were also not commonplace everywhere in the world. As a result, for many investors, the economic decline in the UK was too severe for them to invest their capital in the UK equity market.
On top of these two very negative factors, the UK has a distinct lack of large-cap technology companies. Growth has been incredibly hard to find since the financial crisis in 2008 and as a result, investors have been prepared to pay even more for it. Technology was clearly an area that could grow and investors looked to the US for large-cap tech. In 2020, while the UK market lost 10%, the Nasdaq gained 40% for investors.
Even with all these factors considered, in our view, dividends are the primary reason why the UK found itself so low against global markets. Historically, approximately half of the UK equity market’s returns have come from dividends and they represent a key component of the return profile. At the worst point in 2020, dividends were cut by 40%, amounting to a reduction from GBP 100 billion to GBP 60 billion.
We saw cuts from companies that had no choice as they had no business income, such as those in the travel or leisure industries. Banks were asked by the regulator not to pay dividends in order to preserve capital. And then there were companies, such as Shell, that cut their dividends significantly.
An improving picture and a unique opportunity
However now the picture is changing. As we move through the Brexit process, there is increasing clarity and international investors’ more positive view is reflected in the strengthening UK currency. Regarding the pandemic, the UK’s outlook has significantly improved following its largely successful handling of the vaccine rollout. As a result, the economy is springing back to life and the Bank of England has upgraded its growth forecast for 2021 to 7.5%. This is a material improvement compared to where we thought the UK would be just a few months before.
Most importantly, we are seeing a visible and tangible return to dividends. Companies in sectors such as industrials and construction cut dividends when they perhaps did not need to, as their activity remains strong. We have also seen the return of dividends from some banks and even those companies that cut dividends significantly are now increasing them.
In addition, we are experiencing an unprecedented amount of UK corporate activity across sectors and market caps. Companies and private equity outside of the UK market have acted quickly. Companies are being removed from the stock market on a daily basis, providing clear evidence that the UK is undervalued relative to other asset classes.
In our view, the evidence is compelling that there is currently a unique opportunity for investors in UK equity income. As dividends are reset, investors can harness them. Specifically, we are currently seeing some of the most compelling opportunities across small- and mid-cap companies. In large caps, Lloyds Banking Group and BP have both recently reported results, leading analysts to upgrade their expectations. Both firms are on single-digit price-to-earnings multiples and are now paying dividends.
We believe UK equities remain undervalued relative to other markets, but the return of dividends represents a catalyst to unlock that value.
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.