Though it may not feel like it, with a cost-of-living crisis and inflation raising prices throughout the economy, investing in the UK is comparatively cheap. This is because UK equities are trading at a wide discount to other markets. According to a report from investment bank Panmure Gordon in December 2023, equities listed in the UK are 19% cheaper than their international peers on a like-for-like basis.
Unfortunately, this reflects investors’ less-than-positive view of the UK. The discount has existed since the shock 2016 Brexit vote, as investors pulled money out of UK equities and have remained wary about further geopolitical uncertainty and the country’s sluggish economic outlook.
Simultaneously, many major equity markets around the world became more attractive. Several major indices – including the S&P 500, Euro Stoxx 50 and Nikkei 225 – are up over the year for various reasons. However, these now higher valuations have made global equities more expensive for new investors. This is forcing many to rethink how they gain exposure to global earnings growth and income.
Going global via Paternoster Square
It is worth remembering that many UK equities are, in fact, not UK-focused in practice and instead draw a high proportion of their revenues from overseas. This is most evident in the FTSE 100. Although it is the index of the largest companies listed on the London Stock Exchange, based at 10 Paternoster Square in the City, most of them are global organisations with revenues coming from many markets around the world. Some 75% of the index’s revenues come from overseas (calculated September 2022).
Therefore, a better way to look at the UK equity market is to realise it provides access to overseas earnings at a discounted rate. This means analysing a UK-listed equity and taking into consideration its operations and where they make their sales, which is an objective approach.
Exploiting the UK’s valuation gap
A disparity between where a company earns its revenues and where it is listed can present an opportunity for investors.
For example, FTSE 100-listed Rio Tinto is one of the world’s largest mining and material companies with a valuation of £46bn and over 52,000 employees across 35 countries. Its listing location in London is a world away from its mines across Australia, North America, Asia and Africa.
Investing in Rio Tinto provides exposure to a company that pays healthy dividends earned through revenue generated in China and around the world. And because it is part of the UK equity market, which has fallen out of favour, this company can be invested in at a discount. Crucially, this is about more than just price and can be an important factor from a risk-management perspective. Companies that generate revenues around the world are necessarily less reliant upon a single market and therefore offer greater diversification benefits than domestically focused peers.
This theme runs throughout the City of London Investment Trust (CTY). In the trust’s most recent annual report, we revealed that 69% of investee company revenues came from overseas, as of 30 September 2023.
Not only is the trust accessing attractive, income-generating companies with worldwide exposure, but doing so in a cost-effective way.
Targeting global companies at a discount through the UK’s valuation gap has presented some great opportunities to the CTY portfolio – with some even appearing in the trust’s top 10 holdings. Two of the most notable examples that highlight this theme are BAE Systems and Unilever.
The former is one of the world’s largest defence contractors, with the US government its biggest customer. An escalation of several conflicts in the last two years is reflective of what many analysts believe to be the end of the post-cold war peace dividend, which freed governments from high levels of defence spending. And Unilever, which owns a vast range of valuable household brands, sold around the world. This includes a strong presence in emerging markets where consumers are increasing their spending every year on premium goods.
There are several good reasons why UK equity market valuations are low, but prices don’t always exactly reflect the underlying fundamentals. With a market as unique as the UK – where so many constituents have global operations – this is worth bearing in mind when assessing valuation opportunities.
Glossary
Discount – Refers to a situation when a security is trading for lower than its fundamental or intrinsic value. The opposite of trading at a premium.
Diversification – A way of spreading risk by mixing different types of assets/asset classes in a portfolio, on the assumption that these assets will behave differently in any given scenario. Assets with low correlation should provide the most diversification.
Dividend – A variable discretionary payment made by a company to its shareholders.
Emerging market – The economy of a developing country that is transitioning to become more integrated with the global economy. This can include making progress in areas such as depth and access to bond and equity markets and development of modern financial and regulatory institutions.
Equity – A security representing ownership, typically listed on a stock exchange. ‘Equities’ as an asset class means investments in shares, as opposed to, for instance, bonds. To have ‘equity’ in a company means to hold shares in that company and therefore have part ownership.
Valuation metrics – Metrics used to gauge a company’s performance, financial health and expectations for future earnings, eg. price to earnings (P/E) ratio and return on equity (ROE).
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