Portfolio Manager Indriatti van Hien discusses why undervalued UK stocks have never looked more compelling.
- Markets have started to price in expectations for higher inflation, stronger economic growth and a withdrawal of quantitative easing. We have recently seen weakness from sectors that had outperformed during the pandemic, such as technology stocks.
- UK equities can provide a fertile hunting ground for investors looking for value opportunities and to benefit from a backdrop of rising interest rates. Some multinationals are currently trading at significant discounts to international peers (courtesy of Brexit), while the beaten-up UK domestic retail, travel and leisure stocks may be undervalued if a potential earnings recovery comes through.
After two years of COVID-dominated news flow, the spotlight has moved, with inflation and interest rate hikes likely to take center stage in the year ahead. The Bank of England’s decision to increase interest rates late last year, albeit to still lower than pre-COVID levels, underlines our view that it is not just investors who are more concerned about persistent inflation than the adverse impact of new COVID strains on developed, and vaccinated, economies. Central bankers are worried too.
Markets have already started to price in yield curve steepening in line with expectations for higher inflation and economic growth. Figure 1 shows that the "darlings of the quantitative easing trade" such as technology stocks have started underperforming. Unlike the unprecedented global pandemic, there is a well-precedented playbook that comes with a rates cycle; sell your tech and consumer staples and buy banks, miners and cheap cyclical stocks. Will interest rate rises prove to be the catalyst for a snap back of that oh-so-stretched elastic between value and growth stocks? Will this force investors to turn away from the tech-heavy indices in the U.S. and return to the UK market? The UK market with its materially higher benchmark weightings to commodities and financials versus other global equity indices, provides investors with a fertile hunting ground for those looking to benefit from potential opportunities arising from higher interest rates.
Figure 1: "QE Trades" Starting to Underperform
Source: BNP Paribas Exane Strategy Research: 2022 Outlook: The Next V+. Bloomberg, BNP Paribas Exane estimates, Janus Henderson Investors, as at 31 December 2021. Indices rebased to 100 at 1 January 2020. Chart reproduced with permission. Past performance is not a guide to future performance. Non profitable tech companies = Goldman Sachs Non-Profitable Tech Index. ARKK ETF = ARKK Innovation Exchange Traded Fund) invests in disruptive innovation stocks. IPO Performance Index = FTSE Renaissance Global IPO Index. RHS: GS Retail Favorites Index= Goldman Sachs defined basket of more than 50 U.S.-listed stocks popular with retail traders.
Figure 2 illustrates the very high correlation between the performance of the UK market relative to global equity markets and the performance of value versus growth stocks globally. If value becomes the plat du jour in 2022, a painful rotation could be in store for investors as, much like the UK equity market, "value" stocks have never been more out of favor. We have seen some actively managed funds with a value mandate fall dramatically since the Global Financial Crisis (and the start of quantitative easing).
Figure 2: UK Equities Are Attractive Versus Global Equities
Source: MSCI, IBES, Morgan Stanley Research, Janus Henderson Investors analysis, as at 31 December 2021. Past performance is not a guide to future performance. Chart reproduced with permission. Note: average relative valuations use 12-month forward data where available and trailing data where forward PE is not available.
Once investors reach the shores of the UK equity market, they will find not just the behemoths of traditional value investing, but also some multinationals currently trading at significant discounts to international peers (courtesy of Brexit). Beaten-up UK domestic retail, travel and leisure stocks look primed for earnings recovery, trading at a "double discount" (courtesy of Brexit and COVID). Potentially manna from heaven for investors searching for both value and growth.
Negative headlines around Brexit negotiations, the Irish protocol in particular, a government running low on goodwill with the public and impending tax rate rises continue to dampen sentiment towards the UK market. This, coupled with some very muted earnings forecasts for the year ahead, which look incongruous given the above-trend UK GDP growth forecast for 2022, suggest that the "spring is coiled" and that, after years of underperformance, the UK equity market could well be ready to shine again. If not now, when?
Steepening yield curve: a yield curve graph plots the yields of similar quality bonds against their maturities. A steepening yield curve typically indicates that investors expect rising inflation and stronger economic growth.
Quantitative easing: an unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system, most commonly by purchasing government bonds.
Cyclical stocks: companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by the ups and downs in the overall economy, when compared to non-cyclical companies.
Value investing: value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase. One of the favored techniques is to buy companies with low price to earnings (P/E) ratios.
Growth investing: growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
PE or price-to-earnings: is calculated by dividing the current share price by its earnings per share. A high PE ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high PE ratio. Forward PE typically is based on either projected earnings for the following 12 months or the next full-year fiscal period.
PBV or price-to-book: is calculated by dividing a company’s market value (share price) by the book value of its equity. The higher the P/B ratio, the higher the premium the market is willing to pay for the company above the book (balance sheet) value of its assets and vice versa.
PDiv or price-to-dividend: is calculated by dividing price per share by dividends paid per share.
Note: funds that have a high exposure to a particular country or geographical region carry a higher level of risk than those that are more broadly diversified.