Bargain Basement Britain

Wed 21 Feb 2018

Over the last month global equity markets have sold off; since the 15^th of January the MSCI AC World Index has fallen -4.12%, the S&P 500 -4.22% and the Japanese Nikkei -6.0%. The UK market similarly has tumbled with the FTSE 100 plummeting -6.36% over the last 4 weeks¹.

With stocks cheaper compared to a few months many see valuations as attractive, especially considering that strong equity performance had left valuations looking stretched.

UK companies have lagged their American and European counterparts over the last year so this sell off has occurred from a lower zenith in the UK. British companies look cheap but are they a bargain?

What does the data say?

On a number of valuation metrics the UK market does indeed look like a good deal. FTSE 100 companies are global companies and source over two thirds of their revenue from abroad, so maybe this is a good opportunity to buy a global business at a cut price. The table below shows selected valuation metrics for the major world indices.

It is important to remember like-for-like comparisons between indices can be misleading as their compositions differ widely. For example, the IT sector, whose firms often sport higher valuations, accounts for 24.2% of the S&P compared to 7.2% of the Eurostoxx⁵. Despite the issues surrounding the comparison of indices, UK companies are being valued at a discount.

An historic perspective

UK equities are now trading close to their 10 year average P/E but this still remains a premium to the 5 year nadir. When we consider that pre-referendum the FTSE 100 was trading at a ratio of 16x, many will argue this is a prime opportunity to bag a bargain. If one believes that UK company fundamentals, in terms of future sales and earnings growth is no different to 18 months ago, it is difficult not to agree that the UK is attractively priced.  That chart below shows how the price to forward earnings ratio for the FTSE 100 has moved over the last 10 years.

The Brexit premium

The UK’s cut price is widely recognised as a cost of Brexit uncertainty. The impact of Brexit for UK companies is unknown, the loss of tariff-free access to Europe and imposition of WTO rules is a real possibility. Companies in the FTSE 100 derive c.20% of sales from Europe⁷, and Brexit may have lasting consequences for future earnings.

Moreover, the UK has tended to underperform when monetary policy is tightened, if the Bank of England has to hike interest rates to tackle imported inflation (from tariffs on goods and Sterling depreciation) a difficult environment for UK stocks could occur. This clearly is a big if, but stock pickers should remain cognisant that equity markets theoretically discount the future. Take British Airways owner IAG who release earnings results this week. The stock is trading on a forward P/E of 6.1x, comparably cheap to competitors, but its European operations are substantial and what Brexit will do to its business is currently finger in the air conjecture.

Uncertainties for the bargain hunter

It is entirely possible that UK companies are oversold and tarnishing the entire market with an uncertainty levy is unfair. Clearly there will be winners and losers from Brexit and many will point to how UK equities have rallied on the back of the Pound weakening. The UK’s multinationals originate c.70% of revenue abroad but report profits in Sterling. When the value of the Pound falls, the value of their profits automatically rises as does their share price. The Brexit outcome is far from binary and how the market will react to news flow on negotiations, transitions etc. is unpredictable.

The questions for those about to buy UK equities need to cover a few angles, with a focus on how the stock’s earnings are affected by new trade rules and moves in Sterling. Both of these are inherently difficult to predict. Therefore we currently remain underweight UK equities in our portfolios and feel that other geographies present better opportunities.

References:

[1] Source: Financial Express. Gross Returns in Sterling to 21/02/2018.

[2] Forward P/E using consensus estimates for earnings.

[3] Current Enterprise Value with forward EBITDA consensus estimates for EBITDA.

[4] FCF calculated using forward estimates of Free Cash Flow and Index price as at 16/02/2018.

[5] S&P Global, Eurostoxx

 [6] Chart source. Mazars, calculations using forward P/E.

[7] Research by the Capital Group.