19 May 2024
As a fundamental investor, my goal is to buy a company with great fundamentals at the lowest price possible. In most cases, the price and fundamentals are highly correlated: if I want to buy a great business I have to be ready to pay up for it.
So, how do you go about it? One option is to try to find companies with fundamentals that are not fully recognised yet. The company may have two divisions: one loss-making and the other highly profitable. Combined, the two segments generate average results, but if one segment is sold off, the remaining business suddenly becomes highly attractive. Other times, the business has a great service but lacks scale, which keeps its profitability well below the long-term potential. This is the case of Trustpilot, which I purchased in October 2023.
Another option for finding mispriced opportunities is to avoid ‘crowded’ places and look for ideas in out-of-favour sectors and countries. A $20 bill will not lie for too long at the Grand Central Station in Manhattan. But it may be a few days before someone notices it lying in the suburbs of Omaha.
Sometimes, you can find a rare opportunity that combines two factors: a great business not yet recognised by the market in an unloved market.
In that case, you stand to benefit from the double discount.
To me, the UK market falls into this ‘rare opportunity’ category.
So, how do you go about it? One option is to try to find companies with fundamentals that are not fully recognised yet. The company may have two divisions: one loss-making and the other highly profitable. Combined, the two segments generate average results, but if one segment is sold off, the remaining business suddenly becomes highly attractive. Other times, the business has a great service but lacks scale, which keeps its profitability well below the long-term potential. This is the case of Trustpilot, which I purchased in October 2023.
Another option for finding mispriced opportunities is to avoid ‘crowded’ places and look for ideas in out-of-favour sectors and countries. A $20 bill will not lie for too long at the Grand Central Station in Manhattan. But it may be a few days before someone notices it lying in the suburbs of Omaha.
Sometimes, you can find a rare opportunity that combines two factors: a great business not yet recognised by the market in an unloved market.
In that case, you stand to benefit from the double discount.
To me, the UK market falls into this ‘rare opportunity’ category.
A series of negative ‘catalysts’ in the past
The UK economy has suffered from various factors, including Brexit, COVID lockdowns, higher energy costs, and interest rates. Since 2016, the country has had five Prime Ministers.
These drivers are all 'reversible' thanks to an open market-based economy governed by the rule of law. A good case of the self-correcting nature of the UK system is Liz Truss' mini-budget, which a former PM introduced in 2022. The market was sceptical about the ambitious tax cuts that would have led to higher budget deficit, sending government bond yields to multi-year highs. Not only Truss had to retract her plan, but pretty soon she lost her job as a Prime Minister.
These drivers are all 'reversible' thanks to an open market-based economy governed by the rule of law. A good case of the self-correcting nature of the UK system is Liz Truss' mini-budget, which a former PM introduced in 2022. The market was sceptical about the ambitious tax cuts that would have led to higher budget deficit, sending government bond yields to multi-year highs. Not only Truss had to retract her plan, but pretty soon she lost her job as a Prime Minister.
Cheaper than EMs and (almost) back to 2009 valuation level
The UK has many similarities with Emerging Markets: weakening currency, lack of consumer confidence, deteriorating public services and distrust towards politicians. It is perhaps not surprising that UK stocks are now cheaper than their EM peers.
The fact that the UK stocks are cheap both on an absolute (11.7x PE) and relative basis (over 50% discount to the US) is particularly exciting. Many UK stocks are almost as cheap as during the global financial crisis of 2008-2009.
The fact that the UK stocks are cheap both on an absolute (11.7x PE) and relative basis (over 50% discount to the US) is particularly exciting. Many UK stocks are almost as cheap as during the global financial crisis of 2008-2009.
Don't blame sector weights for the UK discount
Typically associated with banks and resource companies, the UK market is expected to trade at a discount to the tech-heavy S&P 500.
However, these days UK market is cheap not only because of the different sector weightings compared to the US, for example. Companies in the same sector would still trade at lower multiples if they were based in the UK than in the US. Be it BP and Shell vs Exxon and Chevron, or HSBC and Barclays vs Bank of America and JP Morgan.
From the current macro perspective (the least important factor in the investment approach I follow), heavy exposure to the resources and financial sector may even put the UK market at an advantage.
However, these days UK market is cheap not only because of the different sector weightings compared to the US, for example. Companies in the same sector would still trade at lower multiples if they were based in the UK than in the US. Be it BP and Shell vs Exxon and Chevron, or HSBC and Barclays vs Bank of America and JP Morgan.
From the current macro perspective (the least important factor in the investment approach I follow), heavy exposure to the resources and financial sector may even put the UK market at an advantage.
Unattractive for the wrong reasons
The growth of passive funds and relentless pressure on costs experienced by active asset managers means that to survive these managers need first and foremost to get bigger. They cannot ignore performance, but a well-performing small fund could still be a loss-making business compared to a much larger fund that just 'actively' tracks an index.
As a result, many UK stocks are just too small and not liquid enough for many global investors. It is these large investment funds that have the means to invest in the best technology and hire the best analysts.
As a result, a not very well-known UK company that is not large enough and whose shares don't actively trade will likely be less efficiently priced than its Wall Street peer with a higher market cap.
In addition to that, Europe (and the UK) introduced the Mifid regulation, which, among other changes, forced asset managers to pay for research services separately from the execution of their trades. This put pressure on many independent brokers and reduced the overall quantity of sell-side research. It is not uncommon for a small UK company to be covered by just 1 or 2 analysts, often sponsored by the same company. There are a few companies in Europe and the UK that are not covered by analysts at all.
All this leads to less efficiency in the market and increases opportunities for diligent investors with modest amount of capital.
As a result, many UK stocks are just too small and not liquid enough for many global investors. It is these large investment funds that have the means to invest in the best technology and hire the best analysts.
As a result, a not very well-known UK company that is not large enough and whose shares don't actively trade will likely be less efficiently priced than its Wall Street peer with a higher market cap.
In addition to that, Europe (and the UK) introduced the Mifid regulation, which, among other changes, forced asset managers to pay for research services separately from the execution of their trades. This put pressure on many independent brokers and reduced the overall quantity of sell-side research. It is not uncommon for a small UK company to be covered by just 1 or 2 analysts, often sponsored by the same company. There are a few companies in Europe and the UK that are not covered by analysts at all.
All this leads to less efficiency in the market and increases opportunities for diligent investors with modest amount of capital.
Finally, it is worth noting that a few UK mid-caps (not just the largest companies) have significant international operations, particularly in the US. However, due to their domicile and listing, they are associated with the issues of the local economy and are not valued at the same multiple as their US peer.
Five drivers of revaluation
The higher growth of Emerging Markets is often offset by poor state policies or corporate governance. Despite China's fastest growth among large economies over the past 40 years, its stock market is at the same level as 30 years ago.
In other cases, minority shareholders may suffer from the transfer of value by controlling shareholders (via shareholder loans or other value-destroying related-party transactions). Investors in Korean conglomerates have a few stories to tell.
The UK market, on the other hand, benefits from much higher corporate governance standards and one of the best legal systems. This, coupled with a record-low valuation of its companies, makes it an exciting opportunity. The following four drivers will likely correct valuations quite soon.
In other cases, minority shareholders may suffer from the transfer of value by controlling shareholders (via shareholder loans or other value-destroying related-party transactions). Investors in Korean conglomerates have a few stories to tell.
The UK market, on the other hand, benefits from much higher corporate governance standards and one of the best legal systems. This, coupled with a record-low valuation of its companies, makes it an exciting opportunity. The following four drivers will likely correct valuations quite soon.
1. Record M&A volumes
The UK remains one of the few open economies. The relatively free flow of capital eventually corrects mispricings. In this case, if public investors move away from UK stocks, strategic investors and private equity funds, especially from the other side of the Atlantic, are quickly stepping in.
Over the past 10 years, there have been about 40 bids every year for publicly-listed UK companies. The deal volume surged to record 64 bids in 2023. So far, 2024 looks to set a new record with over 20 bids announced already. The value of deals has already exceeded 2018.
Over the past 10 years, there have been about 40 bids every year for publicly-listed UK companies. The deal volume surged to record 64 bids in 2023. So far, 2024 looks to set a new record with over 20 bids announced already. The value of deals has already exceeded 2018.
2. Record buybacks
Almost half of all UK companies are now carrying out share repurchases. This is the same if not higher than in the US. With lower liquidity and often high insider ownership (e.g. Fraser Group, Next) such buybacks can lead to more significant impact on stock prices.
3. An elephant in the room: DB Pension
The less discussed factor is the defined benefit (DB) pension and accounting changes. Earlier, UK companies favoured pension plans that invested in fixed income to avoid volatility and negative impact on their P&Ls. UK pension funds turned into steady sellers of British stocks.
However, today, DB pension funds are in surplus, and the government is working on initiatives to tap into that surplus. Proposals such as better disclosure of performance, the share of UK holdings, and other measures are discussed.
If the pension funds stop selling UK stocks (they probably won't have anything left anyway), this is already a marginally positive factor.
But there is a sense among the market participants that the £1.4tn managed by DB pension plans could one day turn into net buyers of domestic stocks.
However, today, DB pension funds are in surplus, and the government is working on initiatives to tap into that surplus. Proposals such as better disclosure of performance, the share of UK holdings, and other measures are discussed.
If the pension funds stop selling UK stocks (they probably won't have anything left anyway), this is already a marginally positive factor.
But there is a sense among the market participants that the £1.4tn managed by DB pension plans could one day turn into net buyers of domestic stocks.
4. Higher cost of capital today, higher returns tomorrow
Historically, entering the market when interest rates were high had led to strong results. The opposite is also true. It is easy to understand why. Firstly, the price you pay is one critical factor of your returns. Investor A who buys an asset generating $10,000 a year for one million, will get one-tenth of the returns of Investor B if he pays just 100,000 for the same asset. The same asset generates completely different returns depending on the price you pay.
The less obvious driver is on the supply side. The harder it is to raise new capital, the less competition there will be in a particular sector or country. It may be bad news for consumers, but it is encouraging for owners of existing companies.
The less obvious driver is on the supply side. The harder it is to raise new capital, the less competition there will be in a particular sector or country. It may be bad news for consumers, but it is encouraging for owners of existing companies.
5. Macro?
While I rarely buy or sell stocks because of my macro views, there are signs the worst is behind for the UK economy. This could support further earnings growth and stronger investor sentiment. Some of the green shoots include:
- UK GDP growth has turned positive in Q1 2024 after two consequent declines.
- Real wage growth has been accelerating.
- Bank of England is now likely to cut the rates already in June 2024.
What UK stocks are worth looking at
The list of UK stocks that look attractive from a valuation point of view is very long. Some of the names have been covered in my Monthly Stock Idea Lab publications (see the March edition here). I currently own 11 UK-listed stocks, including the largest auto insurer, Admiral; a founder-led pub company, JD Wetherspoon; a leading product review, Trustpilot; a unique gaming company, Games Workshop, a founder-led clothing retailer, Frasers Group.
I plan to cover more mid-caps as I see a few companies trading at 5-8x P/E with a net cash position and decent businesses. UK-listed E&Ps also screen highly attractive. You should expect two separate reports from me in the next several weeks.
Some of the companies will be featured in the Monthly Stock Idea Lab next Sunday (26 May).
One important warning is that investors should ask themselves about the business quality and industry exposure they get when they buy a particular stock.
For example, many value investors favour UK-listed energy companies, pointing out that they distributed 20-30% of capital in the past two years. Well, this is not surprising, given that 2022 was an extraordinary year for energy markets. I do not think it is prudent to forecast such conditions repeating any time soon. And if you add the low returns from new investments in renewables, then the future outlook looks different. In any case, a 4% dividend yield offered by Shell, for example, with an additional 4-5% returns via buybacks, leads to just 8-9% shareholder yield. Not particularly attractive for a company that has no long-term structural growth.
I am also not convinced about Tobacco companies that face sharp declines in their core product and have to compete in the new segment where they lack substantial advantages.
I plan to cover more mid-caps as I see a few companies trading at 5-8x P/E with a net cash position and decent businesses. UK-listed E&Ps also screen highly attractive. You should expect two separate reports from me in the next several weeks.
Some of the companies will be featured in the Monthly Stock Idea Lab next Sunday (26 May).
One important warning is that investors should ask themselves about the business quality and industry exposure they get when they buy a particular stock.
For example, many value investors favour UK-listed energy companies, pointing out that they distributed 20-30% of capital in the past two years. Well, this is not surprising, given that 2022 was an extraordinary year for energy markets. I do not think it is prudent to forecast such conditions repeating any time soon. And if you add the low returns from new investments in renewables, then the future outlook looks different. In any case, a 4% dividend yield offered by Shell, for example, with an additional 4-5% returns via buybacks, leads to just 8-9% shareholder yield. Not particularly attractive for a company that has no long-term structural growth.
I am also not convinced about Tobacco companies that face sharp declines in their core product and have to compete in the new segment where they lack substantial advantages.