It’s Been A Dark Time For UK Investors, But Some Green Shoots Are Popping Up

It’s Been A Dark Time For UK Investors, But Some Green Shoots Are Popping Up
Luke Suddards

over 1 year ago4 mins

  • Investing is about finding asymmetric opportunities where the upside price potential is greater than downside price potential.

  • Here’s the bright side for the FTSE 100: it’s got a record low forward P/E ratio of 8.6, the highest dividend yield amongst developed markets (4.1%), and buybacks as well as the potential for foreign takeovers of UK companies.

  • You could consider implementing a pairs trade by buying the FTSE 100 and selling the FTSE 250, or alternatively by just purchasing the FTSE 100 on its own.

Investing is about finding asymmetric opportunities where the upside price potential is greater than downside price potential.

Here’s the bright side for the FTSE 100: it’s got a record low forward P/E ratio of 8.6, the highest dividend yield amongst developed markets (4.1%), and buybacks as well as the potential for foreign takeovers of UK companies.

You could consider implementing a pairs trade by buying the FTSE 100 and selling the FTSE 250, or alternatively by just purchasing the FTSE 100 on its own.

Mentioned in story

There’s been a constant stream of pessimism about “UK plc” of late – and this naturally awakened the contrarian in me. So I decided to look at the corporate UK landscape from a different perspective, hunting for whatever green shoots I might find. I dug into analyses from JPMorgan and AJ Bell and found three big reasons for optimism in Britain’s largest companies. Here they are…

1. They have an impressively low forward P/E.

From a valuation perspective, the country’s stocks appear attractively priced. The MSCI’s UK index’s forward P/E ratio – the price-to-earnings measure that uses forecasted profits in its calculation – has fallen to a record low relative to the MSCI World index. And as you can tell from the chart, it’s now dipped well below two standard deviations from its usual, or “mean”, level, and is trading at a discount of about 40%. This wide deviation increases the probability that the price will “mean revert”, or return to its long-term average.

MSCI UK’s 12-month forward P/E divided by the MSCI World 12-month forward P/E. Solid horizontal line represents mean value, with +2 and -2 standard deviations in dotted lines. Sources: JPMorgan and IBES.
MSCI UK’s 12-month forward P/E divided by the MSCI World 12-month forward P/E. Solid horizontal line represents mean value, with +2 and -2 standard deviations in dotted lines. Sources: JPMorgan and IBES.

It’s impossible to pick bottoms unless you’ve got a crystal ball, but investing is a game of tilting the odds more in your favor. At a forward P/E multiple of 8.6x, the MSCI UK index’s valuation is less likely to compress further. Let’s face it, the forward P/E of the UK index isn’t just cheap compared to its peers – it’s cheap compared to its own 20-year history as well.

2. They’ve got some nice-looking dividend yields.

There are two components that make up the total returns from shares – capital appreciation (i.e. the increase in stock valuation) and yield via dividend payouts. We’ve discussed the first one above, and on the topic of dividend yields, the UK once again stands out. The FTSE 100 provides investors with a yield of 4.1% – far outstripping shares from other advanced economies. And two factors suggest that those yields will continue even as recession fears and earnings’ headwinds grow. First, the FTSE 100 makes 70% of its revenue overseas, and the weakened pound means foreign profits are worth even more when they’re brought back home. And second, the dividend payout ratio has already adjusted considerably lower: it’s at lows of around 50%, compared to its previous 70% peak.

Dividend yield across major developed markets. Sources: JPMorgan and IBES.
Dividend yield across major developed markets. Sources: JPMorgan and IBES.

3. There are some strong prospects for buybacks and foreign acquisitions.

Given the very cheap share prices of many UK firms, corporate boards have decided to repurchase their own stocks – to the tune of almost £51 billion ($57 billion) this year, according to an AJ Bell analysis. And when you’re bullish on stocks, it’s not a bad thing having a big player in the market bidding up the share price. Those cheap share prices could drive another factor too: an increase in takeovers of UK companies by foreign players. Combine very cheap valuations with a weak pound and you hit the sweet spot for the checkbooks to come out. This may provide an additional layer of returns over and above the yield and valuation components.

So what’s the opportunity then?

You’re never going to have a 100% chance of success in the game of investing, but the key is to find asymmetric opportunities – where the upside price potential is higher than the downside potential. This creates a margin of safety and increases your probability of extracting solid returns. And from that standpoint, the FTSE 100 is providing a compelling investment opportunity.

There are two ways you could play it. The first would be via a pairs trade, buying the undervalued FTSE 100 (the more multinationally focused index) and selling the relatively overvalued FTSE 250 (the more domestically focused index). In this way, you’re hedged, or market neutral, and can still make gains whether the market goes up, down or sideways. The second would be to invest in the FTSE 100 outright, perhaps by buying the iShares Core FTSE 100 UCITS ETF (ticker: ISF; expense ratio: 0.07%).

Zooming in and going a bit more granular on a sectoral basis, UK homebuilders are flashing cheap, trading at a roughly 45% discount to the FTSE 100. Given the size of that haircut, it would seem like the expected housing market decline and the general negative sentiment toward the sector, have largely been priced in. It’s important to note this sector is also sensitive to Bank of England (BoE) interest rate expectations. Therefore, if the BoE adopts fewer hikes than investors expect or if we get a softer landing in the housing market, we could see a sharp surge in shares of homebuilders, such as Persimmon (PSN), Vistry Group (VTY), Crest Nicholson (CRST), and Barratt Developments (BDEV).

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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