UK equities are due for a revival. What might trigger it?
Adrian Gosden and Chris Morrison discuss UK equity income investing, above-average dividend yields on offer and what surging buybacks may mean for unloved UK stocks.
It’s well understood that the UK equity market is incredibly cheap versus history and versus other markets. On a simple price-to-earnings ratio, shares of BP, Lloyds and Barclays are pretty much as low as they’ve ever been.
The reasons also are well known but briefly: UK pension and insurance funds, on advice from their consultants, have drastically cut exposure over the past 25 years, to diversify their portfolios. Market returns are seen to be greater in the US, particularly in technology stocks – especially the so-called Magnificent Seven (Apple, Microsoft, Alphabet et al). Brexit was seen by international investors as adding risk, so they looked elsewhere. Stamp duty on share purchases and the removal of tax credit on UK dividends don’t help. Some relief here from the government would be beneficial but we don’t expect it.
Cash-rich, undervalued
It’s interesting to us to consider where we may be headed and what catalysts may bring renewed attention and momentum to this unloved market. For example, the UK market responds positively to falling inflation, and that’s likely to happen this year, along with rate cuts from the Bank of England and other central banks.
This appears more pronounced in UK smaller and mid cap shares, possibly due to their more cyclical nature.
Big buybacks
Typically, FTSE 100 companies buy back GBP10 billion-GBP20 billion worth of shares a year. This surged to GBP58 billion in 2022, more than twice the average, and GBP55 billion in 2023, according to AJ Bell data. We expect a similar number this year, for a total of around GBP150 billion over three years. This is extremely positive for us as income investors because companies don’t do buybacks unless their dividends are secure.
BP, Barclays
We expect to see a good year of corporate merger and acquisition (M&A) activity in 2024, driven in part by depressed company valuations. One of our holdings, trucking and logistics company Wincanton, recently received an approach by a French company recently at a 50% premium to the share price. Devro, a maker of sausage skins, was taken out on a 60% premium. If high-profile FTSE 100 companies were acquired on those kinds of premiums, that also might put UK equities on the radar of big investors.
What about Japan?
We don’t believe that UK equities will be undervalued forever. It’s worth citing Japan, which was long seen as uninvestable — until it wasn’t. Japan equities generated strong returns last year and investors scrambled to get in. Of course, Japan’s market dynamics, economy and corporate culture differ significantly from those of the UK, yet Japan shows how momentum can turn quickly.
As equity income investors, we are contrarians; we find opportunities where others don’t. We look for companies with robust balance sheets, strong cash flow profiles and a willingness to reward shareholders with payouts. If we can buy these companies at a discount to their intrinsic value, all the better. We aim for the strategy to deliver income (dividends) with the prospect of capital returns as the companies we invest in prosper.
The long-term average annual total return in the UK equities market is around 8%, so the current yield on the strategy gets you more than half-way there. Dividends are an important part of the return profile in UK equities, and dividend reinvestment is a key driver of returns over the long term. We believe a UK equity income strategy has an important role to play in a diversified portfolio, and we feel confident that UK equities, in part due to their unpopularity, offer good long-term possibilities.
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