Head of Equity Strategy
Summary: UK equities are currently offering an estimated 9% annualised real rate return for the long-term investor driven by a significant valuation discount to global equities currently at 42%. For foreign investors that are willing to take risk on the GBP could potentially get an even higher future return if the GBP appreciates against the EUR and USD. With UK equities currently valued below their long-term historical valuation level there is also the possibility to get additional expected return from a mean reversion in UK equity valuation. As a result, UK equities offer very attractive expected returns for the long-term investors, but it requires the mentality of going against consensus and having a long-term investment horizon.
Recently sell-side analysts have pushed the views that UK equities are among the cheapest in the world relative to its own historical valuation and especially relative to the global equity market. One thing is cheapness relative to some definition of earnings another, but it is more interesting to look at what it means for expected returns, because that is what should drive investor decisions. Companies can return capital to shareholders through dividends and buybacks of its own shares which often called the shareholder yield.
Dividends and buybacks are made possible costs have been paid for operations and capital expenditures have been expensed to main and expand the business. The available funds after these necessities are called free cash flow to the firm and can either be retained (build up cash balances), paid out to shareholders (dividends or buybacks), or used to reduce debt on the balance sheet. Investors care about the return of capital to shareholders and thus the shareholder yield is the starting point for estimated expected returns.
In a steady state, that is revenue growing with inflation and capital expenditures requirements remain unchanged on a relative basis, the shareholder yield is your annualised expected return on capital invested over your investment horizon, because the business will be able to generate this return stream indefinitely. Expected returns also relate to future growth and historically economies in the developed world have delivered 2% annualised real rate growth which is predominately a function of productivity. If we assume this rate going forward then the long-term expected real rate return is 9% annualised in UK equities. If we assume 3% annualised inflation over the next 10 years the expected nominal return in UK equities could be 12%.
UK equities are also valued at 10% discount to its own historical valuation and thus on top of the expected returns calculations above the long-term investor might also get a valuation mean reversion effect and thus the real rate return could be above 10% annualised over the 10 years.
The current shareholder yield of 7% in UK equities has been reached twice since 2006 in November 2008 during the Great Financial Crisis and March 2020 during the global Covid pandemic. Investors buying UK equities in November 2008 realized close to 10% annualised nominal returns in the subsequent 10 years. Buying shares in March 2020 will likely prove to have been an extraordinary good starting point for long-term returns in UK equities.
One thing to consider for foreign investors in EUR and USD is the currency exposure related to a position in UK equities. The GBP spot trade weighted is weak relative to its long-term history and thus assuming mean-reversion foreign investors could get additional return from a potential GBP appreciation against the USD and EUR. However, to reduce the impact from the GBP investors should consider hedging their GBP exposure. For an EUR investor the largest ETF tracking UK equities hedged into EUR is the UBS ETF (LU) MSCI United Kingdom UCITS ETF (hedged to EUR) A-acc (UKE:xmil) which is an accumulating ETF (no dividends) tracking MSCI United Kingdom hedged into EUR. The total expense ratio is 0.3% annually compared to around 0.07% for the non-currency hedged ETFs, so the investor pays 0.23% annually to avoid the development of the GBP to impact expected returns.
When we talk about UK equities and their high expected returns, specially relative to global equities, attention must be paid to the shocking developments in UK equity valuations. In the period from 2007 until the Brexit referendum in June 2016, UK equities were valued in tandem with the global equity market with a more less consistent valuation discount reflecting that the UK equity market has a larger tilt towards the financials, energy, and materials sector which typically have a lower equity valuation due to the pro-cyclicality. The Brexit referendum in favour of the UK leaving the EU was initially not a shock to the UK equity market, but as investors realized what it would mean for long-term economic activity, inflation, and competitiveness the valuation gap to global equities widened significantly and has only become worser since Brexit. Today, UK equities are valued at a 42% discount to global equities.
Essentially, it is the market’s brutal vote over UK equities as a part of the market that is getting less and less interesting. The political circus that has been part of the UK society since Brexit has not helped either on sentiment and the latest inflation problem that seems to be worse in the UK than elsewhere is another shoe to drop for the global investor. But the unattractiveness of UK equities is exactly why the expected returns are high UK equities and why the bold global investor should begin increasing the exposure to UK equities. The only requirement being a good portion of patience.
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