By Thomas Moore, Investment Manager, Aberdeen Standard Equity Income Trust
It’s now a little over five years since the Brexit referendum and over that period UK equities have found themselves decidedly unloved on account of several factors. These include:
- Substantial political uncertainty regarding the shape of the UK’s relationship with Europe
- Index being composed of sectors deemed to be “old economy”
- The UK suffering one of the most severe downturns in developed markets in the immediate aftermath of Covid-19
However, times of uncertainty can create opportunity and if we consider a long term, evidence-based approach to asset allocation, UK equities currently offer a great deal of interest.
Attractive valuations and a healthy yield
Regional equities have followed different paths in recent years. US equities, powered by some of the world’s most important technology stocks, have outperformed other regions by a large margin. As a consequence, US Large Cap valuations have moved sharply above their long-term averages over the last five years with a cyclically-adjusted Price-to-Earnings (P/E) ratio currently around 32.5x. By contrast, the UK equity market is just below its long-term average with a cyclically-adjusted P/E ratio of 17.6x. This is a great starting point for investors because, over longer periods, the starting valuation you pay has been a key determinant of future returns.
2020 was a particularly challenging year for UK dividends given the market’s concentrated pay-out profile and the enormous impact Covid-19 had on economic activity, commodity prices, and companies’ willingness or regulatory ability to pay dividends. Those companies that were at risk of cutting their dividends have now done so. Dividends are now growing again as the cyclical backdrop improves. Today, the FTSE All-Share Index yields around 3.5%, which remains attractive relative to other equity markets and asset classes.
A number of catalysts
Over the last seven years, UK equities have been firmly on the back burner, with BofAML’s Global Fund Manager surveys showing that investors have been materially underweight. For much of this period, Brexit has been a major overhang, followed on by the severe impacts created by Covid-19 on the UK economy and stock market. However, with much more certainty on the UK’s relationship with Europe, the release of vaccines in the fight against Covid-19 and continued monetary and fiscal policy support, risk appetite towards the asset class is starting to inflect.
From a political and economic perspective, headwinds that have faced the UK equity market have started to change into tailwinds. With the clouds of Brexit-led uncertainty now cleared, combined with the more cyclical, value orientated composition of the UK market, investors are re-engaging with the market. Furthermore, lockdown has created huge, pent up demand with people much less able to spend their money, allowing for the highest and second highest level of net savings on record.
Estimates put the scale of current savings at around £190bn. As restrictions continue to ease, the potential is therefore there for significant growth in spending, driving the domestic economy forward. So considering UK plc, the economic backdrop is strengthening supported by rapid vaccination, growing business and consumer confidence, a falling unemployment rate and a likely material boost in consumer spending in the coming months. It appears these dynamics have supported global investors’ moves to reduce their underweight to UK equities in the last few months.
Record levels of M&A
2021 has seen a record in UK Merger & Acquisition activity in terms of the value of deals conducted in the first half of the year. A total of 124 takeovers and purchases of minority stakes have been conducted, worth around £41.5bn. Attractive valuations, Brexit resolution, the pace of the Covid-19 vaccination programme and the rich seam of opportunities in the UK have all underscored this activity.
What is particularly interesting here is that 47% of European private equity deals in 2021 targeted UK companies – almost half of the deals done. With the FTSE All-Share Index trading at a material valuation discount to global equity markets, we are heading for the biggest year for UK private equity takeouts since 2007. A clear conclusion is that, while public markets have left the UK equity market to one side, private equity is capitalising on the opportunity for global growth.
A recent example of this can be found in Tencent’s acquisition of Sumo, a UK based video games developer, which saw a 43% premium paid to shareholders. This is only one of a significant number of deals in the last 12 months with deal pipelines indicating no sign of a slowdown into year-end. Evidence suggests that the depth of opportunity for stock pickers willing and able to take a forward-looking view remains strong in a market that has been overlooked for some time.
Final thoughts
In summary, there are numerous factors that support an increase in longer term UK equity allocations. The UK equity market is currently trading around the steepest valuation discount to global equity markets in 20 years. There is clear evidence that investors are re-engaging with the asset class, with the UK economy set to continue to recover strongly. World class governance standards support investors looking to generate returns from global opportunities. And record M&A activity highlights the latent value that forward-looking stock pickers can currently find in UK equities.
Thomas Moore is manager of Aberdeen Standard Equity Income Trust, an investment trust offering an actively managed portfolio of UK quoted companies. The investment approach is index-agnostic and the focus is on those companies delivering sustainable dividend growth.
Important information
Risk factors you should consider prior to investing:
• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Trust shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value
(NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to
realise investments and may lead to volatility in the market price of the Company’s shares.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• The Alternative Investment Market (AIM) is a flexible, international market that offers small and growing companies the benefits of trading on a world-class public market within a regulatory environment designed specifically for them. AIM is owned and operated by the London Stock Exchange. Companies that trade on AIM may be harder to buy and sell than larger companies and their share prices may move up and down very sharply because they have lower trading volumes and also because of the nature of the companies themselves. In times of economic difficulty, companies listed on AIM could fail altogether and you could lose all your money.
• The Company invests in the securities of smaller companies which are likely to carry a higher degree of risk than larger companies.
Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.
Company selected for illustrative purposes only to demonstrate the investment management style and not as an investment recommendation or indication of future performance.
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