The performance of the UK equity market has proved to be a conundrum to international investors for ...
The performance of the UK equity market has proved to be a conundrum to international investors for much of the past decade.
The market underperformed global equities during the inflating of the 1990s stock market bubble and yet provided no downside protection during its subsequent bursting. The valuation picture for UK equities has rarely looked more attractive. This indicator alone, however, is insufficient for market outperformance ' look at Japan's experience for evidence of this. Marginal buyers are needed to close the UK's valuation gap. Any impetus is likely to come from non-traditional sources and, with recent trends providing encouragement, we have become more positive on UK equities over the medium to long term.
Although the late 1990s were a profitable time in absolute terms, performance from UK equities was less impressive on a relative basis. Between 1996 and 2000 the FTSE 100 rose by a formidable 113%, however, the global equity market ex Japan rose by 157% and the US market grew by 153%. This lag in performance can be explained by two interconnected features of the UK market in the 1990s: low levels of business investment relative to other developed markets and low index weighting towards growth sectors of the economy.
The productivity rationale behind the 1990s bull market had at its foundation an unheralded increase in capital expenditure. Between 1992 and 2000 business investment in the US grew at an unprecedented 9.5% average annualised rate compared with 4.5% in the UK. Investors rewarded the growth markets/sectors seen as investing heavily for the future, which expanded their valuation multiples as a result.
The preponderance of value companies in the UK has been a feature of its domestic universe for some time, with energy, materials, industrials, financials and pharmaceuticals dominating. The IT sector, the main driver of equity performance from 1996-2000, constituted only 2.2% of the UK market, compared with 10.8% of the world index and 16.2% of the US.
The UK's defensive nature, which impeded its performance during the bull market, should have been a support during the subsequent bear market. This proved not to be the case, the beta of the UK to global equities in fact increasing from 0.77 pre-2000 to 0.87 post 2000. Since January 2000, UK equities have fallen in value by 39% while global equities (ex Japan) have fallen by 39% and US equities by 36%.
During the first 18 months of the bear market the UK did outperform, only for this outperformance to evaporate subsequently. Large institutional selling, by both pension funds and insurance companies (circa 45%-50% of the market), has been the driver during this secondary phase. The revision downward of estimates of long-term investment returns by pension funds, the forced selling of insurance funds and the liquidation of equity holdings by life assurance companies has resulted in reduced equity holdings in portfolios. Consensus estimates suggest equity exposure has been reduced by close to 15% across these three groups. Although neither the level of productivity nor the sector composition of the UK market are liable to change in the near future and institutional selling will remain an ongoing concern, the clouds may be lifting.
The valuation of the UK market has reached extreme levels not seen since sterling's exit from ERM in late 1992. The implied level of medium-term earnings growth at current market prices has been below trend GDP (nominal) for the past 10 months. UK director share dealings have historically been a good lead indicator of extremes in market valuation. Directors have been buyers of shares in their own companies for much of the past six months. Recently volumes have increased significantly. Although the valuation case for the UK market is not in doubt, marginal buyers are needed to bring valuations back in line with fundamentals.
Profit growth in the UK has not been as weak as in other developed economies. Free cash-flow generation has grown strongly as a consequence of little or no capital expenditure. This positive effect on balance sheets has provided a number of companies with the means to expand and rendered others take-over targets. Both M&A and private equity interest have increased in 2003. Corporate buy-back announcements have been stepped up in recent months as company executives put cash to work for the benefit of investors. This trend of corporates and private equity investors closing the valuation gap looks set to continue until a re-rating occurs. With this dynamic now in place, UK equities seem ready to take on a more prominent role in global markets.
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