If lots of people are asking ‘Why bother with UK equities?’ then history says that now is the time to invest
UK equities have become unfashionable. Just ask our pension funds – they have less than 14% of their assets in UK shares, compared to almost 50% only ten years ago. Just ask life companies – they now have no more than a fifth of their liabilities covered by London-quoted equities. Just ask your average retail investor and they have been putting money to work in anything other than UK companies – corporate bonds, gold and emerging Markets. The outlook is better elsewhere isn’t it, so we can afford to ignore UK equities, can’t we?
The answer actually lies in the question. As we now know this is what Gordon Brown thought when he sold off half our gold reserves in 1999, we could afford to ignore the yellow metal. Since then gold has gone up over three times in price. And this is also what investors said in 1998, after the Asian crisis – that emerging markets could be ignored, their economies were too unstable. Since then the Brazilian market, for example has gone up over ten times. And of course we could all afford to ignore UK gilts in 1992 when they yielded almost 10% because investors had lost faith in the UK government. Since then gilts have generated a real return of 6% per annum.
The message from investment history is simple, buy something when it is unfashionable, buy something when the question being asked is: “Can’t I afford just to ignore this investment?”
Lessons from history
The ‘killer blow’ for UK equities at the moment is our economy – we all owe far too much, the Government and individuals are borrowed to the hilt and as a result our economy will struggle to grow and equities can’t do well in this environment, can they?
Actually study after study has shown that there is little correlation between equity returns and economic growth. Just look at the ten-year return on US equities between 1999 and the end of 2008, a negative return during the ‘golden age’ of the global economy.
A much better determinant of equity returns is current valuation. Low valuations (alongside low levels of optimism about the outlook) produce the best long term returns. This is because if valuations are low your starting return on investment is going to be higher – for example if you pay ten times earnings for a stock you get your investment back in profits over only ten tears, if you pay twenty times your payback period is twice as long.
Looking at UK equities today the valuation looks attractive. The PE of the All-Share (adjusting for cyclically depressed earnings) is less than 12 times. Starting PE’s at such a level on average produce ten year returns in double figures.
As for my own portfolio the value support is much higher than the average during my twenty year career – my High Alpha portfolio has a PE of only 10 times, is 90% backed by assets, and 180% covered by revenue.
The UK economic outlook is likely to be better than consensus. Maybe not brilliant, but consensus at only 1% growth for 2010 is very capable of being beaten. In fact every significant recovery year since the 1920s has been better than 1%.
But of course you may believe the above and still say that isn’t the rest of the world a superior place to be, that global equity returns will be better than UK equity returns in the future because have they not been better in the past?
Again, referencing historical fact UK equities have actually performed as well as global equities; indeed of all stock markets around the world the UK has had the highest correlation of all with the aggregate global return (see graph).
This is because we are in fact not a nation of domestic shopkeepers we are a nation of global mining and oil companies, of international pharmaceutical enterprises, a nation where our largest quoted bank makes most of its money far from this green and pleasant land. And we understand the global economy in London; that is why we have a competitive advantage in financial services that will only be temporarily eroded by the political and regulatory backlash from the credit crunch.
The UK, because we are a small island has always had to look outside our shores. For centuries our success has been based on understanding and exploiting global commerce, today it is no different and our stock market reflects this. Well over 50% of the All-Share’s profits come from outside of the UK economy.
There are other reasons why the inhabitants of the UK should not give up on their domestic market. You have a competitive advantage when you invest in UK companies – they are familiar, you understand them, you know how they are likely to be managed, audited and regulated – and you should look to exploit this competitive advantage. And if you would rather delegate your investments to us fund managers then there is a lot of intellectual capital investing in our domestic market.
Anthony Bolton may have retired from these shores but you can still find some of the best income, growth or value managers in the world managing UK funds. And from my own perspective there are a huge number of good quality value opportunities in the UK, the ownership of which should produce superior returns to the UK Index over the medium term.
It should also not be forgotten that the vast majority of your liabilities, such as your mortgage or your pension are denominated in sterling and therefore unless you want to hedge your currency exposure you should have a decent part of your assets on-shore.
Carpe diem
The mere fact that so many people are asking why bother with UK equities significantly increases the likelihood that the next ten years is a good period for our domestic market. Emerging markets, gold and bonds have already done their bit; their returns over the last ten years have been so good as to make it likely they have a slower period.
Meanwhile, closer to home the starting valuation of UK equities is attractive, our stock market gives you exposure to all sorts of global trends at a modest price, and our own economy is likely to do better than the current modest expectations imply. Now is not the time to ignore UK equities.
Hugh Sergeant, head of UK equities, River and Mercantile Asset Management
