Jo Rands (pictured), portfolio manager at Martin Currie, part of Franklin Templeton
Capital appreciation has been held back in recent years by a de-rating in UK equities, although the UK's strong dividend culture has provided some relief to investors.
Interestingly, another positive market dynamic has been gaining importance: share buybacks.
The recent prevalence of share buybacks should not really be surprising, given market conditions have been just right.
Many UK companies have strong balance sheets, with excess capital to return, and valuations look attractive to do so.
The pandemic has also likely played a part – rapidly changing conditions reminding management teams of the flexibility buybacks can bring over returning cash via dividends.
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The influence of the US equity market is another thing to note, with investors and management teams alike seeing the positive impact buybacks have had on the US equity market.
Finally, while valuations look this low, UK management teams are also dealing with the heightened concern of becoming an acquisition target. A buyback can therefore act as a defence mechanism against potential acquirers.
The percentage of market cap being acquired (around 2%) is now higher in the UK than in the US, which is significant.
The question is, will companies continue to retire equity at these elevated rates into 2025 and beyond?
Companies should not be overpaying for their shares. UK equities currently trade at a significant discount to long-term averages, more so than European equities, and quite at odds to the hefty premium valuations seen in the US market.
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For many companies, they can continue to buy back shares, even at significantly higher prices and it will still add value.
It is therefore a decision of how companies should allocate their excess capital. Management teams with a proven track record of sensible capital allocation is certainly a trait we look for when investing.
Companies should only be returning surplus cash. They should be prioritising investment in their business, where needed, so if a company finds a compelling investment opportunity, such as M&A, buybacks could slow.
At the other extreme, if there were to be a sharp economic downturn, we could see companies reduce or cancel buyback programmes, to conserve balance sheet strength.
Today, many businesses have healthy balance sheets and generally a low appetite for large scale M&A. Hence, we are seeing companies retiring equity at the same time as continuing to invest in their businesses.
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Businesses across the board are currently facing heightened uncertainty due to unclear UK government policy, increased employer costs and evolving international policies, especially from the US. This increases the near-term range of outcomes and makes the environment tricky.
Problems have compounded since the new Labour government came in with an aggressively pessimistic view of the economy and a budget that squeezed the private sector to fund more spending on the public sector, which is not traditionally viewed as the best way to encourage growth.
This has acted to depress business and consumer confidence and defer spending decisions. Yet, despite all the uncertainty, many UK businesses are in good shape with strong balance sheets.
While businesses grapple with uncertainty, their shares trade at bargain valuations and balance sheets remain healthy, the current rate of share buybacks could well be sustained.
Continued share buybacks will act to support returns, alongside the impressive dividend yields already available to UK equity investor returns.
Jo Rands is portfolio manager and research analyst, UK equities, at Martin Currie, part of Franklin Templeton
