British stocks are not that cheap

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Good morning. The process of everything continues. But today, Unhedged is going where no high dares to go: the UK stock market. Don't worry, we'll be racing back to America, home of the libertarians and the Fed, tomorrow. Email me: robert.armstrong@ft.com

UK shares

While this newsletter is, by mandate, focused on the United States, we make regular trips abroad, either because international markets highlight the United States or simply because we're interested. But we don't write much about the UK markets, despite being part of a UK-based news organisation. There are a lot of smart people at the Financial Times in London who are already doing this. But some opportunities we can't miss. This is part of an article by Stephanie Stacey and Kostas Morselas, entitled “UK penny stocks trade at record discount to US”, published on Saturday.

British stocks are trading at near a record discount compared to their Wall Street counterparts. . .

London-listed stocks have lagged behind their peers in recent years, with heavyweight sectors such as banking and energy failing to keep pace with the rapid growth of technology stocks, and political uncertainty following the vote to leave the European Union in 2016 weighing on the market.

“The thing that makes me excited about UK stocks is the incredible value on offer in the market,” said Alex Wright, portfolio manager at Fidelity International. He favors value stocks, which could benefit when “we return to a more normal environment for inflation and interest rates,” and said the financial sector is the largest position in his portfolios.

The widget also contains this amazing graph:

Further evidence of the unpopularity of UK stocks comes from Bank of America's monthly survey of global fund managers. The report finds that fund managers, on the whole, underweight the UK compared to any other asset class tracked by the survey:

Unhedged loves penny stocks, as painful as that love affair has been in recent years. However, Stacy and the Morcellas have their finger on the main issue. Is the UK market cheap or is it only concentrated in cheap sectors? This is part of the problem, but there is a broader way of looking at what is going on. The UK is on the wrong side of at least two, perhaps three, major market trends.

First, investors were paying more and more for growth rather than value. Below is a chart of the discount of the Russell Value Index to the Russell Growth Index. These are US indices, and I chose them because I had difficulty finding good valuation data for global value and growth indices. But something similar is clearly happening in most markets: penny stocks are very cheap right now.

After that, investors showed their willingness to pay more and more for US stocks compared to stocks from the rest of the world:

Finally, US companies tend to be much larger than British companies. Even excluding the ten largest US companies, the average S&P 500 stock has more than twice the market capitalization of the average FTSE 100 stock. Investors have been favoring large-cap stocks lately. For example, the MSCI World Index of large-cap stocks has outperformed the MSCI World Index of mid-cap stocks by about five percentage points annually over the past five years.

So the UK stock market – with smaller companies on average, more skewed towards value sectors, and stuck outside the US – is facing a triple whammy at the moment. The three curses overlap to a large extent (many large stocks are growth stocks, etc.), but not entirely. The interesting question is whether the UK discount will persist once these factors are controlled. The assumed answer should be no. Markets are very global and very efficient. Why do global investors decide to choose the UK in particular? It is true that the UK economy is not growing much, but appropriate valuations adjust to growth.

However, strange things happen. The discount may be there.

It is worth noting that UK stocks would be a stark buy even if there was no UK discount on UK companies in particular. Buying a UK index fund can be an effective way to bet that international mid-cap value stocks are set to make a comeback. However, the issue of the UK's unique discount remains interesting.

It may be possible to answer the question scientifically, with careful statistical analysis. I won't do that, due to lack of time and laziness. But there is another completely unscientific but very interesting way to look at this: one company at a time. Do any UK stocks look, on the face of it, like bargains, compared to similar companies in the US?

For example, Shell looks like a cheap stock in the UK. The oil producer trades at 10 times trailing earnings; Major US oil producers trade at 15 times. It shows how some key numbers line up with Chevron (numbers from S&P CapitalIQ):

Shell has become smaller, and Chevron has become larger. Chevron is expected to grow its profits more quickly over the next two years as well. Chevron is less influential. Worth 5 turns of price/earnings ratio? maybe. Now try the consumer goods giant Unilever against its American competitor Colgate:

Again, the UK company is cheaper, but grows slower (both retrospectively and prospectively), is more leveraged, and in this case has much lower returns on capital. It is difficult to describe it unequivocally as “cheaper”. A better outlook for the UK is that GSK is in direct confrontation with Bristol Myers:

This time, the British company has stronger potential earnings growth, due to the expiration of the Bristol patent, as well as stronger returns, for roughly the same earnings multiple. Worth a look?

These are just three examples. But looking across the screen at UK stocks, these problems are repeated. UK stocks tend to be cheap compared to US stocks for good reasons. If UK stock indices are so amazingly cheap, where are the amazingly cheap UK companies? Readers, send me your candidates.

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