UK equity valuations present a once-in-a-lifetime discount opportunity

Fund managers investing in UK companies have had to be very patient investors over the last few years. But as Callum Abbott, co-portfolio manager of the JPMorgan Claverhouse Investment Trust (JCH), explains, the current investment case for UK equities can hardly fail to sway anyone who believes that valuation remains a key element of successful investment management.

“The UK market is just very, very cheap: it really is a once-in-a lifetime discount opportunity,” he argues, pointing to the MSCI UK index’s current 40% discount to the MSCI World index.

On a historical perspective, although it may feel to many investors as though cheap UK stocks are a permanent fixture, things haven’t always been like this.

As the graph above highlights, UK equities traded at a premium to their long run average versus the world index through the late 1970s and and early ‘80s, and were also at a premium in the second half of the 1990s. But since the Brexit vote of 2016, domestic stocks have endured a persistent and painful derating.¹

Similarly, the UK market’s price-to-earnings (P/E) ratio which is a good indicator of how valuable the market considers it to be – having reached highs of over 24 or 25 times since the start of the millennium – is now at much lower levels, at just around 10 times at the start of 2024. Of the major regional markets, only China’s P/E ratio is at a comparably depressed level – and as Meadon observes, “China has much greater economic woes than the UK.”

Yield is a further measure where the UK is demonstrably cheap, at 6.3% compared with other developed market yields in the 3% to 5% range. At least patient investors are being rewarded with an attractive income while they wait for the valuation tide to turn.

Significantly, a full 2.5% of that meaty payout is coming from UK share buybacks,² with sectors such as tobacco companies, miners and banks all increasing their focus on buying back their own shares at rock-bottom prices, rather than investing elsewhere. The JCH team believes that buyback boom could help to swing sentiment in due course.

Why are UK valuations so low?

Of course, it’s important to ask why the UK, in particular, has derated so much in recent years. In large part, it’s a reflection of structural moves forcing the price-insensitive selling of domestic equities.

Legislation is a key factor, Meadon says, with regulatory changes pushing institutional investors - pension funds, insurers, asset managers – to de-risk their portfolios away from equities and towards bonds.

Benchmark changes are another. The US accounts for some 71% of the MSCI World index, while the UK has a weighting of just 4%³: such shifts will inevitably have an impact on the make-up of both passive and active portfolios. And as already mentioned, Brexit has been a third contributor to the broad sell-off.

Is the tide about to turn?

The Claverhouse team anticipates that a shift in sentiment is coming. “We are clearly much closer towards the end than the beginning of the price-insensitive selling process, which has caused this generational low point in valuations,” Meadon argues.

One catalyst for change could be government action, he says. Chancellor Jeremy Hunt is well aware that regulatory changes have made the UK a less attractive proposition for investors in recent years, and that steps need to be taken to improve the situation.

A second potential catalyst is an expected upturn in M&A activity. It’s already in evidence among smaller companies, and there are now signs of a pick-up among large caps too: Meadon points to the recent Barratt bid for fellow house builder Redrow, and to packager Mondi’s plans to bid for DS Smith.

If change is on its way for UK markets, the attractions for patient investors are compelling. UK economic indicators are gradually improving (although the global geopolitical backdrop remains fraught), and the fact that UK equities are trading at multi-generational lows means that in effect they are providing access to world-class companies at bargain-basement prices compared with their peers trading on other major markets.

Claverhouse: 51 years of dividend growth

Against that backdrop, we feel that JCH is a robust choice. Not only does it comprise only UK stocks undiluted by overseas holdings – unlike many of its rivals in the UK equity income sector – but it has regularly outperformed its benchmark, the FTSE All-Share index, not that we can guarantee the future.

The trust takes a barbell approach, investing in a range of growth and value-focused stocks. Such a philosophy will never result in table-topping returns, Meadon explains, but it provides a valuable element of natural diversification and risk reduction.

Better still, JCH pays a chunky yield providing some compensation to bridge the gap until valuations strengthen. It has also built up a valuable track record of unbroken dividend growth, with 51 consecutive years of rising dividends under its belt backed by robust revenue reserves, to support future payouts.

Not that dividends can be guaranteed but as JCH co-portfolio manager Callum Abbot observes, the trust has achieved compound annual dividend growth averaging 9%⁴ over those 51 years, providing “meaningful uplift” in comparison with UK dividend growth averaging around 6%⁵ and inflation 5%⁶ a year over that period.

Even over the last three challenging years of high inflation, dividends have increased broadly in line with price rises. “Importantly, we’ve been able to keep delivering real growth for our investors,” Abbot adds.

Signs are that the time is coming when JCH investors can look forward to growth from improving blue-chip valuations as well as robust dividends.

¹ Source: J.P. Morgan Asset Management using data from MSCI, I/B/E/S, Morgan Stanley Research. Based on PE (Price to Earnings), PBV (Price to Book Value) and PD (Price to Dividend). Average relative valuations use 12 month forward data where available. Data from 31 January 1974 to 25 January 2024.

² Source: J.P. Morgan Asset Management using data from MSCI, I/B/E/S, Morgan Stanley Research. Yields use trailing 12-month data. Data as of 19 October 2023. Past performance is not a reliable indicator of current and future results.

³ Source: Factset as at 31 May 2024.

⁴ Dividend growth is calculated as the compounded annual growth rate of dividends paid by JPMorgan Claverhouse Investment Trust plc(excluding special dividends)over the period1972–2023. Dividend paid by the product may exceed the gains of the product, resulting in erosion of the capital invested. It may not be possible to maintain dividend payments indefinitely and the value of your investment could ultimately be reduced to zero. Dividend payments are not guaranteed.

⁵ Source:Citi,MSCI trailing data, UK DPS saw 5.7% annualized growth from March 1972 to March 2023.

⁶ Average inflation calculated from Bloomberg data for UKCPI over the period 1972-2023.

Summary Risk Indicator:

The risk indicator assumes you keep the product for 5 year(s). The risk of the product may be significantly higher if held for less than the recommended holding period.

Investment Objective:

The Company aims to provide a combination of capital and income growth from a portfolio consisting mostly of companies listed on the London Stock Exchange. The Company’s portfolio consists typically between 60 and 80 individual equities in which the Manager has high conviction. The Company has the ability to use borrowing to gear the portfolio within the range of 5% net cash to 20% geared in normal market conditions.

Risk Profile:

• Where permitted, a Company may invest in other investment funds that utilise gearing (borrowing) which will exaggerate market movements both up and down.
• This Company may use derivatives for investment purposes or for efficient portfolio management.
• External factors may cause an entire asset class to decline in value. Prices and values of all shares or all bonds and income could decline at the same time, or fluctuate in response to the performance of individual companies and general market conditions.
• This Company may utilise gearing (borrowing) which will exaggerate market movements both up and down.
• This Company may also invest in smaller companies which may increase its risk profile.
• The share price may trade at a discount to the Net Asset Value of the Company.
• The single market in which the Company primarily invests, in this case the UK, may be subject to particular political and economic risks and, as a result, the Company may be more volatile than more broadly diversified companies.