Investors don’t need to leave their home market to find value

Inside Money: the fog of Brexit masks some alluring opportunities in the UK market; but the clouds enveloping one of the Woodford-run funds will take time to clear, writes Andrew Pitts

A decade ago, in early March 2009, the stockmarket equivalent of blood on the streets was in full flow. Hindsight shows it was a very good time to buy bonds or equities, not to mention real assets such as property and infrastructure. It was the nadir of the global financial crisis and, bar a few bumps on the way, stockmarkets of developed countries have not looked back, particularly in the US, where the benchmark S&P 500 index has gained in excess of 400% in sterling-adjusted terms.

Blood was again spattering Wall St pavements towards the end of 2018. But the US Federal Reserve’s reaction to rapid market losses and a ballooning yield on 10-year Treasury bonds was to perform a screeching U-turn on the expected pace of interest rate rises. In this post-quantitative easing era, it demonstrates that investors continue to be in thrall to the actions of central bankers and vice versa.

All markets have taken their lead from the US, which has gained 11% in the year to date. With the year-end results season out of the way, it is timely to point out again that the US market remains overvalued by most yardsticks. In the February issue I observed that the level of the 10-year cyclically adjusted price earnings (Cape) ratio – then at 29 times – was synonymous with the severe market crashes of 2000 and 1929. The bad news is that Cape has now risen to 30, which compares very unfavourably with a mean reading of 16.6 and a median of 15.7 over about 150 years.

Fund managers will undoubtedly continue to find outstanding companies to invest in, but it will be difficult for them to buck the prevailing mood in the markets, which looks to be darkening. At this late stage in the economic cycle, growth-oriented investors will need to set their horizons a little further into the future before the strong gains that have been on offer over the past decade materialise again.

Why UK income funds look appealing

The outlook for investors seeking an income looks comparatively brighter and, somewhat paradoxically, some of the best opportunities are in the UK.

But, as they did a decade ago, investors will need strong nerves to back this particular conviction. In the May 2018 issue, I predicted that “the outcome of Brexit ‘negotiations’ will most likely depend on the status of the Ireland/Northern Ireland border”. So it has proved – but the chaos surrounding the Conservative government and the deadlock in Brexit negotiations has tested the patience of overseas investors, not to mention several important manufacturers, who are deserting these shores. Investors have been steadily withdrawing from UK-listed stocks, leaving market heavyweights in particular looking relatively undervalued.

Nevertheless, at 7232 on 15 March the FTSE 100 index has rebounded nicely since the start of the year, up 5.8%, but still some way from the 12-month high of 7903 set last May. The index’s current 4.54% yield has some support from dividend cover of 1.52x and a p/e ratio of 14.5. The Cape ratio for the FTSE 100 is estimated to be just over half that of the US market.

Francis Brooke and Hugo Ure, managers of the cautiously managed Troy Income & Growth investment trust, have become more positive on prospects: “The combination of Brexit uncertainty, the growing possibility of a radical Labour government and an index virtually devoid of technology stocks has resulted in the market yield approaching 4.5% - higher than it has been since the Great Financial Crisis of 2008/09.”

Reassuringly, the managers of this Money Observer Rated Fund point out that dividend cover for the market as a whole has been improving, from a low of 1.3x in 2015 to just under 2x today. “So the yield is higher and the sustainability of the underlying dividends has increased. In aggregate we believe that the income prospects for the market are better than they were three years ago.”

The general pullback from UK-listed stocks has also thrown up some opportunities to invest in companies that derive earnings from overseas at bargain prices.

David Horner and David Taylor, managers of the MI Chelverton UK Equity Income fund, state: “It is noticeable within our small and mid-cap universe that we can now access non-UK earnings at similar levels of valuation to domestic earners, which has not been the case for some time.”

That investors should look beyond the current Brexit impasse and the future trading relationship is a recurring theme among managers of Rated Funds in the UK equity income group. Martin Cholwill, manager of Royal London UK Equity Income, says: “I have not tried to position the fund for any particular Brexit outcome. The UK stockmarket is supported by its dividend yield, with current consensus forecasts anticipating growth in 2019, following positive performance in 2018.”

Value exists across the market capitalisation spectrum for UK equity income investors. Much like in the 2008/09 period, however, they must ignore the Brexit fog to make the most of the opportunity.

The author was editor of Money Observer from 1998 to 2015.

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