Equity Research; UK Blue Chips perk up
UK’s ‘rational exuberance’ is clearly in evidence
2024 so far is behaving itself – with major UK indices delivering positive and consistent investor returns despite a coalescing of risk factors this year, mainly wars and elections. UK indices YTD has been a rare treat and ahead of the normally slower summer season it is worth asking why?
What are the main drivers to the sudden change of heart?
a) Compelling valuations – UK indices remain inexpensive relative to their global peers. The scale of this difference reflects numerous factors such as differing growth rates, UK index composition, Brexit, UK political uncertainty, and pension funds’ reducing exposure to UK equities over the last two decades in favour of liability matching investment strategies. The UK’s YTD strong performance has been matched by strong performances elsewhere (this is a global equity rally) meaning these differentials remain intact.
| Index Return | UK | FRANCE | USA | JAPAN |
| 2020 | -11.60% | -4.50% | 9.01% | 17.80% |
| 2021 | 18.40% | 28.60% | 20.30% | 6.30% |
| 2022 | 4.67% | -7.60% | -7.40% | -7.80% |
| 2023 | 7.90% | 17.30% | 15.40% | 30.40% |
| Cumulative | 19.54% | 33.11% | 40.13% | 50.55% |
| YTD 2024 | 9.37% | 8.78% | 4.85% | 15.17% |
source: CSS Investments
The data shows the UK has lagged in terms of valuation and performance over 2020-2023. From a macro perspective this period has been interesting because the major factors, C-19 pandemic, re-opening, Russia/ Ukraine war and rising global interest rates have all been global factors.
Whilst cheap UK valuations are an old chestnut, what has changed is UK companies are now doing something about their low valuations, beyond moaning about it / publicizing it. Companies are considering solutions and are in some cases, under pressure to do so.
b) Mergers & Acquisitions (M&A)
H1 2024 M&A has been significant with an agreed cash deal worth £2.78bn for Virgin Money from Nationwide and an all stock agreement for DS Smith worth c£5bn from US giant International Paper. Other cash deals in the mid cap space included Keysight Technologies acquisition of Spirent for £1.1bn and Wincanton bought for £753m by GXO.
Darktrace has agreed to be acquired by Thoma Bravo a private equity buyer for $5.3bn in cash.
Then there is rather odd BHP approach for Anglo American (theoretically worth £30bn excluding divestments). Given the details of this offer, which has been rejected by the Anglo American board it remains to be seen if this progresses any further.
As data from the ONS shows (below) M&A has been ongoing this decade but the overall numbers for Q1 2024 at c. £14bn are similar to recent quarters (disregarding BHP/ Anglo American).
Source: Office of National Statistics
Since Brexit, barring a few failed rallies, sterling has remained weak against the US dollar and Euro. Purchasers of UK companies are incentivized, in timing terms, to consider acquisitions of UK assets and have done so.
c) Departures from the UK. Companies leaving the UK, be it moving domicile or the primary listing or the corporate HQ or some permutation of these is negative in the medium and long term. But the short term effect is more interesting.
The short run effect of a company planning to leave for the USA, or just threatening to leave, has been to increase their share price quite substantially. UK investors have been jubilant on the hearing the news that the company is considering leaving the country.
That being said, firstly the UK/ LSE should not encourage any large UK listed company to leave as it is very clear they are not easily replaced. London as a destination for IPO’s is now only just in the top 20 for new listings ahead of Astana in Kazakhstan. London raised just US$1bn in IPO’s in 2023, a level last seen in 2009.
Secondly not every UK company can easily leave. Many lack a significant overseas business either in North America or globally or would be relevant to non UK investors.
The alternative is the EU and the departure of TUI AG for Frankfurt appears an important forerunner of things to come and demonstrates this route is viable for companies with a significant EU business.
Still the short term returns are impossible to ignore.
Source: www.google.com
Taking three of the largest ‘departees’ as a group they are broadly up 30% in six months since moving their primary listing from London.
Shell, whose CEO has publicly discussed moving the listing posed the question as to why the oil major, currently on a 9x rating in London, should not move to New York where Chevron, Exxon Mobil are on 12x-13x earnings and have a more positive regulatory environment. This discussion prompted speculation, which the CEO did nothing to calm, that Shell was seriously considering a move. The result has been considerable outperformance.
d) Share buybacks– UK companies have stepped up in 2024 with new share buyback programs. Particularly eye-catching was Barclays promise to buy £10bn worth of shares from 21st February 2024 to end 2026. This amounted to c.41% of Barclays share capital on the news, but now is c.33%. This decision has triggered a near 20% jump in Barclays which has lost no time in so far repurchasing c. 223m new shares at an average of 182p at a cost of £406m.
Buybacks like these beg the question as to whether such vast amounts of shares are available using the relatively limited means of daily repurchases of c. £10m in Barclays’ case and given the free float constraints. The mechanics of the operation remain questionable (i.e. 250 working days *£10m = £2.5bn) hence £7.5bn at the end of three years. Obviously the numbers can be changed but actually achieving will be a challenge (but not an impossible one) The same is true for other large buybacks. It will be interesting how this pans out.
NatWest has increased its annual buyback authority to 15% (from 5%) of share capital to enable it to pick up more of the UK government’s stake. Assuming the government clings on long enough for the IPO, this would finally achieve a near total exit and clearance of the 15 year overhang.
Away from financials Informa lifted its buyback by 50% to £500m another impressive mandate.
Share buybacks signal confidence in future profits, they signal directors’ willingness to increase shareholder returns and they put off short sellers. By providing purchase support, a buyback operation can help underwrite the share price. In our view the UK is becoming more like the US with companies more willing to heed investor pressure and buyback shares with surplus cash. Longer term a shrinking share capital will boost EPS and hence valuation, other factors being the same.
e) Stable Consumer/ Cuts in National Insurance
Unlike previous periods of significant monetary tightening (1973-74), (1978-1980), (1988-1990) the consumer and unemployment data have not shown rapidly changing numbers or financial stress since the current tightening cycle began in December 2021.
Other than isolated cases of retail companies whose labels are slowly dying and a weak pubs sector other consumer dependent sectors have held up.
Given both the short timeframe and the lag effects involved, the UK government has done all it reasonably could to cut the tax burden on working people. Obviously its motivations are with an eye to a General Election that must be held by 28th January 2025. This ‘election priming’ has encouraged investors to look forward and not back. The forthcoming NatWest IPO looks like a ‘giveaway’ fiscal event with political intentions.
f) Inflation
Simple explanations also work. Equity markets are catching up with the cumulative inflation this decade of c. 30%. This pace of cumulative inflation is normally spread over a decade, and whilst it is now subsiding, cost increases have been pronounced in many sectors leaving many consumers facing cash squeezes. The cash has been transferred to the corporate sector however.
Mitigating the cash squeeze to some extent has been pay increases with earnings growth of 6.1% in the year to end January 2024.
The rate of pay growth since end 2020 at c. 22% has helped consumer stability and hence corporate profitability.
Where is the UK market going? / Conclusion
For the UK to ‘catch-up’ with its peers, is possible to see an index read north of 10,000 in the not too distant future. That would imply a 20% uplift in valuations from present levels. My view is this is possible in the next 18 months assuming a calm global environment, a move downwards in the rate cycle and of course lower inflation levels. These are big conditional statements, and reality frequently veers off from trajectory. Personally I think the UK bull market has further to run in the short term because of the factors above. Perhaps more so than global equities.
One key issue is the fact the US economy has been strong and experiencing decent labour demand and pay growth. The Federal Reserve is concerned that cutting interest rates now or soon, could cause an overheated inflationary environment yet again, hence their reticence in starting a down cycle in interest rates.
So far in 2024 only the Swiss central bank and the Swedish Riksbank have embarked on a rate cut cycle but outweighing both was the Bank of Japan move to increase interest rates, for the first time in 17 years.
In my view global interest rates could modestly decline in the second half but the move when it happens will be very gradual and not significant for either equity or bond markets.
Ahead of the normal slow summer period and the busier second half with the vital US election and the UK general election, it is tempting to see choppier waters ahead. I would also venture investors seem quite emotional at the moment. In the Fear v Greed analysis at the moment the latter is clearly dominant. It is noteworthy that the world’s greatest investor, Mr Warren Buffett is holding record levels of cash (similar to his holdings in 2019) suggesting he thinks US stocks are high. Old Warren has not been wrong too many times!