Adapting to rolling strikes of all stripes has become second nature in the UK over the past couple of years. In 2022, the country lost more days to industrial action than in any other since Margaret Thatcher was in office. Twenty Twenty-Three was little better.
One strike which has garnered much less attention, at least until recently, is that being staged by the natural buyers of UK equities. Domestic pension funds, wealth managers and retail investors have all, for differing reasons, baulked at the UK stock market. Pension funds have reduced equity exposure as they prioritise minimising risk over maximising return. Wealth managers have rapidly reduced the long-standing home bias within their asset allocation models. Finally, memories of recent financial crises and underinvestment in financial education have further thinned a dwindling base of retail equity investors. While these trends are not irreversible, it seems unlikely that any of these groups will be piling back into UK equities any time soon.
However, all is not lost. A new and somewhat surprising buyer of UK equities has emerged. Over the past couple of years, London-listed companies have been discreetly hoovering up their own shares. If the market remains this attractively valued, we expect the trend to continue.
While many market participants view the London market as a museum for corporate dinosaurs, we see something quite different. Sure, many FTSE heavyweights lack the glamour and excitement of the US tech giants, but they generate prodigious amounts of cash. They also typically have robust models, generate decent returns on capital and have sensible amounts of debt on their balance sheets. After reinvesting in their business to maintain operations and grow a little, and paying shareholders a – typically generous – regular dividend, many still have significant ‘leftover’ cash. Investment bank Canaccord’s Quest valuation platform suggests that the UK market is trading on a 7.0% free cashflow yield. This is a very healthy premium to the global market, trading on 5.0%, and makes the US market’s 4.5% free cashflow yield look relatively expensive. Therein lies the opportunity for UK companies and the market in which they reside.
Crossing the picket line
As a dyed in the wool equity income investor, I never thought I’d be writing an article about the merits of share buybacks…but such is the opportunity facing the market today! Extreme negative sentiment towards UK stocks over recent years has created a situation where walls of excess cashflows are colliding with bargain-basement valuations. Many UK PLC boards have decided that they can’t just keep looking this gift horse in the mouth.
In 2022 and 2023 FTSE 100 firms bought back record amounts of stock. The same is true for Europe more broadly. So much so that European companies are buying back roughly the same proportion of outstanding shares as those in the US – the traditional home of the stock repurchase. Importantly, this hasn’t come at the expense of ordinary dividends. The UK market yields 3.9% and ordinary dividends grew in 2022 and are likely to do so again in 2023.
At an individual stock level, businesses as diverse as oil major BP, home improvement retailer Kingfisher and buy-to-let mortgage lender OSB have bought back significant chunks of their outstanding equity over the past couple of years. Like midnight feasters these gluttons are discreetly devouring themselves while the investment world has its back turned.
Careful of not getting too carried away, we recognise that buybacks are often viewed with suspicion by income-focussed investors. Over the years we’ve had countless discussions with UK PLC management teams about how they should spend their cash. In some cases it’s been very clear that they’re far less price-sensitive when it comes to buying their own stock than they would be about acquiring the stock of a competitor. In one of these meetings a CFO described the quantum of his company’s stock buyback as a “balancing item” for “mopping up excess cashflow” once all other capital allocation priorities had been satisfied. This focus on reducing share count, irrespective of share price, has always rankled us.
Yet more positively some UK corporates now have a very clearly defined framework when it comes to stock repurchases. Fashion retailer Next has, for years, been carefully buying back its own shares. It has retired more than half of its outstanding stock over the past 20 years. Importantly however, it only does so when the prevailing share price offers a prospective return above the company’s 8% hurdle rate.
Some grumble that actions like these rob the country of the investment desperately needed to drive economic growth. At an aggregate level we don’t disagree. However, from an individual company viewpoint, it’s increasingly hard to argue that buying back your own very cheap stock isn’t a rational, low-risk use of excess cash.
In time we expect the UK market’s anomalously low valuation to sort itself out. The question then becomes how much of its share capital can bargain-hunting UK PLCs gobble up in the meantime.
