A conundrum in UK equity valuations requires careful stock selection

Chess pieces set up on a chess board - Rathbone Investment Management

Investors today are paying a relatively high price for the domestically focused FTSE 250 compared with its larger multinational peers in the FTSE 100. This may seem counter-intuitive given Brexit uncertainty and concerns about the outlook for the domestic economy. But the answer to this conundrum may not be as simple as merely buying the cheaper of the two indices.

Last year’s plunge in sterling following the UK vote to leave the European Union (EU) was good news for the FTSE 100 because it boosted the foreign earnings of multinationals (figure 1). Yet the index has underperformed other large-cap indices around the Western world this year, which is unusual because they tend to rise and fall together. 

This could be a consequence of Brexit-related uncertainty following an unproductive start to the negotiations. In recent months, a mini rally in sterling — amid mounting speculation of a UK rate rise — has also put downward pressure on the large-cap index.

Still, it is surprising that the more domestically focused FTSE 250 is still relatively expensive, given it has underperformed the main market since the EU referendum. Among the various headwinds has been a squeeze on consumers from weak wage growth coinciding with an increase in the rate of inflation. The high level of consumer debt is also a cause for concern. Meanwhile, many business activities remain vulnerable to Brexit. 

There is considerable uncertainty about the nature of future trade relations and terms with the rest of Europe, and the ability of financial services firms to enjoy ‘passporting rights’ that would enable them to continue operating across the region without significant additional costs. This situation is leading to weaker demand in certain segments of the real estate sector, for example. In a recent survey from the Confederation of British Industry 42% of businesses said that Brexit had affected their investment decisions, and the impact has been negative in an overwhelming 98% of those instances. 

While survey data suggests improving business investment intentions in both manufacturing and services in the months ahead, these intentions are still very weak for a non-recessionary period. Brexit-related uncertainty seems to be biting.

Although the UK economy is still growing, economists have been revising down their forecasts for the year ahead. Headwinds for the UK consumer from falling real (inflation-adjusted) wages are about to get stronger as household energy bills and rail fares go up.

Other areas of the economy are unlikely to be able to pick up the slack. Exports of non-oil goods have recovered since the middle of 2016 but are only growing at the same pace as imports. Although exports have been boosted by sterling’s depreciation, this has only driven net trade from a deficit back to balance. It appears that exporters are using at least some of the currency weakness to boost their profit margins rather than their output.

Figure 1: Currency boost

The pound's weakness following last year's vote for Brexit boosted the overseas earnings of companies in the FTSE 100, propelling the index higher.

Small, medium or large?

Comparing the returns of the two UK indices over a longer period reveals a different story to that of the past year or so. Since 2009 the FTSE 250 has outperformed the FTSE 100 substantially in terms of share price. Yet the earnings of large-cap UK companies have not lagged those of small- and mid-caps by nearly as much.

As a result, an unusually large valuation gap has appeared. The equity risk premium for the FTSE 250 — the additional returns that investors expect to compensate for the risk of investing in the companies in the index — is much lower than that for the FTSE 100 (figure 2). Given the uncertainty around UK revenues — which account for less than 25% of the FTSE 100 revenues but around 50% of the FTSE 250 — this difference seems unwarranted.

Over the longer term, the FTSE 250 has invariably outperformed the FTSE 100, regardless of the value of sterling. But the magnitude of the outperformance from year to year is closely and positively correlated with the exchange rate. We believe sterling is unlikely to rise meaningfully in the near term, which is why on average we would expect UK large-cap equities to outperform small- and mid-caps over the next year or so.

In addition, sector composition makes the FTSE 100 the most defensive major global market, in the sense that it has the highest proportion of companies in the less economically sensitive sectors of consumer staples, healthcare, telecoms and utilities. Our own research indicates that the FTSE 100 is the least sensitive of any major developed market to a fall in global industrial production. So the FTSE 100 would appear to be a safer place to be in the event of a slowdown in growth.

However, the FTSE 100 also has large weightings to sectors such as energy, mining and banks, which may prove to be less interesting long-term investments from a growth perspective, even though they offer cheap valuations and decent dividend yields at present.

Furthermore, and despite the less favourable near-term domestic backdrop, we continue to view the mid-cap area in particular as the productive source of interesting stock ideas that it always has been. While many mid-cap firms are domestically exposed and therefore vulnerable to a challenging outlook for the consumer and for business investment, there are some pockets of relative resilience. For example, they include UK housebuilders, which continue to benefit from a structural shortage of housing, government support in the form of the Help to Buy scheme and decent affordability. 

While conventional retailers are under significant structural pressure from the seemingly inexorable rise of Amazon, the UK has a number of online business models that are also taking share from ‘old economy’ operators. This may enable them to enjoy decent growth even in a weaker domestic economy. Also many mid-caps have invested heavily in expanding abroad in terms of exports and, in many cases, building a physical presence in other economies, insulating them to varying degrees from a UK slowdown.

So within the more challenging and uneven mid-cap market there are decent opportunities, which are coupled with the fact that a large proportion of the FTSE 100 is in areas with fairly unexciting long-term growth potential. This combination suggests that the UK market is one where active management or ‘stock picking’ may be particularly productive relative to following the index.

Figure 2: Mind the gap

One result of a weaker pound since the Brexit vote is that a rare valuation gap has opened up between the FTSE 100 and 250 indices, which preesnts an opporutnity for investors.

The equity risk premium is the excess return that investing in equities provides over the risk- free rate, such as return from government bonds

This article first appeared in Investment Insights Q4 2017

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