The perils and potential of investing in the UK stock market
George Godber and Georgina Hamilton, Fund Managers at Polar Capital, look at the over-riding emotions around investing in the UK.
For some the over-riding emotion around investing in the UK is fear. Fear of looking like a fool. Sticking with the crowd. Avoiding going out on a limb. Fear of the unknown and potential disasters. For others it is despair. Giving up because it is just too hard to work out. For almost all, objectivity is hard. Brexit touches everyone.
It is these emotions and behavioural psychologies that create buying opportunities for investors. The collective impact of these behaviours has led to an exceptionally underweight position towards UK-listed equities. In fact, the BAML Global Fund Manager Survey (18 December 2018) highlights allocations to the UK as one of its lowest since records began. This has left the UK at a valuation discount to its own long-term average as well as that of other countries.
Further to this, the headline valuation of the UK, at 13x P/E, hides a high level of dispersion in the underlying equities. Brexit has polarised views on shares. There are lightning rods of sentiment with many trading on 7x earnings and others on 25x earnings which provides an excellent opportunity to cherry-pick shares on valuations even lower than the headline number. Not only is the market cheap relative to its history and peer group but there is even the chance to put together a portfolio of shares significantly cheaper. Why does this matter? When valuations are lower, the opportunity is considerable and prospective returns tend to be better.
But what about the risks associated with dipping your toe into the UK stock market? The trouble with risk is it is very difficult to measure. Legendary value investor, Howard Marks, once said: “I do not think most investors fear volatility. In fact, I’ve never heard anyone say: ‘The prospective return isn’t big enough to warrant bearing all that volatility’. What they fear is the possibility of permanent loss.”
In the current climate, permanent capital loss is rife. EY reports [The Price of Uncertainty; Q4 2018] that one in six listed companies had a profit warning in the UK in 2018 which is near the levels of 2008. More importantly, the average share price movement on a profit warning across UK-listed companies was 23% in Q4 2018. This is the highest share price movement since the financial crisis in 2008. Typically, share prices are falling disproportionately more than their profit shortfalls would suggest. This capital impairment demonstrates the elevated level of risk in the system.
Source: EY’s ‘The Price of Uncertainty’; Q4 2018
Why are companies issuing profit warnings? Presumably this is a consequence of slowing growth not just in the UK but also overseas. A combination of trade wars hampering international growth, Brexit delaying business investment decisions and negative UK consumer spending power has led to tempered, and in some cases bleak, profit outlooks.
So why are share price falls disproportionately larger than the profit falls? Fear. Fear on a macro level. There is limited spare cash on the sidelines to take a longer-term view because investors have withdrawn over £10bn from the UK All Companies sector since the referendum result. Or fear on a micro level. Throughout 2017 and 2018, one profit warning often led to many more, and capital impairments have been considerably larger than in previous years with a number of stocks down over 80%. Shares falling has become self-fulfilling.
The valuation opportunity is high. The risk of investing is high. Currently these are reasonably evenly balanced but both sides are ’grossed up’. It is like two big elephants balancing on a seesaw. If you have lower capital impairment and a tempering of risk, then you would likely see the risk/reward environment become extremely attractive very fast. However, if the worst fears around President Trump’s trade wars or a UK general election are crystallised, caution is warranted.
Where we are going from here is speculative. Speculation is always extraordinarily difficult but right now it is even more unpredictable because it lies in the hands of politicians. While we do not know where we are going, we do know where we are. And valuations in the UK are good.
Issued by Polar Capital
George Godber and Georgina Hamilton
Fund Managers, Polar Capital UK Value Opportunities Fund
9 April 2019
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