U.K. stocks are the ‘trade of the 2020s’ says markets sage Rob Arnott

The reigning view among investment professionals is that U.S. big caps are richly priced, though still good buys at these super-low interest rates, and the best ground for bargain hunting is the emerging markets. That’s assuming you don’t mind the rocky ride from parking part of your portfolio in Russia, Turkey, and Brazil. But would you believe that the world’s cheapest major market is none other than the United Kingdom? The U.K. offers not just the lowest prices measured by all the standard metrics such as cash flow to earnings, it’s also a developed, sophisticated economy that’s far less volatile than developing nations. “The U.K. is the trade of the 2020s,” declares Rob Arnott, chief of Research Affiliates, a firm that designs investment strategies for $157 billion in mutual funds and ETFs.

In a recent article, Arnott, and colleagues Vitali Kalesnik and Lillian Wu make a strong case for U.K. equities. They note that the island nation’s economy sustained a one-two punch that’s flattened its economy and its markets: the upheaval from its Brexit split from the E.U., and a COVID lockdown far more severe than in the U.S. and elsewhere. The damage from both are waning fast, but the strong comeback isn’t remotely mirrored in the U.K.’s still beaten-down share prices. “Most investors are transfixed by current events, but surprisingly few will ask: ‘Will these matter much in five years?'” the authors write. The lift-off is underway, and the time to board is now.

The U.K. market’s done poorly for years

After hitting a multi-year high in April of 2015, U.K. shares zigzagged but went nowhere, rising just over 4% in by the close of 2019. “The U.K. faced the looming danger of a no-deal Brexit,” says Kalesnik. “The U.K. is a huge trading partner with the EU. An outcome imposing tariffs on both sides would have been a bad result.” Brussels had seemed determined to punish the U.K. to show that any departing nation would receive tough treatment. U.K. stock prices reflected the high probability of a catastrophic outcome. As the Brexit threat dragged into 2020, the COVID crisis dealt the economy a second crushing blow. The U.K. suffered one of the world’s worst outbreaks, compounded by the rise of dangerous new strains. By February 2021, the U.K. stood in a tie with Italy for enduring the largest number of COVID-related deaths, relative its population, among all developed nations.

The twin crises caused the deepest damage suffered by any major economy last year. The U.K.’s national income shrank by 11.2%, the sharpest fall in the developed world. The decline exceeded the pullback in India by 1.3 points and the Euro Area by 3.4 points, and was three times steeper than in the U.S. The cataclysm took its toll on stocks. While the S&P 500 gained 16.2% in 2020, the FTSE 100 retreated 14.3%.

Surprise! The U.K. got a good Brexit deal, and is staging a quick recovery from the pandemic

The pandemic’s ravages appear to have helped the U.K. skirt a potentially damaging accord with the E.U. “Politicians were more amenable to a softer scenario,” says Kalesnik. “COVID helped, because they saw it as the wrong time to hobble the U.K. economy.” The agreement reached on Christmas Eve of 2020 allows the U.K. to remain in the tariff-free zone for trading goods that encompasses the E.U.’s 27 member nations. Although services are excluded and while London has lost banking business to the likes of Frankfurt and Dublin, the U.K. remains a vibrant global hub for financial services.

The U.K. also sidestepped its continental neighbors’ severe logjams in getting its people vaccinated. As of March 21, over 28 million Brits have received at least one dose, which means its vaccination record of 44 for every 100 residents, is second only to Israel, and beats the U.S. which is at 34 per hundred. No fewer than 80% of folks 65 or older have gotten a stab, and by mid-July, almost all residents should have had the opportunity to receive at least the first shot. The rate of new cases is among the world’s lowest.

The U.K. remains in a tight lockdown that’s shuttered all restaurants and non-essential shops, in part because the government fears that infections may migrate from France and other nations where COVID rages on. But the the route to a recovery from the pandemic may be coming into view much earlier than the experts predicted just a few months ago. Using IMF and OECD data, Research Affliliates predicts that the U.K. will grow GDP by 4.2% this year and 4.1% in 2022, beating the Euro Area’s 3.7% and 3.3%.

The markets are already turning from gloom to guarded optimism. Since the start of 2021, the FTSE has waxed 3.9%, more or less matching the U.S.

Expected returns on U.K. stocks are the best in world––mainly ’cause they’re so cheap

A big reason that U.K.’s such a deal: Its dominant companies are mostly old economy stalwarts in manufacturing, energy, telecom, and financial services. Among its biggest names are BP and Royal Dutch Shell, Vodafone, British Telecom, Barclays, and HSBC. Those are value plays, and a category that’s underperformed growth for over a decade. So in buying British stocks, you’re getting shares that are doubly underpriced: They’ve long been cheap as part of the value bucket, and got an extra markdown via the hit from Brexit and COVID.

An excellent metric for gauging whether stocks around the globe are richly, lowly or reasonably priced is the ratio of price to cash flow. Research Affiliates uses the cash flow proxy EBITDA. U.K. stocks are now selling for a remarkable 6.9 times their companies’ average annual cash flow over the previous five years. In other words, they’re generating $14.50 in EBITDA for every $100 investors pay for a share. That multiple’s 50% cheaper than the figure of around 12 for both developed world overall, and the U.S. Emerging markets, justifiably renowned as a bargain, are 25% more expensive than the U.K. at a price-to-cash flow of 8.6.

The U.K. multiple is also exceptionally low versus history. It’s been higher in around 88% of past periods. That’s a great sign, says Kalesnik. You’d expect the ratio to be much loftier, he says, since today’s ultra-low rates are pumping multiples in the U.S. and other major markets. If investors decide to bestow the kind of valuations usually accorded in a super-low rate environment, the shift would supercharge U.K. returns.

Even assuming that doesn’t happen, and making extremely conservative assumptions, U.K. stocks promise the world’s biggest gains in the years ahead. Research Affiliates forecasts that over the next decade, they’ll deliver total, annual returns of 8.1% a year, consisting of 3.25% in dividends, 4.1% from earnings growth, and 0.8% from an increase in their price-to-earnings multiple from below-average levels. That edges emerging markets at 7.8% projected yearly gains, and pummels the U.S. at 1.9%, a trifle that’s unlikely to match inflation.

Bigger gains could come if freedom from the E.U. jumpstarts growth

The reason returns in the 8% range are highly probable: U.K. shares are so cheap. The low prices provide a dividend yield far higher than in the U.S., and the modest multiple makes a gradual rise in the P/E practically a sure thing. The big upside would come if the U.K. break from the E.U.’s strictures acts an a tonic for entrepreneurship.

“That not what a lot of investors think now,” says Arnott. “The general perception is that everything is horrible, that U.K. companies aren’t going anywhere. But it’s that narrative that makes them so cheap.”

He goes on to say that the U.K. economy isn’t vibrant, and hasn’t been for a long time. But that Brexit could furnish the energy to make the U.K. what he calls “The Singapore of Europe.” “It isn’t a pipe dream,” says Arnott. “Unencumbered by E.U. regulations and horrific costs, they could follow in the footsteps of an Asian tiger.” That’s just the the upside scenario. If Britain simply returns to the pre-COVID, pre-Brexit U.K. of old, investors will prosper more than in any of the sexier markets where prices are exorbitant, and the big money’s been made.

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