Richard Penny, AAA-rated fund manager specialising in investing in the UK stock market joined CRUX Asset Management in 2018. The TM CRUX UK Special Situations Fund has just had its third anniversary. https://www.cruxam.com/funds/tm-crux-uk-special-situations-fund
Source: CRUX Asset Management as at 30 September 2021.
The UK Stock market has seen modest returns since 2000. Brexit and the UK's "value" positioning have not been helpful. Now with Brexit behind us and the growth versus value debate less clear cut, the UK with its lower valuations and recovering earnings, offers valuable and very necessary diversification for global equities portfolios.
With overweight exposure to financials, resources and tobacco, it is clear why UK stocks are deemed unexciting and priced at a discount to other markets. This is certainly the case in comparison to the US market with its overweight positions in stocks such as the FANGs and Tesla.
Growth companies globally have outperformed in 13 of the last 15 years, a fact that will lead different investors to different conclusions. For some, obviously, growth is the way to go, whereas others might sense this trend is overdone and that a prolonged resurgence in value is inevitable.
Growth companies have delivered excellent profit increases but critically the prices people pay have also increased in the current very low interest rate environment. In reality, very high growth company valuations may be justifiable given such historically low interest rates. However, any move up in rates could see a significant derating for growth stocks.
The TM CRUX UK Special Situations Fund believes that now is a very dangerous time to heavily favour growth over value. We also believe that the UK on average combines a better combination of growth and valuation than many other markets. Finally, it is our view that a stock picking approach can now find larger value stocks with catalysts and smaller, cheaper, stocks benefitting from global trends in cloud computing, digital technology and life sciences, notably gene and cell therapy. These are areas where we have invested with success and have current exposure.
The profit outlook for global economies have been very unclear over the last couple of years, during the global epidemic. Under such circumstances the valuation of markets can become very unclear. One tried and tested method that has generally been predictive of future return is the CAPE (cyclically adjusted price/earnings ratio).
This measure also known as the Shiller PE, takes the average of the previous 10 years profits and divides it by the current market valuation. It is an indication of the earnings power of an economy and gives conflicting return profiles for global stock markets.
The chart below sees the UK at a level not far off the lows of 2008/9 while the US has only been more expensive in 2000 and 1929. The UK when it has been at a CAPE of 12 has delivered annual returns of c.10% over the next 15 years. The US, on the other hand, would historically have given returns of less than 2% annually over the next ten years.
Source: Simon French at Panmure Gordon 2021
An obvious objection to this is that we live in times of extreme change, and that the US is much more exposed to some of the growth trends in computing, life sciences, driverless vehicles and reducing carbon emissions. Again, we can adjust for this and divide the valuation by the level of growth to get a PEG. Simon French at Panmure Gordon demonstrates below that the UK is cheaper than other global markets.
Source: Simon French at Panmure Gordon 2021
This could be overlooking that UK growth is driven by a two-year cyclical expansion, whereas the US has more long-term growth drivers that deserve a richer valuation. A further analysis of the UK, applying global sector valuations to specific geographic markets, does, however, demonstrate that the UK still trades at a discount versus the rest of the world peers. At a sector level, we can get better insight.
Take cloud computing: one of the more exciting sectors for many investors. It is seeing strong revenue growth and with highly recurrent sales has strong economics, unlike some other emerging sectors. Analysis in Q2 2021 by GCA Research produced an average EV/Revenue multiple for over 100 US cloud computing companies of 11.3x. UK companies typically trade at 4-6 times revenues. These US companies don't tend to list on NASDAQ with valuations below $500m and the UK tends to favour smaller companies below $500m. Although this is not quite an apples versus apples comparison, with valuations less than 50% of peers, the returns for flexible stock pickers can be significant.
A similar scenario can be seen in the life sciences sector. The US has fully embraced novel sectors such as gene and cell therapy, data-based medicine and robotic surgery, and companies enjoy rich valuations. The UK has strong traditions in many of these sectors with world leading universities and research institutions providing the foundation for an emerging corporate sector. Yet valuations in the UK are much more modest with many companies overlooked, which offers bargains compared to US peers.
By most measures the UK is a low priced and undervalued market. During Brexit it moved to a 50-year discount to equities in the rest of the world. The UK is thus often considered to be a lower quality, value market when compared to other markets offering stronger growth prospects.
Yet we think the UK is on average still cheap when growth and specific sectors are investigated closely. For those prepared to do intensive research and pick stocks it is possible to find secular growth companies in the UK at much cheaper prices than their global counterparts. Such an approach can avoid the choice between eye wateringly expensive growth stocks and structurally challenged value stocks.
