25th Sep by Edmund Shing

21 comments 4261 reads

Market Musings 25/09/21:
The UK: Contrarian trade of the decade?

Recent podcasts you may care to listen to:

All You Need to know about IPOs

Every Dog has its Day - Eventually

ed0ba6wW91ULl9L8rOXhVRNYjkgxI9eZmXiv3X7a_gxFvgBxP7q4dqEuXdX4p0VHb6oV8M9tRL48jbicOSGWN5szxRxzY5e3J3i1c5RacqKOWTPQJA-hEyjrHsB0UAQVEl0vpOzn=s0 I simply do not have enough fingers on my two hands to count all of the reasons that an investor should avoid the UK.

UK stocks have lagged global stock markets since 2008

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Source: MSCI, Bloomberg

Latterly, the relatively poor performance of UK large-cap stocks in the form of the FTSE 100 index has been put down to a lack of growth stocks in the UK stock market, for instance in the technology sector. This is objectively difficult to argue with, given the massive difference in sector weightings between the two markets.

US stock market heavy in Tech/Communications, Consumer, while UK weighted to Financials, Industrials, Staples, Energy, Materials

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Source: Bloomberg

Bear in mind though, that this UK stock market underperformance has not always been the case. It has certainly been the case since 2008, but look at the period between 1990 and 2008! Coming out of the early 1990s recession, UK stocks had two strong runs. - firstly between 1991 and 2000, and then again from 2003 post the TMT bubble and burst up to late 2007.

UK stocks led the World from 1990 to the GFC

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Source: MSCI, Bloomberg

Lower commodity prices and interest rates a headwind for the UK

But that does not mean that there is no growth for the stock market investor in the UK. Rather, the nature of this potential growth is simply far more cyclical in nature, depending typically on two key drivers - interest rates and commodity & energy prices.

Financials (Banks and Insurance companies) are sensitive in particular to interest rates and economic growth - the higher economic growth and long-term bond yields are, generally the better for them.

Energy and Materials sectors are evidently sensitive to metals and oil & gas prices, as those prices determine their selling prices and thus their profitability.

Both of these drivers have been trending lower the years since the Great Financial Crisis, as can be seen in the chart below.

Both…

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timarr

26th Sep

All these together with a tendency to rest on our laurels it's no great surprise to find the tide going against us.

Rising wages with no increase in productivity and a reduction in the pool of cheap labour is more likely to be the underlying problem. Everything else is just noise. In general raising standards - such as with H&S - and improvements to the rule of law - such as the Human Rights Act - make the UK more attractive to capital, rather than less.

Edmund is right, of course, the UK market as a whole has underperformed since 2015, but that's largely due to the dominance of the multi-nationals in the FTSE 100 where the miners, in particular, look cheap. Lower down the indices stand up quite well to global comparisons.

We're likely to have a fraught winter as the twin discontinuities of the pandemic and Brexit play out, with consequent inflation in wages and goods but but in the longer term the undervaluation of many of the UK's companies, both small and large, will continue to attract overseas interest.

In the short term smaller companies are likely to have quite a difficult time. Rising import costs and the increasing cost of labour will leave a lot of them under considerable financial strain. We're beginning to see logistics companies failing because they can't get drivers at wages their contracts allow for. Such is the nature of discontinuities - long term contracts, short term market fluctuations.

Personally, while I agree with Edmund that the UK is cheap, I think a lot of care is needed in the short-term. We're going to see some surprises ahead, and a lot of them aren't going to be nice.

illiswilgig

Timarr,

totally agree. I've been fascinated for a long time by the UK's poor productivity growth. Together with the apparent inabiliy of private sector, public sector and government to address it and invest sufficiently. Whether through poor judgement, neglect, delayism, austerity. It'a a long list of excuses. You choose.

It's seemed to me that there is no easy solution to our addiction to cheap labour and poor conditions. And increasingly that it won't be ending well. The sudden confluence of pandemic, brexit consequences, energy crisis and ESG concerns seems to be delivering quite a shock to a system with very little resilience. I expect Turmoil. The only question is how much?

At the moment government seems quite satisfied with a 'free market' solution based upon survival of the fittest. That may change should the consequences escalate and be reflected in the opinion polls, though I rather suspect its too late to do much other than window dressing at this late stage?

But its not all doom and gloom - well managed companies that have been investing in new products, productivity and efficiency will benefit - particularly in markets set to grow from the pandemic recovery, energy transition, automation, digitalisation and ESG requirements.

It's one thing to recognise it - quite another thing to find the right small cap companies that tick all the boxes and will survive and thrive to become the new winners - at prices that are still reasonable if not cheap! Lucky I like a challenge.

Certainly interesting times,

cheers

At the moment government seems quite satisfied with a 'free market' solution based upon survival of the fittest.

The problem with that, as even the most dimwitted economist could tell them, is that free markets take time to adjust to discontinuities - and what happens in the short-term can be distinctly unpleasant for a populist government. When you drop a pandemic on top of a cliff edge Brexit and then add in an administration that largely seems to make policy by a combination of ideology and improvisation you have a recipe for considerable disruption in the short term.

If that merely damaged the competitiveness of British business I doubt the government would care but when it results in pictures of people queuing for petrol or gaps on supermarket shelves then it leads to knee-jerk responses in an attempt to override the free market - which will lead to yet more problems. Consider the government's latest wheeze to overcome the HGV driver shortage - writing to all of those drivers with licenses but not actually driving lorries.

Imagine that the campaign works. Imagine what happens next when ambulance drivers, refuse collection drivers, school bus drivers, etc are suddenly in short supply ...

The trouble with all of this is that it's unpredictable. It's not just that UK companies are reliant on a large pool of cheap labour which has suddenly been removed, it's also that the entire supply chain is fragile. Fragile systems can fracture in all sorts of unexpected ways.

In the longer term we'll see adjustments through all sorts of innovations. Businesses are incredibly adaptable. But in the short term it's important to keep an eye on the balance sheets of companies. Any business can be affected by the unexpected, those with strong balance sheets will survive regardless. Those with weak finances may go under even if they otherwise have bright futures.

Interesting times, indeed.

JohnEustace

I fear that with the end of furlough and the Covid protections on bankruptcy at the end of this month it will be the likes of Begbies Traynor (LON:BEG) and Manolete Partners (LON:MANO) that will be getting the attention in the near term. I’m not sure we’ve reached the “blood on the streets” stage that makes the U.K. in general a screaming bargain - and I hope that phrase remains a metaphor.

Silver Moon

27th Sep

timarr, I've an enormous amount of respect for you, but I have to disagree with your paragraph:

To begin with, rising wages were in effect simply keeping up with the cost of living, sort of. I come from an industrial coalface, namely a unionized tyre factory where I spent 40 years of my life seeing changes you wouldn't believe. Nearly half the years as a rubber worker, the remainder on the staff. As a supervisor I once told my team that the latest pressure should not be held against our Management but against the little yellow custards who were after out business and jobs. The Company is now a shadow of its former self and American-owned to boot.

Silver

RayStraw

Surprised that energy costs have not been mentioned unless I missed it. Gas price is up around 250% this year. This will hit consumers hard, the public will have less spending money but also companies will have higher costs which will lead to higher prices. Some companies have already shut down production which has had knock-on effects, such as CO2 shortage as it's a by product from fertilizer production. If the Govt. did not step in and pay a US company millions of £s we would have even more problems.

I'm feeling very bearish on the UK economy.

Abbas

Hi guys

Any tip on the best nuclear growth company to invest in?
thanks

Hi Silver Moon

I've an enormous amount of respect for you, but I have to disagree with your paragraph:

And I you. I was referring to the current situation, rather than that of the past - where, I agree wages have been stagnant for lower paid workers for most of this century, if not longer. The problem has been that where companies can simply employ cheap labour from the EU or export jobs to lower wage economies they've had very little incentive to improve productivity.

In the UK we've now cut ourselves off from that cheap pool of labour at the same time as we're seeing some reversal in globalisation - issues with China, issues with transport costs, issues with just in time manufacturing, issues with ESG standards, etc. Combined that will push up wages and cut company profits, barring productvity improvements.

Companies will, where they can, respond by automating or moving offshore. The former will improve productivity, but will also leave a lot of people struggling to find work. In time that too will balance out, as new jobs are created out of the new industries. But that tends to take time and to come at the cost of leaving older generations without anything very useful to do.

The UK will remain strong economically because we have a lot of natural advantages - our common law system, the financial sector's capital raising capabilities, the English language, etc. but rebalancing the economy - aka "levelling up" is easier to talk about than do.

Bronstein

29th Sep

Here in the UK, why do we have a conservative government trying to govern by socialist principles.? Answer: Because of its populist outlook. Faced with a socialist media every problem is framed as one for the government to solve. This leads to the rather ridiculous situation where free marketeers are running around privatising railways and pumping billions into the NHS. The economy needs time to adjust to post-Brexit realities. Why did haulage firms not begin training more drivers 3 years ago? Surely the new emigration rules meant the reduction in cheap foreign labour was inevitable, This is, after all, what the people voted for. Given time, we will find a new equilibrium and in all but the most extreme cases, the government should steer clear, ignore the clamour from the pro-EU media and let the market sort itself out.

Rolls Royce?

Lot of points, but to answer this one:

Why did haulage firms not begin training more drivers 3 years ago

Because three years ago they had no idea what the rules were going to be. Most logistics companies work on margins of between 1% and 2% - where were they supposed to find the money from to start training drivers they might not have needed?

The free market adjusts, given time. But the consequences in the meantime can be quite painful, especially if you're a populist government thinking about calling an early election.

Yes the world was a different place 3 years ago. Who foresaw Covid then? If margins are so tight then how will the haulage firms afford the wage rises that drivers are getting.

Also with Brexit/Covid, many European drivers went back home and have not been able to return. But there is large shortage in Europe as well, it is not just a UK problem.

Also with Covid, training and testing has largely been suspended. Also many drivers have retired or found other jobs.

It's not just a training issue, you need to find people who are willing to do that type of work, it is the same working on the land, most British it seems don't want that type of work.

If margins are so tight then how will the haulage firms afford the wage rises that drivers are getting.

They can't. Either hauliers will go bust or they'll have to renegotiate contracts. Which will increase costs to retailers and ultimately to consumers.

It's certainly true that the pandemic has triggered many of these problems and the EU has HGV driver shortages as well. However, the EU isn't seeing the same distribution issues as the UK - they have a bigger pool of drivers to choose from and rail freight is able to pick up some of the slack.

In the UK we've got a reduction in the number of drivers available due to the new immigation rules, a shortfall of new drivers due to testing being suspended for most of 2020, problems at the DVLC who are seemingly unable to issue newly qualified drivers with licences and changes to tax rules making HGV driving less financially attractive. All of those are things that the government could have done something about, if they had chosen to do so.

jwebster

Buying cheap UK stocks is a theme which has come up a few times now, including Bloomberg and others. The various valuation ratios look appealing. Thinking about this from my own perspective, I like to break it down as follows.

Firstly, the FTSE100, specifically the miners, financials and oil.

The miners I follow RIO and AAL. The good thing about these two is all their earnings come from abroad, so it’s a nice hedge against UK travails. Their respective PER and dividend yield estimates (from Stocko) for 2022 are 6.37 11.7% and 6.25 6.88%. Seems great, but we are coming off a high point in the metals cycle. Prices, after a good run up are now fading, especially iron ore. It’s all a China story of course, as they are the big swing consumer. The ruptures with Evergrande are pointing to a possible slowdown in property construction along with Xi’s efforts to rebalance the economy and deflate debt. The last time China sneezed was back in 2016, RIO’s share price fell over 60% from 58 to 22 pounds. This time RIO has recently fallen about 32% from 95 to 65. I’m waiting to see if a further shake out happens.

On financials, LLOY is interesting for me. Fits the ‘cheap’ sticker with 2022 PER of 7.88 and yield of 5.57% and a discount on book. The potential here is rising interest rates, which would help banks by providing a wider spread on their lending. At the moment, much of UK consumer lending is dire, particularly mortgages, as vast levels of deposits have led to a price war with margin compression. HSBC being the worst in my mind, after the regulator stopped them from upstreaming surplus deposits to HK, they dumped them into UK lending (purely in my view, no evidence for this). LLOY at least has a decent consumer loan and card book, so there’s good margin there still. But, with UK growth looking a bit shaky, underlying revenues likely static, no growth. The other big financial I looked into was LGEN with a forward PER of 8.28 and yield 6.88%. Again, tasty valuations, but I became a bit stuck in the mire of detail with LGEN as they have recently been pushing buying private pension liabilities and earning tidy fees. But, have they correctly matched long term assets with liabilities? And even can they with Gilts at 0.99%? I couldn’t put capital at risk here unless I figured that out, which is difficult.

A brighter spot for investors has been RDSA which is rating upwards on the back of a rising oil price. Has the overhang of potential stranded assets, also is not the lowest cost provider by far, that’s Saudi and the likes of Russia. But, I’ve read analysis which argued that oil will stay expensive for a while yet, because while EVs and carbon taxes are on the way, this is offset by increasing Asian demand for oil and a lack of capital investment in new supply, holding price up for some years to come, until its eventual demise.

Even though FTSE100 is cheap, there are issues you need to look through, by sector.

On small caps, yes many do look cheap compared to overseas markets. I’ve been holding a small cap fund THRG, which has done well this year. Also, there has been a burst of foreign firms buying up cheap UK firms. I’ve found it a lot simpler to hold a fund here than pick through companies, given it’s an investment theme. I suspect a downrating might wash through now with this cocktail of woes - covid, Brexit, inflation, USA tapering, China slowdown. Looking at the chart suggests a lower price might come.

UK plc is cheap. Small caps were my favourite so far, I’m waiting on the large caps until these macro issues develop further, especially China and tapering.

The real Tim

30th Sep

Edmund. Thanks enormously for the wise words as ever. My only question would be over timing. In effect, your article has been right for the last 10 years+ and the US exuberence wrong for a similar period. So, is it wiser to wait until 3-6 months of the UK outperforming is observed and miss the bottom but also miss the risk of being early(again) to the longest delayed party ever?

Richard Goodwin

3rd Oct

Why did haulage firms not begin training more drivers 3 years ago?

The Public sector in general is great at telegraphing the general thrust of its intentions but rubbish at providing actionable certainties which can be used as the basis for planning. Sometimes this is for good reason, in this case because noone knew how Brexit would look.

Firms certainly did not have 5 years actionable warning.

dulciemo

6th Oct

I enjoy your analysis and comments. The voice of reason with a lot of common sense. And as I get older I see common sense as a great gift and sorely lacking in many people. Keep it up timarr.

Greedo

Sat 11:54am

One thing that has intrigued me is that why do investors invest in large companies that don't pay dividends? I don't understand reasoning and I am sure there is one. I am old fashion in that I like metaphorical cash in my pocket. It is probably why I missed out on the tech boom and chose instead in buying dividend payers with high FCF - mainly Footsie companies. These companies are not going to double overnight they require patience.

However, I am kicking myself for not investing in Apple and Netflix 10 years ago when I was procrastinating kind of ironic as I work in tech sector :).

I heard somewhere recently that we could be heading for stagflation in UK. Our issue in this country has been low, persistent productivity and now coupled with higher inflation we could be heading for "interesting" times. It could be the right time to buy those high divi companies.

Value investing could become en vogue

Sat 1:19pm

Why pay out profits to shareholders, when it can be invested in the business?

I think it is a fundamental problem with some large UK companies and part of the reason they don't grow. These companies tend to have high debts which maybe ok when interest rates are low but could be a problem when interest rates rise.

I have held some companies because of dividends but then they cut them last year. Shares have not gone up in 20 years, would have been better off buying Apple and the dividend would be higher as well now.

BnB

Sat 1:32pm

Value investing typically relies on cyclical growth which is the last thing you experience in periods of stagnation. You need the most secure profit growers. Appropriately to your first point, these tend to be large companies with big moats which, instead of focusing on pay-outs to shareholders, concentrate on compounding profits by re-investing for further growth, which is why their share prices rise consistently over time and returns far exceed the dividends that they elect not to pay out. Such companies are actually rare in the UK mid-large cap space, which accounts for the enormous premia placed on the likes of Halma and Spirax Sarco. The US market is loaded with them, starting with the FAANGMs and embracing many software providers but also heavyweights like Mastercard, Thermo Fisher or Illumina.

Market Musings 25/09/21: The UK: Contrarian trade of the decade?

Market Musings 25/09/21:
The UK: Contrarian trade of the decade?

Every Dog has its Day - Eventually

Lower commodity prices and interest rates a headwind for the UK

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Edmund Shing

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