Feature – UK equites


There is undoubtedly a discount for UK stocks.


Blake Hutchins, Troy Asset Management


He blames a succession of raids on the tax advantages previ- ously enjoyed by pension funds (by chancellors Nigel Lawson and Gordon Brown) along with new accounting rules, which put pension assets and liabilities onto corporate balance sheets. This resulted in the closure of many of these pension schemes and a consequent major shift in asset allocation towards bonds. Typically, XPS Pensions’ defined benefit (DB) clients only have a 10% allocation to global equities. Alasdair Gill, a partner at the pension consulting and administration business, says: “There’s very little new money on the defined benefit side – so they are de-risking and allocating more to bonds.” By contrast, in the defined contribution (DC) world, XPS Pen- sions still sees plenty of assets going into equities and growth assets. However, there is a low allocation to the UK. “It’s partly because the UK became a smaller part of the world index,” Gill says.


Also, the growth phase of a DC pot is typically done on a mar- ket capitalisation approach and passively, as the mandates tend to go to lower cost investment approaches.


Although the UK made up 10% of global indices about 20 years ago, it’s only 4% now. “The fall has been driven by a mix of de- equitisation, fewer initial public offerings [IPOs] to replace companies being taken over – and there is less choice,” Wid- dowson says.


This begs the question: do international investors need UK exposure? Many now invest in equities on a global or thematic basis rather than in a single country. Ashby says: “Combined with the negative investor sentiment post-Brexit and it’s not hard to see why UK equities are so unloved.”


The 1.8% club But there are other reasons for such a low allocation to UK equities. One is that pension schemes focus on being diversi- fied across sectors and the UK equity market doesn’t help here. Elaine Torry, partner and co-head of trustee DB investment at Hymans Robertson, says: “Diversification is a key risk manage- ment tool for pension schemes and that is reflected in the way


40 | portfolio institutional | October 2023 | Issue 127


that the vast majority of pension schemes invest in equities, both at sector and geographical levels.” Peek under the bonnet of the UK’s main stock market indexes and they are dominated by energy and commodities producers (Shell, BP and Rio Tinto), defensive consumer staples (Unile- ver, Diageo and British American Tobacco), banks (HSBC) and pharmaceuticals (AstraZeneca and GSK), with few of the fash- ionable technology stocks. And these sector skews are an argu- ment for having more diversified exposure. UK pension funds collectively now own just 1.8% of the domes- tic equity market, according to the latest data from the Office for National Statistics. But it’s not just pension funds that are shunning UK equities. The market has undergone a significant change in ownership in recent years. Individual ownership of UK-listed shares fell to just 12% in 2020 (the latest figures available) compared with 20% in 1991. This has broadly been offset by a big increase by overseas institutions.


Deep discount Today, the significant valuation discount in UK equities is increasingly attracting interest from those overseas institu- tions. Ashby says: “To be clear, the FTSE100 is not expensive – trading on a prospective price-to-earnings (P/E) ratio of below 11 times. However, this is now almost exactly the same prospec- tive P/E for the FTSE250, even though mid-cap stocks should over time offer higher growth potential. Small caps look even cheaper, with the FTSE Small Cap on a prospective P/E of just over eight.”


This is all in stark contrast to the US, where the S&P500 trades on 18 times earnings. However, Ballard says: “There are big structural differences between the two equity markets that can- not be ignored. Despite that, it is remarkable that this 40% dis- count is near the cheapest it has been.” Another sweetener for investors is that the FTSE All-Share offers an aggregate prospective dividend yield of 4.9%. And Schroders says the prospects for dividend growth look good because the dividend cover ratio, which represents how many times a com- pany can pay dividends to its shareholders using net income, is higher than average across the UK equity market.


Unloved, but attractive Sterling has also been the best performing currency within the G10 so far in 2023, which suggests that international investors are less concerned about the longer-term outlook, even with the uncertainty of an upcoming general election. Another positive is that the tightening of interest rates is near- ing an end. And though inflation may not be completely tamed and the rise in the oil price is problematic, it is still marching in the right direction.


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