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Politicians, regulators and City grandees are all focused on revitalising the UK’s struggling stock market. The problem is two-fold: companies are disappearing and not enough new ones are arriving to make up for the losses. The market is shrinking at a pace that will dislodge the UK from its top spot in Europe, amid fears of a terminal decline. This phenomenon is a result of multiple factors. But the belief that UK stocks trade at a discount relative to international peers is significant and now ingrained.
There are good reasons for this. The FTSE 100 is big in lowly rated sectors such as resources and banks and lacking in highly rated technology stocks. A growing number of companies opting to leave the London market for the US has reinforced the idea that an omnipresent discount exists.
But this debate is rumbling on as there are signs of a tentative UK bounceback. IPO activity is returning; the success of Raspberry Pi’s float has been followed by the listing of a new investment vehicle from the founders of buyout business Melrose. Foreign listings could follow in the form of fast-fashion group Shein and even French TV business Canal+. The market is trading close to record highs set in May and, in a trade-weighted basis, sterling is the highest since 2016.
Yet the market’s perceived discount remains as big as ever: the FTSE All-Share index trades on just 11 times forward earnings or near a 40 per cent discount to the rest of the developed world’s stock markets. This is down, in no small way, to the boom in US tech stocks amid a frenzy over artificial intelligence.
The bald discount is hard to deny. But James Arnold, who runs UBS’s strategic insights team, thinks the more relevant question is whether the UK systemically undervalues equity, and he says the answer is definitively no.
Arnold finds a strong correlation between stock valuations, based on price to gross asset value, and profitability, measured by cash flow return on investment. With an R-squared of 80 per cent for the Stoxx 600 index, this relationship explains most of the difference in company valuations. And this holds true across US, UK and EU markets. That suggests it is simply lower average profitability that explains much of why UK companies are lower-valued than their US peers.
That, to be blunt, is a management problem rather than a market one, though, Arnold concedes, this is exacerbated by the UK’s excessive focus on dividends over growth, and the ensuing risk aversion. Addressing those issues head on should be London’s next challenge.
Letter in response to this column:
Why banks’ stock derivatives desks make such good returns / From Michael Seigne, Founder, Candor Partners, Binsted Mede, Hampshire, UK
