A favourite bedtime story for my son is Eric Carle’s The Very Hungry Caterpillar.
The larvae eats its way through many fruits and sugary treats day by day, before blooming into a beautiful butterfly. Given my son’s tendency to eat everything placed in front of him, I sometimes wonder if the story’s words are in fact a memoir of his day.
This theme of sluggish growth before gorging its way to beauty is also somewhat reminiscent of the current UK equity market.
The FTSE All-Share in aggregate has grown earnings per share (EPS) by 46% since the previous index high in May 2018. Over the same period, at the index level, EPS growth in the US has been an impressive but not wildly superior 56%, Europe grew 54% and Japan by a measly 26%.
Put differently, private markets and overseas companies seem to be rating UK PLC at a much higher valuation than other investors
Yet despite the UK keeping pace, the market has de-rated close to a 10-year low, while other major markets, particularly the US, trade at much sturdier valuations.
Source: Bloomberg, 10 years to 31/12/2023
Private equity is taking notice of this valuation anomaly and deploying capital into the UK market, with rarely a week going by without a UK listed company being acquired. Over the past five years, there have been more than 270 takeovers, at an average premium 45% higher than undisturbed share prices.
Put differently, private markets and overseas companies seem to be rating UK PLC at a much higher valuation than other investors.
The UK market is, quite simply, eating itself!
When companies generate cash flow from their operations, management have a decision to make on capital allocation: pay dividends, pay down debt, invest in growth capital expenditure or acquire other businesses. Dividends have been a historical preference for UK PLC versus international peers (the merits of this can perhaps be debated).
An alternative to the above listed capital allocation decisions, corporate chief executives and boards can spend the profits of the company buying back shares from investors. This can be particularly potent when company shares are lowly valued.
We recently met with Redwheel UK Equity Income and Temple Bar Investment Trust managers, Nick Purves and Ian Lance, who quoted some staggering data.
Source: Redwheel, 29/02/2024
The above list shows that a slug of UK corporates are using surplus cash to buyback a huge chunk of their own shares. For example, NatWest has announced over the past two years that it has shrunk (or will shrink) its share count by 29%.
So long as group profitability remains constant, a proportionally higher amount of cash flow and dividends are available to remaining investors. The energy majors, too, are returning enormous amounts of capital to shareholders, an industry hamstrung on growth capex in non-renewable assets. In the case of BP and Shell, they are buying back 17% of their own market capitalisation.
The UK market is, quite simply, eating itself!
We can see similar patterns within our own investment trust holdings, such as in renewable asset owner Greencoat UK Wind, now paying dividends as well as investing excess cash into the existing portfolio – i.e. buying back shares – rather than solely to fund additional investments.
A slug of UK corporates are using surplus cash to buyback a huge chunk of their own shares
The missing piece of the puzzle is acknowledging future earnings growth. A rational investor should be willing to pay more for a company today whose earnings can grow at a faster rate in the future. Of course, the UK market lacks anything like the revenue growth of Nvidia (thank Cambridge-based Arm’s Nsadaq listing for that!).
However, investors should take note that long-run EPS growth forecasts for the technology sector more broadly are now approaching year 2000 levels – potentially justified in a new artificial intelligence (AI) paradigm, but eery nonetheless, given the following bear market post-2000.
Yet who would have thought one of the last decade’s problem children could outshine AI’s hysteria? Nvidia’s 65% share price run over two years to year-end was dwarfed by Italy’s second largest bank Unicredit’s 95% total return. Of course, a beneficiary of rising interest rates, but performance in part turbocharged by its large share buyback programme.
Somewhat old-economy stocks – banks and energy – are using more modern capital allocation policies to try to drive share price returns for investors, even if that is yet to be recognised in the UK market.
Buying back shares may lack the excitement of layering growth expectations, but it’s a low-risk and accretive investment for steady but undervalued business. When choosing my son’s bedtime story to read, it’s a sleep-at-night strategy which is all that is needed.
Adam Norris is investment manager at Columbia Threadneedle Multi Manager
