Uncovering the value in the UK stock market

What is value investing?

Value investing is an approach where investors look for stocks that exhibit solid fundamentals yet are priced below their true market value. True market value is determined by factors such as future cash flows, competitive advantages, growth prospects, and other key metrics.

Short-term investor sentiment, which can oscillate between fear and greed, often clouds the true value of a stock. The skill of a ‘value investor’ lies in identifying whether a market’s temporary emotional state has diverged from rational analysis and then exploiting it.

Valuations: A key measure

Historic data shows that buying investments when they’re undervalued tends to pay off over time. Future expected returns are higher, the best outcomes are higher, and the worst outcomes are less poor.

The opposite is also true: if you consistently buy expensive assets, you will, over time, achieve lower returns. That may seem obvious, but it still catches many investors out, particularly those influenced by the allure of short-term market trends.

“We think valuations matter because they are the best predictor of future performance – both at the market and individual stock level,” says Nick Purves of Redwheel, co-manager of the SJP UK Equity Income fund.

A closer look at the UK market

Currently, the UK stock market is an interesting opportunity for value investors to consider. Its companies are being more heavily discounted than like-for-like competitors in different global markets, such as the US. Historically, this discount has hovered between 15-25% on average, whereas it now stands at approximately 45-50%. From one perspective, you could see this as the market pricing in macroeconomic and structural headwinds for the UK; however, it may also point to a disconnect between perception and real value.

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This disconnect between perception and real value offers a fertile ground for our active, value-oriented fund managers. They look beyond short-term sentiment and evaluate companies based on solid data, uncovering opportunities that the market may have neglected.

Nick says: “Neglect is good. We want neglect because it suggests there isn’t a fundamental problem with the business. When investor attitudes change, there’s the potential for a lot of these UK-listed businesses to do really well in share price terms.”

(Image: Derek McArthur)

Are UK companies poised for a resurgence?

There are now signs that global companies are realising that they can buy good UK businesses for a fraction of what they’re worth. Over the past decade, the UK market has seen roughly 40 company takeovers each year.

MonThis activity jumped significantly to 64 deals in 2023, and the pace of takeovers has accelerated again in 2024.

Another group recognising the latent potential within UK businesses are the boards of companies themselves.

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Many have started buying back their own shares – a mechanism that can deliver value to shareholders. Share buybacks reduce the number of outstanding shares on the market, which may increase the value of remaining shares and earnings per share.

Over half of companies within the MSCI UK Index have bought back their shares in the last 12 months – the highest percentage of any market in the world. This is another good indicator that UK stocks may be undervalued.

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Nick notes: “UK companies have woken up to the fact they’re not going to wait around for other investors to come in and drive their shares up. They’re basically going to try to realise some of that value themselves.”

Summary

Given prevailing negative perceptions of UK equities, the gap between market price and intrinsic value remains pronounced, with UK stocks trading at a significant discount.