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The London stock market is no longer what it was before. Lists are rare. Successful listings are rare. Chest-beating pundits blame a sluggish post-Brexit economy, red tape and yield-hungry fund managers. These factors are believed to have given London a major structural valuation discount.
Should UK private investors run away from this sorry state of affairs? Should they instead park their savings in Vietnamese EV stocks or Bolivian silver mines?
Probably not. The structural discount thesis faces a challenge in the form of James Arnold, a banker at UBS. Analysis from their strategic insights team suggests the city’s decline is driven by a comparison of British apples with American pears.
It cannot be denied that the UK market largely trades at a low price-to-earnings ratio. Before the 2016 Brexit referendum, it traded at about 15 times forward earnings, in line with the global average. If you excluded the US from the comparison, there was a small premium there too.
The situation in the UK has continued to worsen since 2016. The discount to world equities reached a record 40 percent late last year. This difference compared to America was 20 percent. The UK now trades at just 10 times forward earnings.
Arnold’s quibble is that these comparisons are not the same. His team paired 60 of Britain’s biggest blue-chips with American competitors whom they considered closest in type. Pairs included caterers Compass and Aramark, and engineers Renishaw and Envent.
UBS found that British stocks were either in line with US peers or higher in two-fifths of the cases. Excluding a handful of US tech giants like Meta and Amazon caused a big chunk of the discount to disappear. These have no real equivalent in the UK or anywhere else.
The remaining gap points to modest structural relaxation in the UK. This reflects the result of higher US returns on capital, lower taxes, and a larger domestic market.
A cynic might say that you can support any thesis you like with whatever data you choose. Still, UBS deserves credit for challenging the accepted wisdom. This is often proven wrong.
A useful takeaway from the UBS analysis is that investing in indices is not the same as investing in a country’s economy. Indices are often bizarre artifacts of history and stock exchange marketing campaigns. It is worth understanding their characteristics.
Meanwhile, UK private investors may justify focusing on their local stock market on a few grounds. Firstly, it removes the risk that the base currency of their investments may not correspond to liabilities denominated in sterling. Second, living in the UK may give them a better understanding of what domestic-oriented businesses are doing compared to foreign companies operating abroad.
Furthermore, Arnold believes an inflection point is near. Only a small proportion of UK defined benefit pension funds are still invested in UK shares. Defined contributions and other optional retirement savings should start growing now. This should be supported by comprehensive market assessments as well as the type derived from similar comparisons.
union, darling, union
Milan style defeated The London look on Tuesday. UniCredit and Barclays both beat third-quarter profit expectations. Italian banks, which are also active in Germany and Eastern Europe, made a better impression.
UniCredit investors shrugged at the confirmation of the €6.5bn capital return and higher revenue target. But Barclays’ weak net interest margin in the domestic market pushed its shares down 8 per cent.
Low valuations of banking stocks indicate economic weakness and impending disaster. They are at levels that were only seen during previous financial shocks. Investors see a surge in rate-driven profits as yesterday’s news approaches.
Returns on loans have risen most rapidly in Southern Europe. UniCredit shares are the best performer of any major European lender, rising 70 percent year to date. Investors have little hope of further gains.
The benefits of rate rises are diminishing in the UK. Barclays’ UK net interest margin (NIM) – which measures the difference between the bank’s savings and loan rates – was 3.04 per cent, below the expected figure of 3.12 per cent. Chief Executive CS Venkatakrishnan cut full-year NIM guidance. Competition for deposits in the UK is increasing. UK lenders have increasingly offered higher rates to savers than continental rivals.
“Low deposit beta”, as the pass-on rate is called, explains why UniCredit thinks it can squeeze out an extra €500mn of net interest income this year. Boss Andrea Orcel expects a net profit of at least €7.25 billion in 2023, and the same in 2024. The expected return in dividends and buybacks equates to an incredible 16 percent annual yield.
UniCredit will avoid paying tax on “windfall profits” imposed by Giorgia Meloni’s government. After news of the levy sent bank shares falling, ministers gave lenders the option to reserve an amount equal to 2.5 times the estimated tax charge. UniCredit’s figure is €1.1bn.
Self-help and higher rates have led to a re-rating of UniCredit shares this year. The plan is to compensate for the higher NIM fees. Barclays will cut costs to protect its bottom line.
Only a staunch follower of depressed European bank stocks would notice much difference between the pair. UniCredit shares are valued at 0.7 times their book value. Barclays stock is favored by less than 0.5x. These metrics imply that assets at both lenders are worth much less than their nominal value.
The price-earnings ratio of almost five times has rarely been this low. These stocks look cheap – but they’re cheap for a reason.
The above articles are edited versions of pieces appearing in Lex, the FT’s flagship daily investment column.
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