The writer is founder and chairman of fund manager Research Affiliates
Predicting when markets will turn or what catalysts will trigger the move is more a fun parlour game than a reliable tool for investment strategy.
Nevertheless, sometimes long-term prospects seem clear. That is notably the case now for UK stocks.
We have been saying since the autumn that UK shares may be the trade of the decade, in particular so-called value stocks that appear cheap compared with benchmarks, such as dividend payouts or assets. That is still the case.
What created this potential bargain? Over the past year, Brexit-related perils coupled with concerns of sweeping bankruptcies amid the Covid-19 pandemic understandably induced investor fears.
Brexit drove UK stocks to valuation levels that were the cheapest compared with other developed world markets. Then Covid fears drove value stocks globally to near-record lows relative to growth stocks, in many countries lower even than at the peak of the tech bubble in 2000.
This exodus created bargain prices in UK value stocks, which even after a recent rebound, still offer a compelling opportunity.
As of end-December 2020, the ratio of the price of UK value stocks to the balance sheet value of their assets was 0.97 compared with 1.61 for the broad UK equity market ratio and 2.89 for global developed equity markets.
While most investors are transfixed by the pandemic crisis and Brexit, surprisingly few ask: ‘Will these events matter much in five years?’
Covid-related shutdowns have not after all led to sweeping bankruptcies. And, with the UK among the world’s champions in mass Covid-19 vaccinations, they are unlikely to materialise in future. Likewise, the recent Brexit deal means that UK businesses can operate with much less uncertainty.
As with most crises, Covid and Brexit have changed the UK’s relationship with the world, but not drastically. On a five-year horizon, it seems unlikely that Brexit will leave the UK isolated from global trade and that in fact the UK will remain a vibrant and competitive economy, enjoying robust trade with its global partners.
Consider that the OECD projects UK economic growth rates in 2021 and 2022 of 5.1 per cent and 4.2 per cent respectively. That compares with global growth expected of 5.6 per cent in 2021 and 4.0 per cent in 2022.
Are UK equities risky? Of course, but no more than other developed-economy stock markets.
We gauge potential long-term returns as the sum of dividend yield, expected capital growth, and changes in valuation multiples (which usually mean revert towards historical norms).
For the FTSE 100 stocks over the next 10 years, this means returns of 3.2 per cent from yield, 4.1 per cent from capital growth, and 0.8 per cent per year from a reversion to historical valuation norms.
At the start of 2021, UK value stocks were trading at very nearly their cheapest ever relative to both the market and to growth on metrics such as price to sales, price to dividends, and price to cash flow
Granted, they have recently rallied, up nearly 20 per cent in excess of their growth counterparts from October 1, 2020 through to February 28, 2021. This may lead some to ask if the value stock uptick is merely a bounce or the beginning of a sustained move.
The good news is even after the rebound, UK stocks are still trading at very attractive levels relative to their history — now very cheap versus exceptionally cheap earlier this year.
What does all this mean in terms of potential return going forward for the long-term investor? UK stocks stand out as offering the most attractive risk — return trade-off across the main global asset classes and are priced to earn a return even a notch higher than emerging markets equities with considerably less risk.
An annualised total return of 8 per cent over the next ten years may not sound like much, but in a world of near-zero bond yields, it is tremendous. And that is before the 4 per cent incremental return we are expecting for value stocks.
Our forecast for global developed equities is that they would deliver an annualised total return of 4.0 per cent over the next 10 years. That means investment growth of just over 25 per cent in six years. In contrast, a 12 per cent return for UK value stocks would double an investor’s money in just six years.