Why Are UK Shares Still Undervalued?

MICUK 2021: Private equity firms are seeing the potential of UK equities even if the average investor has yet to, says BlackRock's Roland Arnold

James Gard 5 July, 2021 | 9:15AM
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Union Jack jigsaw puzzle

The UK equity market is still undervalued despite this year’s value rally, according to Roland Arnold, manager of the Silver-rated BlackRock UK Special Situations and UK Smaller Companies funds. Speaking at the Morningstar Investment Conference 2021, Arnold says that this “valuation anomaly” is not likely to last as Brexit and the coronavirus pandemic recedes into the rear view mirror.

While investors now have an equal weighting towards the UK for the first time in five years, having previously been underweight, the market is still at a discount. “There is still value in the UK compared with other global markets,” he says. But this may not last. “Somewhere along the line this valuation [gap] will start to close,” he says.

Arnold sees the recent flurry of M&A activity for UK companies, spurred by private equity firms, as a sign that professional investors at least are recognising the market’s potential – even if flows are not yet reflecting this change in sentiment. “Those with long-term investment horizons are recognising the value that exists,” he says.

Reasons Why the UK is Unloved

Brexit Hangover

More than five years on from the Brexit vote, the issue may still be a factor in why the UK market is underloved, Arnold argues. While the main deal has been put to bed, ongoing discussions and arguments about the finer details may be creating uncertainty in some investor’s minds.

It’s Not a Tech Hub

The perception that the UK, unlike the US,  is not a great place for tech investors could also be a factor, he says. While UK doesn’t have a Google, Apple or Facebook, Arnold says that we have high-growth companies like Rightmove (RMW) and Just Eat Takeaway (JET) that are “technology enabled” businesses.

Value Has Been Out of Sync

Style has been a factor in the UK’s unloved status, with the FTSE 100 full of value stocks like banks and oil firms, which lagged last year but have outperformed in 2021 as economies have recovered. Arnold admits that the pandemic has shaken up the value/growth dynamic, perhaps for good, but high quality businesses will always shine through whatever style is in vogue. “In the mid to long term earnings always reinstate themselves,” he says.

ESG is a Concern Too

Oil and mining stocks, as well as being a style turnoff for some, also present an obstacle in the era of environmental awareness, Arnold says. But while the drive towards the low energy transition has taken on real urgency, these companies have plenty of time to get their houses in order. “They do have the benefit of time … that transition isn’t going to happen today or tomorrow. It’s going to have happen over the next 10, 15, 20 years,” he says. He argues that investors need to see companies like BP (BP.) and Shell (RDSB) as “energy” rather than “oil” companies that can reinvent themselves. “I’m very confident they are going to be energy companies in 20 to 30 years’ time,” he says.

Where to Find High-Growth Companies

The UK is a dynamic stock market, Arnold says, but investors may have to look beyond the large caps to find the best opportunities. He argues that the pandemic has shaken up corporate and consumer life for good. “These changes are positive for some companies, but are terrible for others,” he says. In this era, smaller, niche companies have been more nimble and better at embracing change. They can scale up faster than ever, potentially becoming the giants of the future. “It’s about the ability of these businesses to change, ability to adapt to the conditions around them without the legacy of huge amounts of investment capital or the cultural inertia that goes with being a big business,” he says.

Morningstar Investment Conference 2021

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James Gard  is content editor for Morningstar.co.uk