Outflows from UK equity funds have persisted for four years. The Bank of America Merrill Lynch survey of global investors shows they have rarely been so underweight the UK market. In part, it is good to see UK investors overcoming their traditional home bias to capture more exposure to great US, European and Asian companies. And yet, the popular rush into global funds has not only created opportunities in cheap UK shares, but is not without risk itself.
Global growth – irrespective of value?
Many global funds today are focused exclusively on certain types of company. Long-lived consumer staple companies are the favourite. Unilever, Procter & Gamble, Nestlé have been around for decades and will undoubtedly exist many years into the future. They are great companies.
But the key to future returns is the starting price you pay for an asset. The last nine years since the financial crisis have seen interest rates collapse and bond yields fall to record lows. This has pushed the valuations of these types of companies to levels which look stretched relative to the modest rates of profit growth they are delivering.
Many years of future profit growth are already reflected in their valuations. Yet it has become very fashionable to shun entire areas of equity markets as too cyclical to be worthy of investment, irrespective of cheap valuations.
Valuation drives future returns
Banks, and financial shares generally, are regarded by many investors as one such investment no-go area today. Barclays, Lloyds and the Prudential are also companies with hundreds of years of collective history. Cyclical they may be, but they have stood the test of time. Not only have they faced the headwinds of low interest rates and falling bond yields in recent years, but the banks have had to build up capital to meet tougher new standards. They have also paid out billions of pounds in compensation for PPI claims – in many cases, amounts equivalent to over half the size of their market valuation.
The trend isn’t always your friend
These massive headwinds have rendered bank shares ‘uninvestable’ for many. But trends rarely persist for ever. PPI compensation will stop. Bond and interest rates will rise. UK banks will be able to divert all the cashflow they have used to pay claims and build capital to reward shareholders through dividends. And from cheap valuations they will likely become very attractive investments once more. Investors would do well to take note.
Consumer staples: rolling over?
UK banks: still unloved, but stabilising?