The sheer number of bids for UK companies by overseas businesses proves the UK market is significantly undervalued, according to fund managers, who believe investors should be bullish despite Brexit risks.
UK assets are currently well out of favour with investors, as a look at fund flows shows. In the 12 months to 28 February, more than £6 billion has been pulled from UK equity-focused funds, according to data from Morningstar Direct.
However, UK firms have rarely been in such high demand for merger and acquisition activity from further afield. Already in 2018, we’ve seen a plethora of high-profile offers.
Two weeks ago, Japanese pharma giant Takeda said it was considering making an offer for Irish drugmaker Shire (SHP). According to David Smith, manager of the Henderson High Income Trust (HHI), “that’s just another example of a foreign company looking at the UK as cheap”.
Elsewhere, he points out, Sky (SKY) is being pursued by US giants Comcast (CMCSA) and Fox (FOX); fellow American companies International Paper (IP) and CME (CME) are chasing Smurfit Kappa (SKG) and NEX (NXG); and French firms Klepierre (LI) and Michelin have been eyeing Hammerson (HMSO) and Fenner (FENR).
“If that’s not a ringing endorsement of how cheap the UK is and how, actually, longer term, things will be better after Brexit,” continues Smith. “People from outside the UK are seeing value in the UK. They are happy to take Brexit risk off; UK investors aren’t, but there is an area of the market that is.”
Neil Woodford agrees. The manager of the Morningstar Silver Rated LF Woodford Equity Income fund notes that global corporates are becoming more attuned to the valuation opportunities that now exist within the UK stock market.
This undervaluation stems, he opines, from the unpopularity of UK equities among global institutional investors. “In turn, it may also represent something of a pre-cursor to a re-appraisal of the UK economy’s prospects and the stocks that are exposed to it.”
Professionals Up Their UK Exposure
Woodford has been vocal on this topic for a while and says he continues to increase his exposure to domestically focused stocks “in order to exploit one of the very few outstanding valuation opportunities left in these late-stage bull market conditions”.
Smith gives Whitbread (WTB) as an example of this undervaluation of UK companies, after US activist investor Sachem Head Capital Management bought a stake late last year. Smith says Whitbread’s owning of freehold property valued at 80% of its market cap provides downside support if trading really deteriorates.
Meanwhile, coffee chain Costa Coffee and budget hotel brand Premier Inn are the largest of their type in the UK and are very strong brands. A comparison with two overseas equivalents, Starbucks and Accor – trading on 20 and 25 times earnings respectively – suggests shares should be around £50, a third higher than the current £37 level.
“I think there’s material upside there, but because it’s deemed a Brexit risk, it’s underperformed,” says Smith.
The UK equity income sector, derived mainly of funds investing in this country’s blue chips, is the most out-of-favour area currently. But Gervais Williams, manager of the LF Miton UK Smaller Companies fund, says it’s a similar story at the opposite end of the market.
While in mid-2017 the largest companies in the UK market were trading on rolling median 12-month forward price/earnings multiples of around 15 times, the smallest were on around 11 times, according to data from broker Liberum.
“Even now, with the outperformance we’ve had, we’re still buying stocks in many cases way below fair value – what a pleasure,” he says. But he doesn’t see this situation continuing and thinks the opportunity will be gone in 18 months’ to two years’ time.
The flip side is that Williams sees this environment will encourage more takeover bids for UK companies from foreign entities. The latest deal for an AIM company saw software quality services provider SQS snapped up by German firm Assystem Services Deutschland.
“We are speaking very clearly to our companies and just saying ‘by the way, don’t even think about it’,” Williams adds. He gives a conversation with Zotefoams (ZTF), one of his funds’ largest holdings, as an anecdotal example.
The share price is currently marching towards £6, having traded in a range of between £2.50 and £3.50 between 2012 and 2017. Williams said at the previous level he would have been “devastated” if the firm had been bought at £10. Now, he’d be devastated if it was taken over at £15.
He continues: “So, please don’t get confused because you might get a takeover premium at 50% versus the share price – tell them to go away. Because once you start the discussion, once you get to the GKN (GKN) stage, it’s a discussion about what’s the present value and you’ve lost the context of the long-term value.”
However, in aggregate, Richard Power, manager of the FP Octopus UK Micro Cap Growth fund, says while smaller UK companies could have become “sitting ducks to overseas acquirers” in the aftermath of the referendum, the reverse happened. “We’ve seen a lot of these companies on the front foot, buying businesses in the US, in Europe, which kind of helped Brexit-proof them as well,” he explains.
