At first glance, the outlook for British equities does not look very good. The British economy is strugglingwhile corporate executives are increasingly looking to include their companies across the pond given what they perceive as chronic discounting applied to the UK. listings. Abcam (ABCM), Arms (ARM) and Ferguson (FERG) are just three names that have chosen wholly or partially to list outside the UK in recent times.
Although it may not seem like it, the above could represent a good opportunity for value investors for a couple of simple reasons. Firstly, our preferred vehicle has in any case somewhat limited exposure to the UK economy and, secondly, discounted valuations, while perhaps irritating to CEOs, are clearly not a bad thing for anyone looking to buy. In fact, I’d go so far as to say that UK stocks look like a fair deal right now for long-term investors.
Franklin FTSE UK ETF
Enter the Franklin FTSE UK ETF (NYSERCA:FLGB), hereinafter referred to by its ticker symbol. FLGB background description says it aims to track the FTSE UK Capped index. It currently charges a respectable 9 basis points per year for this service.
Now, although it may not say so explicitly, this index looks a lot like the UK’s most commonly traded blue chip index: the FTSE 100. Below are FLGB’s top twelve holdings compared to the iShares Core FTSE 100 UCITS ETF (ISF.L), which is a large FTSE 100 ETF listed in London. You can see that they are almost identical.
|Company Name||ISF.L (%)||FLGB (%)|
HSBC Holdings plc
|British American Tobacco plc||2.98||3.03|
|Reckitt Benckiser Group plc||2.03||2.08|
Data source: Franklin Templeton and iShares
The reason I mention this is that the international bias of the FTSE 100 has already been well documented. FTSE Russell had it in more than 80% in terms of share of revenue generated outside the UK.
I’m sure this has been noted in previous analyzes of this ETF, but this point is worth emphasizing for a couple of reasons. Firstly, and most obviously, it means that the internal performance of the UK economy is not as important as the ETF’s name might suggest. I would also like to point out that not all of the unique UK stocks in the portfolio are cyclical. Grocery stocks like Tesco (OTCPK:TSCDY)(OTCPK:TSCDF) and sainsbury (OTCQX:JSAIY)(OTCQX: JSNSF), and telecommunications/utilities such as United Utilities (OTCPK:UUGRY)(OTCPK:UUGWF) and BT Group (OTCPK:BTGOF), for example, they are defensive.
Secondly, it means that sales and profits are largely generated in currencies other than sterling. The majority of FLGB readers and potential investors reside in the US, so it is important to consider exchange rate effects.
A relative bargain
As mentioned in the introduction, there is a degree of negativity surrounding UK equities. Many executives have moved their listings to the United States, or are considering doing so, because they believe this will attract a higher valuation multiple. The global oil giant Shell (SHEL), the largest holding in FLGB and the FTSE 100, it was even rumored to be considering a change for this reason.
At the risk of stating the obvious, it shouldn’t really matter where a stock trades. Its market valuation should reflect its intrinsic valuation. With this in mind, the tendency for executives to think about listing across the pond could mean they think their market valuations in London are not a fair reflection of intrinsic value. It could also mean that the US market is simply overvalued, in which case a higher multiple would be undeserved but beneficial, at least for short-term investors.
This begs the question: are UK stocks really cheap or not? FLGB’s portfolio trades at a weighted P/E ratio of 11 according to Morningstar. Its P/B is 1.55 according to the same source.
That represents a notable discount for the United States and, to a lesser extent, Europe. Vanguard S&P 500 Index (FLIGHT), for example, trades at a P/E of 22 and 4x book value, while its FTSE Europe ETF (VGK) is trading with a P/E of 12x and a P/B of 1.8x.
Such a discount applied to FLGB could be justified for three reasons. The first two are that, one, European and US stocks are higher quality, which, all things being equal, would attract a higher multiple, and two, those stocks could also possess greater growth prospects.
Regarding quality, we can calculate the implied return on equity by multiplying P/B by the inverse of P/E. That gives us E/B, or earnings dividend to book value, which of course is ROE. Indeed, doing this for FLGB (~14%), VOO (~18%) and VGK (~15%) would imply that UK stocks are not as high quality, certainly compared to US stocks.
As for growth, well, it doesn’t matter much. With a P/E of 11, FLGB holdings could generate an annualized return of around 9% simply by sending all of its earnings to shareholders. At the high end, multiplying ROE by the retained earnings ratio (~50% in the case of FLGB) would result in an annual return of around 11%, including dividends. (Please note that the UK does not impose withholding tax on dividends.)
The third and final point to consider is that earnings may be reaching a cyclical peak. Energy and finance represent around 30% of the FLGB according to Seeking Alpha, and those benefit from a combination of higher commodity prices, higher interest rates, and benign credit quality. Put another way, the “E” in P/E may be more inflated in FGLB than in, say, VOO, which would make its P/E deceptively low.
FLGB Holdings Breakdown
Historical CAPE ratio by region
While the UK’s CAPE ratio is naturally higher than the current P/E, it is nonetheless at a discount to its historical average, unlike Europe (which is more or less in line with its average) and the United States ( a clear premium). As a result, I’m inclined to think that the UK equity space, and by extension the FLGB, is certainly cheap and a fair deal for long-term investors. Buy.