The great British bargain show

0:06Pushkin. It's been a pretty great past year or so for US stocks, but you know what it hasn't been a great year for? UK stocks. As we talked about on the show several times, they've really stunk it up. They tend to move sideways. But the question is, is that a justified discount or an irrational one? Are UK stocks actually a good buy? Today on the show, we discuss. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu, back at last from my two-week sojourn in the beautiful island of Taiwan. joined today by my boss, Robert Armstrong, who has dug in to UK stocks to probably the most fanfare we've ever gotten on an unhedged newsletter.

0:49It's ridiculous. FT readers are really into UK stocks, as it turns out. They really are. You know what I'm glad about, Ethan? Yeah. I'm glad Katie Martin isn't here because I don't think she'd be able, this is such a hurtful topic to her, the terrible performance of the UK market, that I don't think she'd be able to be objective. I think that's right. Katie's a very resilient person, but I think even she wouldn't have the constitution to talk for 15 minutes about the valuation of UK stocks. But we are going to because we as Americans have no stake other than bragging rights in this conversation.

1:24And you've just written two really interesting columns getting into some of the issues at play in valuing UK stocks. And I think we have to start high level. Yes. At a high level, you look at a very simple metric, right? Price to earnings ratio between US markets and UK markets. And on that basis, UK stocks look damn cheap. There's something like a 40 to 50 % discount on a PE basis. It's amazing. And we should say, for those of you at home, we're not looking at the charts, we're looking at. They've always been at a discount, but until Until around 2016, and we will talk shortly about the significance of that timing for those who are not aware of it already, the valuation difference just busted out.

2:12Yeah. And now you have this huge discount that's been building for five years, which, as you say, makes you ask, maybe I own these things. Yeah. Maybe there is a huge sale in the UK aisle of the stock market. And there's another factor too, which is, as we've discussed on the show previously with Katie Martin, the UK is a market that likes dividend payers. Yes. Right? So you combine cheap valuations with pretty chunky dividends at these companies. You're looking at like a 4 % dividend yield on the FTSE 100 nearly versus 1 % on the S &P 500. So if you're maybe an investor getting up there in age, it can pay you a decent amount of income on your equity holdings.

2:52There is a tricky question though. Yes, here's the but. Here's the but. The but question is there's a lot of unequal valuations across stock markets right now. There's a lot of factors, as we call them in the business, that are trading at discounts. And it's not totally clear that there is a unique discount for the UK alone. So one way to think about this is in terms of just American stocks versus stocks everywhere else. And the last 10 years has just been amazing for America. Yeah. So is the UK discount just one example of a kind of global discount? If you look at a chart of the global discount, it doesn't look all that different from the chart of the maybe less extreme, but it doesn't look all that different from a chart of UK versus USA.

3:46Yeah, that's right. There are other factors at play too that could help explain why UK stocks are at a broad discount. You mentioned US versus ex-US. There's also the fact that the UK is full of smaller companies relative to the US. Yes. And also, a lot of those companies tend to be value stocks, which is another category that's been very out of favor. So there's plenty of big stocks in the UK. But in the last couple of years, very, very big companies have been in favor with investors. And then, as you say, there's the fact that value stocks are cheap. Now, it's slightly weird to say that value stocks are cheap because what it means to say a stock is a value stock is saying that it's cheap.

4:28So it has a low price to earnings ratio, low price to book ratio. the stock is basically inexpensive relative to the company's cash flows or et cetera. But it's all relative. Cheap stocks can get cheaperer. Yes. And the difference in valuation between cheap stocks and expensive stocks right now is unusually large by historical status. Yeah, yeah. So all of that, the question is, does all of that account for what's going on in the UK or is there something else we're hating on the UK for? And just to put a finer point on it, the point here is it's not enough to just look at headline PE for the UK, headline PE for the US and say, well, golly, there's a huge discount here.

5:10You have to look at the composition of the market, right? And so we've just looked at these three factors, XUS versus US, small cap versus large cap, value versus growth. And on all three dimensions, these are kind of structural problems in terms of the UK market being out of favor. So to answer the question, is there a UK discount? You actually have to adjust for all three of those factors. Of course, it's not always easy to do a regression analysis on stock market factors and market dynamics in this way. But I did look at a fairly thorough effort to do a statistical analysis from a guy called Oliver Jones at Rathbone's group.

5:50And what he found was once you adjust for the size and the profitability and the sector composition of the UK market, there still is a discount over and above what you might see from any old value stock slash XUS stock slash slightly smaller stock. So their conclusion was, yeah, there's something here. And of course, it's always a matter of debate what causes divergences in value like this to occur. They think it's probably down to Brexit. Well, so, I mean, let's think about why it might be Brexit. So you literally look at the chart of the composition adjusted UK market versus US market, right?

6:37Once you take out all the things that are out of favor in the UK, there's still this residual discount. But that gap opens up starting in 2016 when Brexit happens. Right, when Brexit happens. You have to ask an additional question. A, does Brexit have something to do with this? And B, does that make any sense? Yeah, is it rational? Is it rational? So let's start with the irrational, which is where the action is, as always. So you could imagine global investment capital is absolutely global, fungible, et cetera. You can imagine global investors saying, this country has just made, from a strictly commercial point of view, a huge mistake.

7:21They had a privileged position within the largest free trade area in the world. Their companies tend to be very outward facing. and they've just created friction. It was not only a bad idea, it doesn't reflect particularly well on how this country is governed. Yeah. It creates volatility. And you could imagine that being a justified discount. Yes. I think that may indeed be the perception, but I would argue that doesn't make loads of sense. Because whatever you might think about Brexit, let's think about the biggest companies in the UK. Shell is an oil company, AstraZeneca, drug company, Unilever, consumer goods company.

8:09These are all very global companies that operate all over the place. And yes, there are companies in the FTSE 100 or the FTSE 250 that have big exposure to the domestic market, but the meat of the market is global companies. And with not only markets, but like manufacturing capacity that is truly global. Brexit doesn't matter more to them than it does to a large US stock or a large Taiwanese stock or a large stock from Zanzibar. It doesn't matter. Right. So if a discount has been placed on these companies, the global companies within the UK market, that just doesn't make very much sense. In other words, if it were really a Brexit discount, you would expect Brexit exposed stocks to be extra, extra discounted.

8:55Yes. Right? And that doesn't appear to be the case. It seems to be more indiscriminate than that. So, look, I always hesitate. Any statistical analysis of the stock market, you have to handle carefully. For the same reason any study in economics or any of the social sciences, you want a lot of confirmation. You want the study run in different ways. You know, we'll find out if there is a true, if there was during this period, a really true, unique UK discount. We'll figure that out in like 10 years. You know? Yeah. But, you know, if there is one, my question is this. Where is the great British bargain stock?

9:34And I've spent a little time in the last couple of days. I wanted to go here next because you spent a lot of time in two separate newsletters recently looking at, and I think this was like a helpfully concrete way to frame the issue. Let's look at like direct comparable companies in the US and in the UK. Let's look at their financials. Let's look at their valuation ratios. I mean, if there truly is a UK discount, it should be there. It should be kind of obvious. Yes. It wasn't to me. I was unable to find a lot of good examples of UK stocks that were just screamingly cheaper. So I'll give you an example.

10:11So like broadly comparable companies, Shell, very large UK oil company, Chevron, very large US oil company. On a price-to-earnings basis, Shell is cheaper. It's at 10 times earnings. Chevron is at 15. That looks like a big gap. UK discount. Well, Chevron's been, over the last five years, has been growing revenues about 5 % a year. Shell's been shrinking revenues. Return on capital at Chevron's a little higher. It's expected to grow EPS more in the next couple of years. In other words, you look at Shell and Chevron, and to me, it's like, yeah, Shell is cheaper, but it's still a coin toss. Which one would I rather own?

10:52And similarly, you look at big banks, you look at Barclays and Citigroup in the United States. Barclays in the UK, Citigroup in the United States. So they both, while they have retail operations, they also have large card operations. They're also both sort of solidly second tier investment banks. They're not a million miles separate in size. And, you know, once again, Barclays is a bit, both of them traded a big discount to book, you know, investors in general are skeptical about both companies, but Barclays is even cheaper than Citigroup. And you could argue there's an opportunity here, but I would argue in reply that the good bits of Citigroup's business are better than the good bits of Barclays business and that it's exposed to what are probably more promising markets.

11:48So once again, discount, but it's not hard to see reasons for that discount. Yeah. Barclays lower forward earnings growth, more leverage. I mean, that's a good reason to have a discount, right? Absolutely. So again, I search around high and low and I struggle to find the stock that like screams out, buy me I've been picked on because of Brexit and now I am too cheap. Now, it may be I'm looking in the wrong places. I encourage our listeners especially those in the UK, have you found the Great British Bargain? Because I have not quite found it yet. No hate to our listeners at Barclays and Citigroup.

12:23We love you. I mean, some things that are I should mention a couple I should mention a couple though, like Unilever is kind of attractive relative to the big American laundry detergent conglomerates. And you had looked at some booze companies that I had never heard of this before. Diageo, whose products I consume with great regularity. They own Guinness and Bullet Bourbon. Bullet Bourbon and all these different brands. And that looks like for a great brand portfolio that looks relatively cheap compared to the American brown foreman, which is Jack Daniels. So there are ones that it's at least an open, maybe there is a discount here.

13:02Or, you know, markets never make it easy for you. But I haven't found the UK stock that really gets me excited by its value. But I think even still, there is a case here to buying UK stocks. And I think it goes something like this. Maybe or maybe not, there's a small specific UK discount. You can argue about whether it exists. It might be there. What you're really betting on, though, is the three trends, three factors we talked about earlier. XUS versus US, small cap versus large cap, value versus growth. All those have been out of favor. But if you buy UK stocks here, you can kind of make a contrarian bet on that reversing.

13:39On those three, exactly. And a UK ETF is something that gets you all of that. And look, American stocks have been great for 10 years. They're not going to be as great in relative terms for the next 10 years. The chances of that happening are really low. So, yeah, I think there is something interesting about buying the UK index if you are a great believer in mean reversion in the kind of factors we've been discussing here. Yeah. But, I mean, I think as we talked about before, these sort of trends are like multi-decade trends with like no clear inflection point on when they turn around. So, I mean, that is in some ways the risk and the discount are kind of commensurate in that sense, right?

14:20You're kind of taking a dice roll on, will these multi-decade trends turn around in time for me to post good returns? Who's to say? It's very difficult. It's never easy. Beating the market turns out to be hard. Yeah. I could really recommend some bullet bourbon to aid you in your quest to close the UK discount. All right, Rob, we'll be back in just a moment with Longshore.

14:55Welcome back. This is Long Short, that part of the show where we go long a thing we love, short a thing we hate. Rob, are you long or short something? This was a tough call for me, Ethan, but I'm going long the price of cocoa. Oh, it's a good one. For listeners who don't know, the global price of cocoa has gone bananas, to use another food reference. It's like properly hockey sticking. Yeah. So October 2022, a ton of cocoa would cost you$2 ,200. Now it is at$5 ,600. And the reason I'm going long, this parabolic increase in the price of chocolate, is don't mess with Big Mo. So for this, meaning momentum.

15:42So, you know, it's going up. Things that are going up tend to keep going up. And I'm going to make a few bucks. And then I'm going to get out before it comes crashing down, Ethan, because I'm cleverer than all the other cocoa traders. Well, I think the futures market is way ahead of you. I saw earlier today a story in Bloomberg that cocoa futures are over$9 ,000 at this point. And just people in the futures market are going nuts. Okay, so is there some clever arbitrage we can do where we long the physical and we'll short the futures and we'll have this brilliant... I'm sure somebody at some hedge fund has a wicked arbitrage going on this.

16:16It all raises the question, do cocoa traders actually eat chocolate? Is it the kind of thing where you need distance from the craft so you don't actually eat chocolate if you're a cocoa trader? Good point. How about you, Ethan? What's your long or your short? Well, Rob, I'm just back from a trip to Taiwan. It's great being there. It's a beautiful country. but I am long Taiwan semiconductor manufacturing company, TSMC which people may know about but it just, going to the factory in person and to their science museum was just like incredible experience because it's so massive it's like this titanic military level fortress of semiconductor manufacturing, it's obviously like one of the largest semiconductor fabricators in the world and it shows man the largest, yeah, I think that's right you know, I was hanging outside one of the buildings where the staff go in and out, and the security people were very uncomfortable with me loitering there.

17:08I think they're very concerned about industrial espionage. Yes. But Rob, I actually brought you a gift from the TSMC Museum of Innovation. It's your very own Taiwan Semiconductor Manufacturing Company hat. Yes. This is cool, man. I love corporate swag. I have it on over my headphones here in the studio. It's a good look. And I am looking good. You're ready to innovate. It's like very slick. It doesn't, the logo is very small and subtle and off to the side. And the hat itself is black with a single white stripe. And it just sort of screams out like industrial dominance and secrecy. I went on a tour of a science museum in Taiwan.

17:53And the tour guide who, you know, English is a second language. But, you know, he spent the entire trip. his catchphrase was diversify. After every exhibit, when we moved from one exhibit to the next exhibit, he would say diversify. Diversify. Diversify. Worse advice. It's not bad. For technologists and investors alike, diversify. Right on. All right, Rob, thanks for being here. Thanks for the hat, man. You're welcome. We'll have you back soon. And listeners, we're back in your feed on Thursday with another episode of Unhedged. We'll catch you then. Unhedged is produced by Jake Harper and edited by Brian Erstad.

18:26Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn, and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

19:05We'll be right back.