‘Unprecedented exodus’ from UK leaves equity valuations at 30-year lows – Man GLG’s Dixon

The relative value of UK equities versus other stock markets has fallen close to 30-year lows following a widespread withdrawal from the asset class by investors, Man GLG’s UK Income fund manager Henry Dixon says.
Investors have sought to avoid the UK amid ongoing Brexit negotiations which appear no closer to a resolution despite the looming deadline, as well as an unaccommodating liquidity backdrop as quantitative tightening begins and bond yields rise. A global trade war has further impacted sentiment.
The combination saw UK equities fall sharply late last year, with the FTSE All-Share index posting a negative return of 9.5% in 2018 and experiencing its third worst derating of share prices in the last 30 years after a 23.6% fall in P/E ratios. Only in 2008 and 2002 have they fallen faster, and versus the MSCI World the relative valuation of the UK is significantly depressed.
“By looking at fund flows we can observe an unprecedented exodus from UK assets and the relative value of the UK is now close to 30-year lows,” he says. “It means valuations and sentiment towards the UK look extreme.”
Dixon, whose UK Income fund is top-quartile over one and three years[1], is optimistic that after such a slide, and with views so skewed to the negative, 2019 offers attractive opportunities, especially given the underlying strength inherent across many UK companies.
He notes that the current derating for the FTSE All-Share of 23.6%[2] is the third worst in percentage terms over a 28-year period, adding that 2018 had the dubious honour of being the year that the index delivered the most earnings growth (15%) for a negative return.
“The key question now is whether this derating and starting valuation provides us with enough of a margin of safety for the year ahead,” Dixon says.
“Firstly, as we look at the major deratings since 1990, we would note that all have been greeted by a rerating of 18% on average in the following year, and an average total return of 24%.”
He said statistically therefore the grounds for optimism in the year ahead look strong.
“As to whether there is any observable good news, all is far from lost,” he adds. “Simplistically there are three key players in any economy, the consumer, government and business. Starting with the consumer we think that record job vacancies, rising wages and falling inflation is not the basis for despair domestically.
“This combination of events is starting to pave the way for a meaningful improvement in income available for discretionary spend which is forecast to return to levels not seen since 2014 and 2015, a period when the UK would be the fastest growing G7 economy.”
While Brexit remains a clear threat, Dixon says he believes investors need to consider it in a wider context.
“While Brexit could provide us with a painful left tail event, the damage done to domestic valuations looks extreme to us, and the balance sheet in some of the sectors that might be worst affected looks to be extremely strong,” he says.
“What is more valuable, in our view, is to try to gauge both the sentiment towards the UK as well as the value opportunity.”
The income fund looks to own stocks uncovered by the existing Undervalued Assets process but which have a yield at least that of the market, stocks which have the propensity to deliver a dividend surprise owing to superior free cash flow and balance sheet metrics, or specific bonds trading at an attractive discount to par in listed equities where they deem equity value exists.
Currently the team is overweight areas including real estate and insurance, as well as materials.
“Housebuilders, for example, are almost all in strong net cash positions and while we acknowledge the more opaque nature of the banking sector’s balance sheet, we take great comfort from the fact that the loan to deposit ratio is at levels not seen since the mid-1980s,” Dixon says.
“The bond portion of the fund is also trading at a meaningful discount to par which has the potential to add pleasing capital upside to what is an attractive running yield.”
Dixon says the outlook for dividends broadly is mixed. While dividends are forecast to be £103bn for 2018, a record figure, and the trailing yield of 4.3% is attractive versus the 20-year average of 3.5%, there are also some headwinds for income investors to contend with.
Dixon says UK market dividend cover in particular is low at just 1.7x, while the concentration of dividends is a clear and present risk, with 5 of the 39 sectors in the UK accounting for 50% of the market yield.
“The UK market set an unwelcome record in 2018 with net debt rising to c £470bn, some 70% higher than pre-crisis levels,” he says.
“Some of the largest dividend payers have been guilty of assuming significant amounts of debt. The Fixed line telecom sector, for example, has seen a near doubling in net debt in the last three years.”
[1] According to FE, covering the period to first of February 2019, and versus the IA UK Equity Income sector
[2] According to Lazarus Partnership and Bloomberg; as at 31 December 2018,