UK Equity Markets have been under tremendous pressure lately due to the uncertain business environment and lack of policy clarity posed by the United Kingdom’s impending withdrawal from the European Union. It has exacerbated the sentiments among ordinary investors and high-profile fund managers alike, into putting on hold their investment decisions and scouting for investment opportunities elsewhere. A look at the valuations of most of the LSE listed stocks shows that they are at their lowest in a decade. The poor state of the British Pound has also not done much in aiding the investor sentiment in any way; while the stocks have become attractive, their fundamentals have not. The British currency has fallen sharply against other major currencies, with fears of further downside in the run-up to the event.
The FTSE 100, representative of the largest companies in the United Kingdom, in terms of revenues and market capitalization, is seen as the barometer of the British economy. Along with its cousin the FTSE 250, it is studied by economists, debt market makers and stock market professionals alike to carefully consider the implications of any unwarranted movements in this index. The British Pound Sterling and FTSE 100 have enjoyed an inverse relationship since long. Whenever there is weakness in the British currency most of the FTSE 100 companies enjoy better fortunes on account of higher revenues. Whenever there is a weakness in any country’s currency, it signals a high earning period for the exporters of that country as well as other businesses dependent on these exporters. A complementary effect of this heightened business activity would be that the currency will be pushed up by higher demand from businesses that borrow money to fund their activities.
The impact of the above on FTSE 100 will be little difficult to interpret. This time around a weakness in the currency is not impacting the fortunes of the FTSE 100 constituent companies in the same way it did in a normal economic cycle. The reason for this is the change in the market landscape in continental Europe due to the impact of Brexit. Continental Europe is the largest market for British exports as well as the largest market from where it sourced its inputs. In the past, when the United Kingdom was a part of the European Union both parties enjoyed favorable trading environment which made goods and services plying to each other’s territories easy and cheap and a significant market had developed taking advantage of these relaxed conditions. However, now with these advantages being a part of history, there is every risk that the business between these two blocks could shrink and goods and services flowing could become expensive; hence, despite a weakening of the British currency, its exports will fall and input costs will increase more than proportionately because of real factors taking precedence over monetary factors.
The scene on the London stock exchange has been very interesting lately. While the market is following global trends in its rally for the past three years, the valuations of British stocks remain low. The FTSE indices are trading at a discount compared to their European counterparts, and forward earnings multiples for most of the companies are at 13-year lows. The reason it seems is a gradual slowdown in the flow of funds entering British capital markets from outside. While domestically the United Kingdom’s economy may not be in a recession, but its external position will certainly deteriorate.
The Low valuations in UK stocks have been caused by a weak Pound among other things that have been discussed above. With burden on the British exchequer to honor its dues of £32.8 billion to the European Union on account of the divorce settlement, the pressure on the pound will increase further. With the general forecast of the impending business conditions also looking bleak, not much support will be coming from corporate income statements. This certainly is not the time or opportunity for value picking.
On the individual company level as well, the performance of the FTSE 100 companies has not been well and most of them have given out not so encouraging guidance for future financial periods. Several high-profile heads have rolled in the past one year and some of the big names among the United Kingdom’s top companies like Thomas Cook have gone under administration. The FTSE 100 index itself has not done well in the past one year, with the index value of 7510.28 recorded on 3 October 2018, and the value on 2 October 2019 being 7,122.54, a reduction of 5.16 per cent over a period of one year.
The industry that is suffering the most in the FTSE 100 list is the Banking and Financial Services industry. This industry is taking the heaviest onslaught of Brexit. With most of the financial services companies having operations across the English Channel, Brexit will most certainly force majority of them to curtail their business activities. The second set of companies that are affected are those belonging to the Hospitality industry. These companies who are already experiencing lower bookings on account of less business and leisure travel.
However, there are other companies who are relatively less affected. Among them, primarily are the export-oriented companies, who are benefiting from the weakening Pound Sterling. The second set of companies are the ones who have a significant proportion of their earnings coming from diversified geographies, like companies who have set up manufacturing bases in other countries. The third set of companies have an evergreen demand no matter what the economic conditions are like, for example, petroleum refining and retailing companies.
Hence there are opportunities within FTSE 100 that is worth exploring; however, caution must also be exercised to see if any undervaluation in a particular stock has been caused by stock specific factors or market-wide factors. Because if the weakness is due to market-wide factors, the prospective investor doesn’t stand to gain much.
There is again the risk of falling into a value trap. A value trap is defined as a stock or stocks which appear to be cheaply priced and an impending value creator, when looked at from the viewpoints of arithmetic valuation multiples like, earnings multiple, cash flow multiple or book value multiples. However, when looked at from the angle of their business fundamentals, they turn out to be junk. The current market conditions prevailing in the United Kingdom warrant that adequate attention be given to studying the fundamentals of a company before making any investment decision and not solely depend on numerical values of relative valuation parameters.