- Despite seeing 34% total return gains since we turned bullish on the iShares MSCI United Kingdom at the height of the March crash, the index still offers significant upside.
- Despite aggressive earnings and dividend cuts, in large part due to the high weightings of the energy and financials sectors, the EWU still trades at a deep valuation discount.
- The BAML Fund Management Survey continues to show that positioning towards U.K. is deeply negative, suggesting that even the slightest improvement in the fundamentals could lead to outsized equity gains.
- Ongoing pound strength should also support U.K. equity outperformance in dollar terms as the direct positive impact of a stronger currency outweighs the negative impact on earnings for companies that generate most of their revenues from overseas.
- The average U.K. large cap stock has actually outperformed since the height of the March crash, potentially signalling what is to come for the broader index.
Despite seeing 34% total return gains since we entered a long position on the iShares MSCI United Kingdom ETF (NYSEARCA:EWU) back at the height of the March crash, we still see scope for significant upside. The ETF offers a low-cost and liquid vehicle to track the MSCI U.K., which represents 85% of the U.K. stock market. Based in dollars, the fund also gives investors exposure to any further gains in the pound. Despite aggressive earnings and dividend cuts, the MSCI U.K. index still trades at a deep valuation discount to its peers as well as its own history. With the ongoing recovery in the pound likely to provide additional support, we continue to see the EWU as an attractive contrarian play.
U.K. Stocks Lagging The Rest Of The World
Comparing the EWU with the MSCI World, the former’s underperformance partly reflects the fact that earnings and dividend expectations have collapsed by far more, largely due to the index’s heavy weighting of financials and energy relative to its peers. Key index components such as HSBC (NYSE:HSBC), Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), and most recently BP (NYSE:BP), which, combined, make up 13% of the index, have all slashed payouts. Forward earnings expectations for the MSCI U.K. have fallen by a whopping 46% over the past 12 months, while forward dividend payment expectations have been cut by 35%. This compares with 26% and 10%, respectively, on the MSCI World.
U.K. Earnings And Dividends Have Seen An Outsized Decline
After such a dramatic collapse in earnings and dividends, we might expect U.K. stocks to be trading at a valuation premium to the MSCI world as investors price in a strong recovery in earnings and dividends as some sense of normalcy returns to the U.K. and global economies. However, U.K. stocks continue to trade at a 25% discount to the MSCI World on a forward PE basis and a 45% discount on a forward dividend yield basis.
Despite The Declines In Earnings And Dividends, Valuations Remain Attractive
Highly Contrarian Opportunity
It seems as though investors are extrapolating the recent underperformance of U.K. earnings and dividends at a time when they should be focusing on the potential for a long-term mean reversion in profitability and dividend payouts. The BAML Fund Management Survey continues to show that positioning towards U.K. is deeply negative, in part due to the still-high weighting of banks and energy companies on the index, which fund managers are also extremely underweight globally. While contrarian market calls do not always pay off, and we could continue to see U.K. stocks underperform in the near term, the fact that investors are so bearish towards the U.K. suggests that even the slightest improvement in the fundamentals could lead to outsized equity gains.
The Pound’s Rally Should Also Provide Support To EWU
As we noted on February 20 in ‘Pound Sterling To Follow Yield Spreads Higher’, the pound has put in a strong recovery of late, outperforming the majority of the world over the past month and rising an impressive 15% from its March low against the dollar. The ongoing narrowing of real yield spreads between the U.K. and the U.S. bodes well for continued sterling strength. Such strength has previously tended to translate into U.K. equity outperformance in dollar terms as the direct positive impact of a stronger currency outweighs the negative impact on earnings for the companies that generate most of their revenues from overseas.
Pound Recovery Bodes Well For Relative Equity Performance
Signs Of Internal Strength In The FTSE 100
The extent to which U.K. equity underperformance has been driven by a handful of large cap stocks can be seen on the chart below. While the MSCI U.K. has dramatically underperformed the MSCI World, a different picture emerges when looking at equally-weighted rather than capitalization-weighted indices. The average U.K. large cap stock has actually outperformed since the height of the March crash, potentially signalling what is to come for the broader index.
Equally-Weighted FTSE 100 Already Showing Signs Of Outperformance