Premier Miton Monthly Income Fund Manager
In this insight note, Emma Mogford, manager of the Premier Miton Monthly Income fund explains why she strongly believes that we are at a pivotal moment in markets.
Recapping on my insight note ‘New trend, new thinking required’, I believe we are at a pivotal moment in markets after a decade of ultra-low interest rates as they move back to more normal levels. Recently in ‘The Economist’ Henry Curr, chief commentator on economics, described the environment today as an ‘upending of the previous regime’. This second insight piece builds on both Henry’s very definitive statement and my previous note. We focus on why the new regime could favour UK equities.
A little bit of history repeating?
UK equities (FTSE All-Share Index) outperformed US equities (S&P 500) during a previous period of rising interest rates. While as an industry we are always clear that past performance is not a guide to future performance, what can we deduce from the below chart? We can see the performance of the FTSE All-share index, a well-known index for UK equities, divided by the performance in the S&P 500, which is an index of some of the 500 largest companies in the US.
When the red line rises, UK equities are outperforming US equities, when it falls and is coloured green, UK equities are underperforming US equities.
What is the story here? From 1965 to 1985, a period that was characterised by higher inflation and higher interest rates globally, UK equities outperformed US equities significantly. In the period from 1986 to 2022, a period of over three decades, UK equities have subsequently underperformed US equities.
Source: Bloomberg, data from 26.02.1965 to 31.08.2022
But with a shift in central bank policy could we now be at an inflection point? Let’s consider our second piece of evidence.
Jam today please
The falling interest rate environment of the 1980s to 2010s lifted the valuation of ‘growth’ stocks. That is because when a company’s profits in the future are discounted back to what they are worth today, that value goes up when the discount rate falls. Discount rates are closely tied to interest rates.
The opposite is true in a rising interest rate environment. As the interest rate rises and the higher the discount rate rises, it becomes more important whether those profits are in the next few years or in 10 years. I believe companies with more cash profits in the here and now will become relatively more attractive than ‘growth’ companies in a rising rate environment.
One of the criticisms of the UK market is that it has relatively more companies in ‘mature’ industries and less in ‘growth’ sectors like technology. I believe that this will be a positive for the UK market, as I believe it was in the 1970s.
One way of thinking about companies with more near-term profits is to look for companies which currently have high profits relative to their share price. These companies are often termed ‘value’ companies and ‘value’ as a style also outperformed in the 1970s. So, do these value companies currently represent good ‘value’ today?
Price is what you pay, value is what you get
I am a big believer that starting valuation matters. A key point is that currently UK equities (again represented by the FTSE All Share Index) are trading at around half the valuation of US equities (using the S&P 500 as our reference index).
The measure of valuation we are using is Price-to-earnings ratio (P/E ratio). The price-to-earnings ratio is the ratio for valuing a company or aggregate market, as we have done here, that measures its current price relative to its earnings.
P/E ratios are used by investors and analysts to determine the relative value of a company’s shares or in our case an aggregate market in a like for like comparison. The chart below shows that the price to earnings for UK equities was only 7.7x on 20th October 2022. US equities are priced at 16.7x, almost twice as much. You can see from the chart that the difference between the two indices is at a recent high. In fact, in 2016 the difference in the P/E ratio for these two markets was as little as 5%.
Source: Source: Bloomberg, data as at 20.10.2022. The left vertical axis shows the P/E ratio figure the right side vertical axis shoes the difference between P/E ratios.
Dividends, undivided: UK companies focus on shareholder distributions
Over the last 10 years, equity markets have been sailing on the trade wind provided by historically low and falling interest rates. That trend has changed and because of that, I think the next decade for UK equities may be typified by lower returns than we had in the last decade.
If this broad, forward-looking view unfolds then dividends will be an increasingly important part of an investor’s total return. The UK market has a long heritage of distributing cash out to shareholders in the form of dividends. Today, companies in the FTSE All-Share pay out 64% of profits as dividends, while in US equities (S&P 500) that number is just 38%: Source Bloomberg as at 13.10.2022.
While the S&P 500 is dominated by technology companies with a focus on growth, the point I’m making here is a salient one. If growth is tougher to find, due to the economic environment we are in, where will returns come from? I believe dividend income will be an increasingly important component of total return. In an environment of inflation, the opportunity to grow one’s income through dividend growth increases the appeal of equity income relative to bond interest.
In the current environment where companies face higher debt interest payments, inflationary costs, and a weak economic outlook, dividends could come under pressure. It is my job as a fund manager to identify and invest in those companies that will not only sustain but can also grow dividends.
Our reference throughout this piece to the ‘UK’ has been to UK equities. It is important to highlight that UK equities are very different to the UK economy. The 100 largest listed companies in the UK, known as the FTSE 100, generate an estimated 80% of their earnings from outside of the UK. The UK is the corporate home and domicile to a strong range of globally significant companies. Both Unilever and Shell have recently chosen to make UK their home over a dual listing with both the UK and the Netherlands.
The current low valuation of UK companies, that we previously touched on, means that investors can get access to world class companies listed in the UK, with its environment of strong corporate governance and management.
Keeping it hip
At Premier Miton, we believe deeply in both active management, stock selection and diversification. I wanted to wrap up this article by highlighting one of companies that we hold within the Premier Miton Monthly Income fund – the hip and knee replacement company Smith and Nephew.
On top of playing into the broad demographic trend in developed markets, with an aging population, this company also offers a dividend yield of 3.1%. This compares to similar companies in the US, such as Stryker and Zimmer Bioment, which offer dividend yields of 1.3% and 0.9% respectively. All things being equal, the share price of Smith and Nephew would need to more than double to trade on the same dividend yield as Stryker. The source for the yield figures quoted here is Bloomberg at 13.10.2022.
In my view this puts Smith and Nephew in the bucket of stocks generating profits in the here and now rather than the promise of profits in the future. Indeed, with ageing demographics and demand for hip and knee replacements growing, there is good reason to think profits could grow in future years.
A distinct trend requires a distinctly different approach
We have lived through falling interest rates for over 30 years and I believe we are entering a period of more normal interest rates. The good news is that there are still opportunities and with this changing trend, I believe there are good arguments for why UK equities look well placed.
To summarise the last 1000 words, I believe that UK equities are currently cheap, cash generative and there is historical precedence for their outperformance. We are finding lots of opportunities to invest in international leaders at a valuation below their global peers.
Against a challenging backdrop, we remain confident that the approach we use in the Premier Miton Monthly Income fund is distinctly the right one. Our focus on ‘quality at a reasonable price’ means the companies we hold in the Fund have been selected based on good pricing power in the face of rising inflation, resilient earnings in face of a volatile economic outlook, but also have opportunities to prosper in this new economic environment.