London market discount is about performance, not geography
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Politicians, regulators and city leaders are focused on reviving the UK’s troubled stock market. The problem is twofold: companies are disappearing and not enough new ones are emerging to make up for the losses. The market is shrinking at a pace that will knock the UK off its European top spot amid fears of a serious downturn. There are many factors at play. But the belief that UK shares trade at a discount to their international peers is significant and deeply entrenched.
There are good reasons for this. The FTSE 100 is heavy on low-rated sectors such as resources and banking, and lacks high-rated technology stocks. The growing number of companies choosing to leave the London market for the US has reinforced the idea that there is a widespread discount.
But the debate continues as there are signs that the UK is recovering. IPO activity is back; the success of Raspberry Pi’s initial public offering was followed by the listing of a New investment vehicle from founders of Melrose buyout firm. Foreign listings could follow in the form of fast-fashion group Shein and even French television business Canal+. The market is trading near a record high set in May and, on a trade-weighted basis, sterling is at its highest since 2016.
Yet the discount perceived by the market remains as large as ever: the FTSE All-Share index trades at just 11 times forward earnings, or close to a 40 percent discount to the rest of the developed world. This is largely due to the boom in US tech stocks amid the AI craze.
It’s hard to deny the blatant discount. But James Arnold, head of UBS’s strategy research team, said the more relevant question was whether the UK was systematically undervaluing its stocks, and he said the answer was a resounding no.
Arnold found a strong correlation between stock valuations, based on price-to-gross assets, and profitability, measured by cash flow investment returns. With an R-squared of 80 percent for the Stoxx 600 index, this relationship explains most of the variation in company valuations. And this holds true across the US, UK and EU markets. That suggests that lower average profits are simply a large part of why UK companies are valued lower than their US counterparts.
Put bluntly, it is a management problem rather than a market problem, although Arnold admits that the problem is exacerbated by the UK’s overemphasis on dividends rather than growth and therefore risk aversion. Tackling those issues head-on will be London’s next challenge.
