By Adrian Gosden and Chris Morrison

It’s well understood that the UK equity market is incredibly cheap versus history and versus other markets. On a simple price-to-earnings ratio, shares of BP, Lloyds and Barclays are pretty much as low as they’ve ever been.

The reasons also are well known but briefly: UK pension and insurance funds, on advice from their consultants, have drastically cut exposure over the past 25 years, to diversify their portfolios. Market returns are seen to be greater in the US, particularly in technology stocks – especially the so-called Magnificent Seven (Apple, Microsoft, Alphabet et al). Brexit was seen by international investors as adding risk, so they looked elsewhere. Stamp duty on share purchases and the removal of tax credit on UK dividends don’t help. Some relief here from the government would be beneficial but we don’t expect it.

Cash-rich, undervalued

Nevertheless, we think it’s an exciting time for income investors. Companies are boosting dividends and share buybacks are surging. Careful investors can generate mid-single-digit yields from a portfolio of undervalued, growing, cash-rich companies. The trailing yield in our equity income strategy is 5.5%, above the typical range for the strategy of 4% to 4.5%.

It’s interesting to us to consider where we may be headed and what catalysts may bring renewed attention and momentum to this unloved market. For example, the UK market responds positively to falling inflation, and that’s likely to happen this year, along with rate cuts from the Bank of England and other central banks.

This appears more pronounced in UK smaller and mid cap shares, possibly due to their more cyclical nature.

Big buybacks

UK plc’s enthusiasm for share buybacks is one of the most compelling trends right now. Having paid their dividends and with healthy balance sheets, companies are buying themselves. That’s positive if they trade at the low valuations.

Typically, FTSE 100 companies buy back GBP10 billion-GBP20 billion worth of shares a year. This surged to GBP58 billion in 2022, more than twice the average, and GBP55 billion in 2023, according to AJ Bell data. We expect a similar number this year, for a total of around GBP150 billion over three years.  This is extremely positive for us as income investors because companies don’t do buybacks unless their dividends are secure.

BP, Barclays

At the same time, the rate of selling of UK equities by pension funds and insurance companies is slowing — they don’t have much left to sell. We think share buybacks may soon exceed institutional share selling for the first time, and we think this imbalance could be a potential inflection point for the market. Take BP, which announced a two-year, $14bln share buyback program; or Barclays, which is set to return £10 billion to shareholders through a combination of dividends and buybacks over three years. This is around 40% of its current market cap. The magnitude is astonishing and something we have not witness in our investment careers.

We expect to see a good year of corporate merger and acquisition (M&A) activity in 2024, driven in part by depressed company valuations. One of our holdings, trucking and logistics company Wincanton, recently received an approach by a French company recently at a 50% premium to the share price. Devro, a maker of sausage skins, was taken out on a 60% premium. If high-profile FTSE 100 companies were acquired on those kinds of premiums, that also might put UK equities on the radar of big investors.

What about Japan?

Those premiums prove our assertion that market valuations for these companies are too low. These rich premiums also allow us as fund managers to recycle capital from the M&As into new ideas.

We don’t believe that UK equities will be undervalued forever. It’s worth citing Japan, which was long seen as uninvestable — until it wasn’t. Japan equities generated strong returns last year and investors scrambled to get in.  Of course, Japan’s market dynamics, economy and corporate culture differ significantly from those of the UK, yet Japan shows how momentum can turn quickly.

As equity income investors, we are contrarians; we find opportunities where others don’t. We look for companies with robust balance sheets, strong cash flow profiles and a willingness to reward shareholders with payouts. If we can buy these companies at a discount to their intrinsic value, all the better. We aim for the strategy to deliver income (dividends) with the prospect of capital returns as the companies we invest in prosper.

The long-term average annual total return in the UK equities market is around 8%, so the current yield on the strategy gets you more than half-way there. Dividends are an important part of the return profile in UK equities, and dividend reinvestment is a key driver of returns over the long term. We believe a UK equity income strategy has an important role to play in a diversified portfolio, and we feel confident that UK equities, in part due to their unpopularity, offer good long-term possibilities.

The value of active minds: independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals 

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