With the Brexit trade deal finally done and the COVID-19 vaccine rollout continuing at a rapid pace, U.K. value stocks could be “the trade of the decade.”
That is the view of Research Affiliates founder Rob Arnott, who said the end of the COVID-19 threat was now in sight in the U.K., potentially creating a “real tailwind” for its economy and equity market.
A combination of factors, including uncertainty surrounding Brexit and the devastating impact of the pandemic, pushed U.K. value stocks to “implausibly cheap levels” at the end of 2020, Arnott said, and they remain “remarkably low.”
The country has emerged as an early leader in the vaccination rollout, with 17.9 million people — around a third of the population — already receiving at least one dose. The government hopes to vaccinate every adult by the end of July. It has also set out its road map out of lockdown, aiming to lift all restrictions by Jun. 21
The post-Brexit trade deal, agreed in December, has also eliminated many concerns, although some areas, such as financial services remain unresolved.
“Around the globe value is trading at extremely deep discounts relative to growth. No matter how we measure valuation, value-to-growth discounts are wider than 95% of the respective country’s or region’s history — except in Australia,” said analysts led by Arnott.
“The tailwinds of Brexit and rapid COVID vaccination make the U.K.’s low valuation especially attractive,” they added.
In January 2016, Research Affiliates named emerging markets (EM) value stocks as the trade of the decade. The analysts said they still liked EM value stocks but that the U.K. equity market, and value stocks in particular, were now even cheaper.
“U.K. equities stand out as offering one of the most attractive risk-return trade-offs, priced to return a notch higher than EM equities with significantly lower volatility,” Arnott said. “Both U.K. and EM value stocks may prove to be the trades of the decade,” he added.
The U.K. has one of the highest COVID-19 death tolls — 121,305, according to government data — behind only the U.S., Brazil, Mexico and India. The economic impact the pandemic has had on the U.K. has also been severe, with most of the country currently in its third lockdown.
Gross domestic product shrank 9.9% last year, the worst annual fall since the ‘Great Frost of 1709.’ Along with the pandemic, negotiations over a post-Brexit trade deal went down to the wire, with an agreement finally reached on Christmas Eve. More broadly, Brexit has had an impact on U.K. valuations ever since the country voted to leave the EU in June 2016, Research Affiliates noted.
U.K. corporate earnings slumped 88% in 2020, much steeper than the 17% fall in the U.S. and the 50% drop in Europe. When it comes to equity market performance, U.K. value stocks fell 15% last year, while growth stocks rose 4%, Research Affiliates said, citing Russell data.
The upshot of all that is that U.K. stocks are currently trading in the cheapest quintile of their historical norms — based on both price-to-book and price-to-five-year average cash flow ratios.
In contrast, Arnott said the U.S. equity market has only been more expensive than its current valuation, based on price-to-book ratio, one-sixth of the time over the last 60 years, and only 8% of the time based on price-to-five-year average cash flow ratio.
Cheap valuations can either mean buying opportunities or a value trap in which U.K. companies keep declining, Arnott noted, before concluding in this case it was the former.
“Neither Brexit nor the COVID-19 pandemic is likely to have near as much impact in 2026 as in 2020-21. Therefore the market shocks induced by these events represent opportunities now,” he said.