Lex: UK de-equitisation Premium

The UK stock market increasingly resembles the Night of the Living Dead: the nearer equities are to the grave, the more energetic they get. Shares in the London Stock Exchange jumped above £11 on Monday, as investors bet on yet another predator emerging. Many fret about the disappearance of venerable quoted UK institutions into private equity and foreign corporate hands.

Citigroup estimates planned and completed leveraged buy-outs in the UK so far this year are equivalent to 3.3 per cent of the equity market’s total value. Bids, though, only tell half the story, with buybacks also gobbling up paper.

De-equitisation in the UK kicked in during 2003, when interest rates were at their lowest. For private equity, borrowing at low rates to buy higher-yielding assets is a relatively straightforward carry trade. Meanwhile, following the bursting of the technology bubble, investors have demanded cash back and corporate executives have appeased them, while reining in capital expenditure.

With the market trading on an earnings yield of 7.7 per cent, what could put a stop to this arbitrage of capital costs? The long-expected credit squeeze remains elusive. Bulls would argue for a reduction in the cost of equity to restore some equilibrium; that is, a re-rating for stocks. That has already happened, dramatically, with the LSE, pricing Macquarie Bank out of the game.

Low capex will eventually mean lower profit growth, however. And current headline earnings yields in the UK reflect record levels of profitability. Morgan Stanley reckons that, normalised across the cycle, UK stocks currently trade on a median earnings yield of 5.4 per cent. Investors buying at these levels, in the hope of a bid, risk digging themselves into a hole.

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