Transcript: The great British bargain show

This is an audio transcript of the Unhedged podcast episode: ‘The great British bargain show’

Ethan Wu
It’s been a pretty great past year or so for US stocks. But you know what it hasn’t been a great year for? UK stocks.

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As we talked about on the show several times, they’ve really stunk it up. They tend to move sideways. But the question is, is that a justified discount or an irrational one? Are UK stocks actually a good buy? Today on the show, we discuss. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I’m reporter Ethan Wu, back at last from my two-week sojourn in the beautiful island of Taiwan, joined today by my boss, Robert Armstrong, who has dug in to UK stocks to probably the most fanfare we’ve ever gotten on an Unhedged newsletter. It’s ridiculous.

Robert Armstrong
FT readers are really into UK stocks, as it turns out.

Ethan Wu
They really are.

Robert Armstrong
You know what I’m glad about, Ethan? I’m glad Katie Martin isn’t here because I don’t think she’d be able. This is such a hurtful topic to her, the terrible performance of the UK market, that I don’t think she’d be able to be objective.

Ethan Wu
I think that’s right. Katie’s a very resilient person, but I think even she wouldn’t have the constitution to talk for 15 minutes about the valuation of UK stocks. But we are going to, because we as Americans have no stake other than bragging rights in this conversation. And you’ve just written two really interesting columns getting into some of the issues at play in valuing UK stocks. And I think we have to start high level, right? At a high level you look at a very simple metric, right — price-to-earnings ratio between US markets and UK markets. And on that basis, UK stocks look damn cheap. There’s something like a 40-50 per cent discount on p/e basis.

Robert Armstrong
It’s amazing. And we should say, you know, for those of you at home who are not looking at the charts we’re looking at, it wasn’t always . . . They’ve always been at a discount. But until around 2016 — and we will talk shortly about the significance of that timing for those who are not aware of it already — the valuation difference just busted out. And now you have this huge discount that’s been building for five years, which as you say, makes you ask, maybe I ought to own these things. Yeah, maybe there is a huge sale in the UK aisle over the stock market.

Ethan Wu
Yeah. And there’s another factor too, which is as we’ve discussed on the show previously with Katie Martin, the UK is a market that likes dividend payers, right?

Robert Armstrong
Yes.

Ethan Wu
So you combine cheap valuations with pretty chunky dividends at these companies. You’re looking at like a 4 per cent dividend yield on the FTSE 100 nearly versus, you know, 1 per cent on the S&P 500. So if you’re maybe, you know, an investor getting up there in age, it can pay you a decent amount of income on your equity holdings.

Robert Armstrong
There is a tricky question though.

Ethan Wu
Yes. Here’s the but.

Robert Armstrong
The but question is, there’s a lot of unequal valuations across stock markets right now. There’s a lot of factors, as we call them in the business, that are trading at discounts. And it’s not totally clear that there is a unique discount for the UK alone. So one way to think about this is in terms of just American stocks versus stocks everywhere else. And the last 10 years has just been amazing for America. So is the UK discount just one example of a kind of global discount? If you look at a chart of the global discount, it doesn’t look all that different from the chart of the — maybe less extreme, but it doesn’t look all that different from a chart of UK versus USA.

Ethan Wu
Yeah, that’s right. There are other factors at play too that could help explain why UK stocks are at a broad discount. You mentioned US versus ex-US. There’s also the fact that the UK is full of smaller companies relative to the US. And also, a lot of those companies tend to be value stocks, which is another category that’s been very out of favour.

Robert Armstrong
So there’s plenty of big stocks in the UK. But in the last couple of years, very, very big companies have been in favour with investors. And then as you say, there’s the fact that value stocks are cheap. Now, it’s slightly weird to say that value stocks are cheap, because what it means to say a stock is a value stock is saying that it’s cheap. So it has a low price-to-earnings ratio, low price-to-book ratio. The stock is basically inexpensive relative to the company’s cash flows or etc. But it’s all relative. Cheap stocks can get “cheaperer”.

Ethan Wu
Yes.

Robert Armstrong
And the difference in valuation between cheap stocks and expensive stocks right now is unusually large by historical (inaudible). So all of that, the question is, does all of that account for what’s going on in the UK or is there something else we’re hating on the UK for?

Ethan Wu
And just to put a finer point on it, the point here is it’s not enough to just look at headline p/e for the UK, headline p/e for the US and say, well, golly, there’s a huge discount here. You have to look at the composition of the market, right? And so we’ve just looked at these three factors: ex-US versus US, small cap versus large cap, value versus growth. And on all three dimensions, these are kind of structural problems in terms of the UK market being out of favour. So to answer the question “Is there a UK discount?” you actually have to adjust for all three of those factors. 

Robert Armstrong
Of course, it’s not always easy to do a regression analysis on stock market factors and, you know, market dynamics in this way. But I did look at a fairly thorough effort to do a statistical analysis from a guy called Oliver Jones at Rathbones Group. And what he found was once you adjust for the size and the profitability and the sector composition of the UK market, there still is a discount over and above what you might see from any old value stocks/ex-US stocks/slightly smaller stocks. So their conclusion was yeah, there’s something here.

Ethan Wu
Yeah.

Robert Armstrong
And of course, it’s always a matter of debate what causes divergences in value like this to occur. They think it’s probably down to Brexit.

Ethan Wu
Well, so I mean, let’s think about why it might be Brexit. So you literally look at the chart of the composition-adjusted UK market versus US market, right? Once you take out all the things that are out of favour in the UK, there’s still this residual discount. But that gap opens up starting in 2016, when Brexit happens.

Robert Armstrong
Yeah, right when Brexit happens. You have to ask an additional question. A, does Brexit have something to do with this? And B, does that make any sense?

Ethan Wu
Yeah. It’s irrational. Yeah.

Robert Armstrong
Is it rational? So let’s start with the irrational, which is where the action is, as always. So you could imagine global investment capital is absolutely global, fungible, etc. You can imagine global investors saying this country has just made, from a strictly commercial point of view, a huge mistake. They were, they had a privileged position within the largest free trade area in the world. Their companies tend to be very outward-facing and they have just created friction. It was not only a bad idea, it doesn’t reflect particularly well on how this country is governed.

Ethan Wu
Yeah, it creates volatility. And you could imagine that being sort of a justified discount.

Robert Armstrong
Yes. I think that may indeed be the perception. But I would argue that doesn’t make loads of sense.

Ethan Wu
Hmm. OK.

Robert Armstrong
Because whatever you might think about Brexit, let’s think about the biggest companies in the UK. Shell is an oil company. AstraZeneca, drug company. Unilever, consumer goods company. These are all very global companies that operate all over the place. And yes, there are companies in the FTSE 100 or the FTSE 250 that have big exposure to the domestic market. But the meat of the market is global companies and with not only markets but like manufacturing capacity that is truly global. Brexit doesn’t matter more to them than it does to a large US stock or a large Taiwanese stock or a large stock from Zanzibar. It doesn’t matter, right? So if a discount has been placed on these companies, global companies within the UK market, that just doesn’t make very much sense.

Ethan Wu
In other words, if it were really a Brexit discount, you would expect Brexit-exposed stocks to be extra, extra discounted, right? And that doesn’t appear to be the case. It seems to be more interesting than that.

Robert Armstrong
So look, I always hesitate. Any statistical analysis of the stock market, you have to handle carefully for the same reason any study in economics or any of the social sciences. You want a lot of confirmation and you want the study, run it different ways. You know, we’ll find out if there is a true . . . If there was during this period, a really true, unique UK discount. We’ll figure that out in like 10 years, you know. But, you know, if there is one, my question is this: where is the great British bargain stock? And I’ve spent a little time in the last couple of days.

Ethan Wu
Yeah. I wanted to go here next because you spent a lot of time in two separate newsletters recently looking at . . . And I think this was like a helpfully concrete way to frame the issue. Let’s look at like direct comparable companies in the US and in the UK. Let’s look at their financials. Let’s look at their valuation ratios. I mean, if there truly is a UK discount, it should be there. It should be kind of obvious.

Robert Armstrong
Yes. It wasn’t to me. I was unable to find a lot of good examples of UK stocks that were just screamingly cheaper. So I’ll give you an example. So like broadly comparable companies: Shell, very large UK oil company; Chevron, very large US oil company. On a price-to-earnings basis, Shell is cheaper. It’s at 10 times earnings, Chevron is at 15. That looks like a big gap. UK discount? Well, Chevron’s been over the last five years has been growing revenues about 5 per cent a year. Shell’s been shrinking revenues. Return on capital, Chevron’s a little higher. It’s expected to grow EPS more in the next couple of years. In other words, you look at Shell and Chevron and to me it’s like, yeah, Shell is cheaper, but it’s still a coin toss which one would I rather own.

And you know, similarly, you look at big banks, you look at Barclays and Citigroup in the United States, Barclays in the UK, Citigroup in the United States. While they have retail operations, they also have large card operations. They’re also both sort of solidly second-tier investment banks. They’re not a million miles separate in size. And you know, once again, Barclays is a bit . . . Both of them trade at a big discount to book. You know, investors in general are sceptical about both companies. But Barclays is even cheaper than Citigroup. And you could argue there’s an opportunity here. But I would argue in reply that the good bits of Citi’s business are better than the good bits of Barclays’ business, and that it’s exposed to what are probably more promising markets. So once again, discount. But it’s not hard to see reasons for that discount.

Ethan Wu
Yeah. Barclays, lower forward earnings growth, more leverage. I mean, that’s a good reason to have a discount, right?

Robert Armstrong
Absolutely. So again, I search around high and low and I struggle to find the stock that like screams out, “Buy me. I’ve been picked on because of Brexit and now I am too cheap”.  Now, it may be I’m looking in the wrong places. I encourage our listeners, especially those in the UK. Have you found the Great British Bargain? Because I have not quite found it yet.

Ethan Wu
Yes. No hate to our listeners at Barclays and Citigroup. We love you.

Robert Armstrong
I mean, some things that are, I should mention a couple though, like Unilever is kind of attractive relative to the big American like laundry detergent conglomerates.

Ethan Wu
Yeah. And you had looked at some booze companies that I had never heard of this before.

Robert Armstrong
Diageo, whose products I consume with great regularity.

Ethan Wu
They own Guinness and Bulleit Bourbon.

Robert Armstrong
Bulleit Bourbon and all these different, these brands. And, you know, that looks like, you know, for a great brand portfolio, that looks relatively cheap compared to the American Brown-Forman, which is Jack Daniel's. So there are ones that it’s at least an open maybe there is a discount here. You know, markets never make it easy for you. But I haven’t found the UK stock that really gets me excited by its value.

Ethan Wu
Yeah. But I think even still, there is a case here to buying UK stocks. And I think it goes something like this. Maybe or maybe not there’s a small, specific UK discount. You can argue about whether it exists. It might be there. What you’re really betting on though is the three trends, the three factors we talked about earlier: ex-US versus US, small cap versus large cap, value versus growth. All those have been out of favour. But if you buy UK stocks here, you can kind of make a contrarian bet on that reversing.

Robert Armstrong
On those three. Exactly. And . . . a UK ETF, is something that gets you all of that. And look, American stocks have been great for 10 years. They’re not gonna be as great in relative terms for the next 10 years. The chances of that happening are really low. So yeah, I think there is something interesting about buying the UK index if you are a great believer in mean reversion, in the kind of factors we’ve been discussing here.

Ethan Wu
Yeah. But I mean, I think as we talked about before, these sort of trends are like multi-decade trends with like no clear inflection point on when they turn around. So I mean, that is in some ways the risk and the discount are kind of commensurate in that sense right? You’re kind of taking a dice roll on will these multi-decade trends turn around in time for me to post good returns? Who’s to say, right?

Robert Armstrong
Yeah. It’s very difficult. It’s never easy. Beating the market turns out to be hard.

Ethan Wu
Yeah. I could really recommend some Bulleit Bourbon to age you in your quest to close the UK discount.

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All right, Rob, we’ll be back in just a moment with Long/Short.

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Welcome back. This is Long/Short, that part of the show where we go long a thing we love, short a thing we hate. Rob, are you long or short something?

Robert Armstrong
This was a tough call for me, Ethan, but I’m going long the price of cocoa.

Ethan Wu
Oh, that’s a good one.

Robert Armstrong
For listeners who don’t know, the global price of cocoa has gone bananas, to use another food reference.

Ethan Wu
It’s like properly hockey-sticking.

Robert Armstrong
Yeah. So October 2022, a tonne of cocoa would cost you $2,200. Now, it is at $5,600. And the reason I’m going long this parabolic increase in the price of chocolate is don’t mess with Big Mo, meaning momentum. So, you know, it’s going up. Things that are going up tend to keep going up. And I’m gonna make a few bucks and then I’m gonna get out before it comes crashing down, Ethan, because I’m cleverer than all the other cocoa traders.

Ethan Wu
Well, I think the futures market’s way ahead of you. I saw earlier today a story in Bloomberg that cocoa futures are over $9,000.

Robert Armstrong
Dang!

Ethan Wu
And people in the futures market are going nuts.

Robert Armstrong
OK. So is there some clever arbitrage we can do where we like long the physical and we’ll short the futures and we’ll have this brilliant . . . I’m sure somebody at some hedge fund has a wicked arbitrage going on this.

Ethan Wu
This all raises the question, do cocoa traders actually eat chocolate? Or is it the kind of thing where you need distance from the craft so you don’t actually eat chocolate if you’re a cocoa trader?

Robert Armstrong
Good point. Well, how about you, Ethan? What’s your long or your short?

Ethan Wu
Well, Rob, I’m just back from a trip to Taiwan. You know, it’s great being there. It’s a beautiful country. But I am long Taiwan Semiconductor Manufacturing Company, TSMC, which, you know, people may know about, but it just . . . going to the factory in person and to their science museum was just like incredible experience because it’s so massive. It’s like this titanic military-level fortress of semiconductor manufacturing. It’s obviously like one of the largest semiconductor fabricators in the world. And it shows, man.

Robert Armstrong
The largest, I think.

Ethan Wu
Yeah, I think that’s right. You know, I was hanging out outside one of the buildings where like the staff go in and out and the security people were very, very uncomfortable with me, with me loitering there. I think they’re very concerned about industrial espionage. But, Rob, I actually brought you a gift.

Robert Armstrong
Awww.

Ethan Wu
From the TSMC Museum of Innovation, your very own Taiwan Semiconductor Manufacturing Company hat.

Robert Armstrong
Yes! This is cool, man. I love corporate swag. I have it on over my headphones here in the studio.

Ethan Wu
It’s a good look.

Robert Armstrong
And I am looking good.

Ethan Wu
You’re ready to innovate.

Robert Armstrong
It’s like very slick. It doesn’t . . . The logo is very small and subtle and off to the side, and the hat itself is black with a single white stripe, and it just sort of screams out like industrial dominance and secrecy.

Ethan Wu
I went on a tour of a science museum in Taiwan. And the tour guide who, you know, English is a second language, but, you know, he spent the entire trip. His catchphrase was diversify. After every exhibit, when we move from one exhibit to the next exhibit, he would say, diversify. Diversify.

Robert Armstrong
Diversify. Worse advice.

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Ethan Wu
For technologists and investors alike. Diversify.

Robert Armstrong
Right on.

Ethan Wu
All right, Rob, thanks for being here.

Robert Armstrong
Thanks for the hat, man.

Ethan Wu
You’re welcome. We’ll have you back soon. And listeners, we’re back in your feed on Thursday with another episode of Unhedged. We’ll catch you then.

Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Ethan Wu. Thanks for listening.

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