1 Nvidia or 561 UK companies – does valuation hold the key?

Nvidia’s $3bn market capitalisation reflects its importance as a leader in graphics processing units which are a vital cog in the development of AI. There is no doubt that the US is a world leader in incubating technology leaders, but the stock market can struggle to value these companies.

It is also worth noting that of the top 10 companies in the S&P 500 in the year 2000, only one survives – Microsoft. Technology firms that seemed all-powerful at the turn of the century have faded into obsolescence or been subsumed into other companies. Industries that develop rapidly can see unexpected change in technology, competition or regulation that can confound investor expectations. Valuations can become stretched, as the hottest stocks attract the greatest flow of funds, driving their valuations to levels that require flawless delivery. The disappointment that can ensue can be a bemusing experience for investors as it becomes clear that the most exciting companies don’t always make the best investments.

The challenge of UK market pessimism

The UK market is facing the opposite challenge. Low valuations would indicate that expectations are extremely low. The market capitalisation of the whole of the FTSE All-Share Index is £2.5 trillion, equivalent to $3.3 trillion and only marginally higher than Nvidia. Yet this is spread across 561 companies and across a wide range of sectors – including energy, pharmaceuticals, finance and mining.

It is possible to see why expectations are so low. The UK equity market has been out of favour for almost a decade following a series of setbacks. After a brief period of positivity following the recent general election, the tone of the messages from the new UK government have been resolutely pessimistic. Undoubtedly, there are still challenges. Government debt is hitting new highs at almost 100% of GDP. Ideally this problem would be solved by faster economic growth via measures to drive up productivity, but this will take time. In the meantime, the UK is facing tax increases that could act as a brake on growth. Despite the government’s business-friendly rhetoric, uncertainty over upcoming tax changes are dragging on consumer and business confidence. The country remains in limbo until the Autumn budget in late-October.

The UK is one of the most lowly valued markets in the world. Side by side, UK companies tend to trade at lower valuations than US companies of comparable quality. We see low expectations as an opportunity for investors who are willing to go against the flow. If expectations are high, then there is a risk that everything has to go right to justify the valuation. Even a small miss can cause a major wobble. By contrast, there is a decent chance that expectations are low enough for UK companies that even a small improvement in their operations could drive a valuation re-rating.

Our focus on valuation

Our focus on valuation is a key element of our investment process. Valuation can, at first glance, appear to be an abstract concept, but its importance can come to life when managing an income portfolio. We seek to understand the drivers of a company’s cash flows, as these will pay for the dividends that our shareholders expect. We look to identify companies whose cash flows and dividends have not been properly factored into their share prices. One of our largest holdings, Imperial Brands, has a new management team who have focused on improving the delivery of cash flows by concentrating on core markets. This has resulted in a turnaround in its profitability, allowing both a generous dividend and a significant share buyback programme. Added together, the dividend and buyback represents a mid-teens total distribution yield. At this pace, it would not be long before the entire market capitalisation of the company has been returned to shareholders. This an example of how low valuations can provide what Benjamin Graham famously called “a margin of safety”.

Identifying companies trading at low valuations does not mean that we neglect growth. We scour the market for companies with both low valuations and positive earnings momentum. We are finding growth in traditional sectors such as Financial Services, including advice group Quilter, which is benefiting from structural tailwinds such as the growing need for financial advice following the shift from Final Salary pensions to Defined Contribution pensions. Construction group Galliford Try is a beneficiary of the drive to rebuild the UK’s infrastructure, particularly its water supply which is Galliford Try’s largest area. Improved price discipline across the sector has allowed Galliford Try to deliver higher profit margins, enabling the company to hit its 2026 targets two years early and announce a growing stream of earnings and dividends. Utility company National Grid is set to benefit from growing electricity demand, partly driven by AI-related demand, supporting higher earnings as they deliver the capital expenditure necessary to facilitate energy transition in the coming decade in the UK and US.

The UK equity market’s resilience

We see the combination of cheap valuation and improving outlook as a powerful combination. This is what we seek in our investments at the company level. This can feel lonely when the rest of the market is focusing exclusively on high growth stocks, regardless of valuation. The era of ultra-low interest rates allowed investors to go for growth without having to worry about dividends or valuations. The cost of capital was low enough that investors could sit there and dream about growth in 10 years’ time. The era of ultra-low interest rates has now ended and investors are more aware of the benefits of investing in traditional companies that pay dividends in the here and now. At the same time, stretched valuations in sectors such as technology have caused some share price volatility, drawing into question the idea that these companies are bullet-proof investments.

As the UK equity market starts to make some headway, after years in the doldrums, we expect asset allocators to question whether they should be increasing their allocations. It is worth considering what impact a small but steady switch away from multi-trillion $ titans like Nvidia towards UK stocks could have on share prices. The UK equity market faces many risks, but over-exuberance is certainly not one of them.

Thomas Moore, is investment manager at abrdn Equity Income Trust.

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