UK equities offer high expected returns for the bold investor

Key points in this equity note:

• UK equities are currently valued at a 7% shareholder yield reflecting an extraordinary high expected real return of around 9% for the long-term investor.
  
  
• Because the GBP trade-weighted spot is below its long-term average and UK equity valuations are below their long-term average there is the possibility for foreign investors that realized expected returns could become even bigger due to GBP appreciation and mean reversion in equity valuations.
  
  
• UK equities are currently valued at 42% discount to global equities as investors have shun the UK equity market ever since the Brexit referendum and following string of political and policy hiccups.

Expected returns on UK equities should attract long-term investors

Recently sell-side analysts have pushed the views that UK equities are among the cheapest in the world relative to its own historical valuation and especially relative to the global equity market. One thing is cheapness relative to some definition of earnings another, but it is more interesting to look at what it means for expected returns, because that is what should drive investor decisions. Companies can return capital to shareholders through dividends and buybacks of its own shares which often called the shareholder yield.

Dividends and buybacks are made possible costs have been paid for operations and capital expenditures have been expensed to main and expand the business. The available funds after these necessities are called free cash flow to the firm and can either be retained (build up cash balances), paid out to shareholders (dividends or buybacks), or used to reduce debt on the balance sheet. Investors care about the return of capital to shareholders and thus the shareholder yield is the starting point for estimated expected returns.

In a steady state, that is revenue growing with inflation and capital expenditures requirements remain unchanged on a relative basis, the shareholder yield is your annualised expected return on capital invested over your investment horizon, because the business will be able to generate this return stream indefinitely. Expected returns also relate to future growth and historically economies in the developed world have delivered 2% annualised real rate growth which is predominately a function of productivity. If we assume this rate going forward then the long-term expected real rate return is 9% annualised in UK equities. If we assume 3% annualised inflation over the next 10 years the expected nominal return in UK equities could be 12%.

UK equities are also valued at 10% discount to its own historical valuation and thus on top of the expected returns calculations above the long-term investor might also get a valuation mean reversion effect and thus the real rate return could be above 10% annualised over the 10 years.

The current shareholder yield of 7% in UK equities has been reached twice since 2006 in November 2008 during the Great Financial Crisis and March 2020 during the global Covid pandemic. Investors buying UK equities in November 2008 realized close to 10% annualised nominal returns in the subsequent 10 years. Buying shares in March 2020 will likely prove to have been an extraordinary good starting point for long-term returns in UK equities.