As fund management legend and Vanguard founder John Bogle once noted: ‘The stock market is a giant distraction from the business of investing. In the long run, investing is about the returns earned by businesses not the stock market.’  

In other words, sentiment may drive prices in the near term but in the end it is profits and cash flows which drive valuation.

From the point of view of investors with exposure to the UK equity market, the bad news is consensus earnings forecasts for the members of the FTSE 100 index fell by 4% in the first six months of this year to £247 billion from £258 billion.

The good news is, that £247 billion figure is still a record high and therefore helps justify why the index is trading close to an all-time peak (further progress, to £261 billion, is expected for 2025).

Yet the 2024 number is only enough the put the UK stock market on 12 to 13 times forward earnings for this year, when Europe is on 13 times, Japan 16 times and the US a meaty 23 times according to analysts’ forecasts.

Therefore, the UK still looks cheap. Investors now have to decide whether the forecasts are any good, what momentum is like and what are the biggest swing factors (to the upside and downside). 

The answers to those questions may help them determine whether the UK equity market is cheap and undervalued or cheap because it deserves to be.

MIX AND MATCH

The easiest way to knock the FTSE 100, especially relative to the US market, is to point out its lack of exposure to secular growth sectors such as technology.

The UK’s premier index is instead heavily weighted towards financial, oil, consumer staples and mining stocks. Three of those sectors are cyclical and hard to forecast, while one typically plods along by comparison with technology. 

Applying these criteria, the UK does deserve a discount to America. That said, an era of higher inflation, higher nominal GDP growth and higher interest rates may be a better environment for cyclical and financial stocks than the low-inflation, low-growth, low-rate sludge of the 2010s which put a much greater premium on secular growth and long-duration assets.

This also raises the issue of concentration risk, as just 10 firms represent 55% of forecast FTSE 100 pre-tax income in 2024 and another 10 firms represent 55% of forecast dividends (see tables).

There is some overlap between the names, but investors who want exposure to the UK in the equity portion of their portfolios need to be comfortable with these stocks in particular, from the point of view of fundamentals, valuation and perhaps an ethical, social and governance (ESG) perspective, given the preponderance of miners, tobacco producers and oils.

Financials, oils, miners and consumer staples dominate FTSE 100 earnings

EARNINGS MOMENTUM

The small drift down in FTSE 100 aggregate pre-tax income forecasts may not encourage everyone, either, although the US has seen a similar degree of downgrades to consensus estimates for 2024.

Just 10 firms represent more than half of the FTSE 100’s forecast profit and dividends

Moreover, the FTSE 100 has managed a 6% capital gain despite those modest earnings downgrades, which is the equivalent of a 10% re-rating already, suggesting someone somewhere is warming to UK equities.

The UK may offer more political stability than previously, after Labour’s general election win, and that may be a nice contrast to parts of Europe or even the US, where a fractious presidential campaign is just hitting top gear and another disputed result is a possibility.

It can also be argued interest rate cuts are coming and the UK may be emerging from a slowdown just as the US enters one, while cash returns remain a potential source of support.

FTSE 100 firms are expected to pay £78.6 billion in ordinary dividends in 2024, with £3 billion in special dividends from HSBC on top, and they are running share buybacks worth £38.5 billion.

Add in £10.8 billion of forecast dividends from the FTSE 250 and £38.2 billion of live or completed takeover offers and the FTSE 350 is offering £169.1 billion in total cash returns (dividends plus buybacks plus takeovers) on its £2.5 trillion market capitalisation for a ‘cash yield’ of 6.8%.

That figure compares very favourably to the 5.25% Bank of England base rate, the 10-year gilt yield of 4.09% and the prevailing rate of inflation which is down to 2.0% based on the latest consumer price index.

Naturally, none of this is to say the UK stock market is going to go up like a rocket but its lowly valuation means it still feels unloved and unloved can mean undervalued.

As the old market saying goes, you can have cheap stocks and good news – but not both at the same time.

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