Ruffer has raised its UK equity exposure to the highest level in more than a decade, the group’s investment director Steve Russell has revealed.
He pointed out valuations are now too cheap to ignore, which is why private equity bids in the domestic market have reached a record level, surpassing activity in regions such as the US and Europe.
“What can they see that we can’t?” Russell asked. “Private equity bids for UK companies are soaring, while at the same time the UK stock market languishes at valuations well below US peers.”
The investment director noted that the FTSE All Share now trades on a forward price-to-earnings ratio (PE) of 13x, whereas the S&P 500 trades on a 21x.
In the last decade, the US market has outperformed its UK equivalent by more than threefold in sterling terms.
Performance of FTSE All share versus S&P 500
Source: FE Analytics
Yet private equity interest in UK businesses has grown dramatically over this time, hitting $64bn this year, with most from US firms.
Source: Ruffer LLP
Uncertainty caused by Brexit is often cited as the main reason for the UK’s underperformance over the latter half of the past decade.
But Russell said another important reason was a lack of tech giants and momentum stocks, which have driven much of the US market’s outperformance.
“Our Ocados and Games Workshops don’t quite cut the mustard in global index terms,” he said. “But private equity isn’t bidding for the tech leviathans.
“They are seeking out value wherever they can find it and with interest rates so low, ‘value’ has almost been redefined.
“As retail and index funds chase the US tech giants to ever higher valuations, the so-called ‘smart’ money of private equity is looking elsewhere.”
Data from Dealogic showed takeover volumes in the UK are more than twice the level as in the US and Europe.
UK-listed companies such as Morrisons, John Laing, Ultra Electronics, G4S, McCarthy & Stone and Aggreko have all received approaches from private equity firms.
Russell said supermarket Morrisons was a business that was “supposedly so dull hardly anyone was interested” before private equity “came snuffling around”.
Shares in Morrisons were trading at 175p before news of a bid came to light; they then surged more than 60% to 293p.
Share price of Morrisons
Source: Google Finance
All these companies had one thing in common before the takeover bids came in, according to Russell: they were too cheap.
“Too cheap for the kind of reliable free cash flows they offer bidders with access to vast amounts of money at ultra-low interest rates,” he explained. “Yes, the UK economy has its issues, but look around the world and who doesn’t?
“What the UK does have is decent companies trading at significant discounts to global peers. Many with cashflow yields significantly higher than the cost of debt.
“Almost nothing in the UK market is too big for private equity interest,” he continued.
“Maybe it is no coincidence the 34% valuation discount between the UK market and the rest of the world roughly matches the average 40% bid premium private equity has paid this year.
“If Morrisons is bought for over £7bn on a PE of 20x (12.5x pre bid), then why not Sainsbury’s (currently valued at less than Morrisons and on a PE of 13x) or even Tesco (current value £20bn, but also on just 13x?)”
This is why Ruffer now holds half its global equity exposure in the UK.
Russell said: “Some of this is in banks and energy, not the obvious candidates for private equity bids, but more than half is in medium and smaller companies.
“Of course, we don’t invest specifically for M&A activity, but it seems others are beginning to share our definition of value.”
Russell is the lead manager of the Ruffer Absolute Return fund. He also runs the £3.9bn Ruffer Total Return fund, which also has roughly half of its equity allocation in UK companies.
Both funds have top-10 holdings in FTSE 100 giants such as Lloyds Banking Group, Natwest, BP and Royal Dutch Shell.