Key points
- UK equities are the cheapest in the developed world, and cheap relative to their own history due to sticky inflation.
- Lower inflation and a more dovish Bank of England will see the market price in a much more optimistic outcome.
- Deflation in China is the key catalyst to drive UK inflation down faster than the market expects.
- Diageo and Tesco should be in every global equities portfolio – they are cheap relative to their business resilience and growth profile because they are listed in the UK
At around 11x times forward earnings, by developed world standards, UK equities appear attractively priced.
In fact, over the past three decades, only during the 2008 financial crisis, September 11 and COVID, has the multiple been lower. Even relative to their own history, British stocks are priced at a 20% discount versus the US at a 15% premium.
Why?
While the rest of the developed world is seeing inflation rapidly fall, headline CPI in the UK is still 6.7% versus 6% in Europe and 3% in the US. Goods inflation has remained stickier in the UK which is spooking the market. The assumption is this will keep the Bank of England (BoE) relatively tight which is weighing on sentiment and equity valuations.
So, is the UK structurally different from the rest of the developed world or can inflation fall faster than consensus expects?
Goods inflation has been stickier in the UK because it is an import dependent economy, so it takes longer for lower prices to feed through. But our analysis shows both demand and price have meaningfully weakened over the last few months suggesting inflation can fall much faster than the market expects. We predict it will be closer to 3.5% by the end of the year versus the market and BoE at 4.5 – 5%.
The slowdown in China is driving this.
China is one of the UK’s largest import partners and it is experiencing deflation. China’s Producer Price Index (PPI), which measures the change in selling prices in China, is currently -4.4%. This will feed into the UK’s import costs, so we see UK goods inflation falling to close to zero by the end of this year. This will be a substantial drag on UK headline inflation over the next six to 12 months.
If CPI declines the way we predict, we expect the BoE to lean dovish – and the market will start to price in a much more positive outlook.
If the macro is on the cusp of a positive surprise, what should you own?
There are two great businesses that we believe should be in every global equities’ portfolio – Diageo and Tesco. Both companies are priced at a discount to global peers because they are listed in the UK – the market doesn’t want to own UK equities, and that’s the opportunity.
Diageo (LON: DGE)
Diageo is the largest Western spirits business and the home to many dominant brands like Johnny Walker Scotch, Tanqueray Gin, Guiness, Don Julio tequila. Two-thirds of the industry is represented by small scale, local players – but Diageo leads with a 10% share of international spirits.
There’s a lot to like about Diageo. The spirits industry is taking share from beer and wine and the company is expanding into categories that are wining share such as tequila, scotch, premium spirits and ready-to-drink. Diageo is in a strong position to grow and be a consolidator in this fragmented market.
The strength of Diageo’s business boils down to three key factors.
The company has enviable “rights to operate”. Scotch can only come from Scotland, tequila can only come from certain parts of Mexico, Cognac can only come from that particular town in France. Operators need to have a plot of land or a distillery in precisely the right location to compete. This is a very real barrier to entry.
Inventory age is another competitive advantage. More than half of the company’s portfolio is aged more than three years. Johnny Walker – a key revenue driver for Diageo – is a great example. You either have 10-year-old aged Whisky or you don’t, and this is why Diageo has more than one-third of the premium scotch market and is three times the size of its next largest competitor.
Diageo also owns its own distribution where it’s possible and where they don’t own it (e.g. the US) distributors consolidate around the company because retail outlets, restaurants, pubs and clubs want their brands.
The company is priced at 20x forward earnings, with operating profits growing high single digit and it’s buying back stock. Diageo is a global business that generates around 50% of profits in the US but is cheap relative to consumer franchises like Pepsi and Hershey which are priced at 22-24x forward earnings which are less profitable and have lower organic growth profiles.
Diageo is cheap relative to its business resilience and growth profile because it’s listed in the UK.
Tesco (LON: TSCO)
Tesco is one of the largest grocers in the UK, but at 11x earnings the market is missing that the company is successfully navigating the two key structural shifts – hard discounter competition and the shift to online.
The discounters like Aldi and Lidl have steadily taken market share in the UK over the last decade, as we’ve seen in many other markets. Tesco’s fought back via price matching to maintain its c.30% share of the in-store grocery market while its full-price peers have felt the brunt of the discounters’ growth. The company has implemented initiatives to protect profitability such as using its scale to secure the best price for customers, growing Tesco branded private label which is more profitable than branded and loyalty programme to target promotions and drive customer spend, and cost discipline.
When it comes to online, Tesco.com launched in 2000 and is the clear winner with nearly 40% of online grocery and we expect the company to continue to win as spend shifts online. The UK is densely populated which is key to running a profitable online business and Tesco has coverage of the entire UK and it’s taken a leaf out of Walmart’s playbook via investing in fulfillment centres attached to large format stores to fulfill online orders. The shift to online hasn’t been materially dilutive to Tesco’s earnings.
Despite this, Tesco is priced at half the multiple of Woolworths in Australia or Walmart in the US.
Tesco is cheap relative to its business resilience and growth profile because it’s listed in the UK.
By the Antipodes Investment Team