WHY THE U.K. IS A COMPELLING, CHEAPER, STORY FOR INVESTORS.

With the United Kingdom entering the fourth and final stage of its reopening plan, it is worth taking another look at the stock market. This is an area of the world we have long favoured due to its compelling valuations and successful vaccination rollout. Admittedly, with case counts on the rise due to the prevalence of the Delta variant, there are some near-term risks. But, with a very high share of its adult population inoculated (about 87 per cent of adults have received a first dose), it is in a comparatively strong position.

We examined five key valuation metrics — trailing P/E, forward P/E, priceto-sales, price-to-book, and the equity risk premium (forward earnings yield less 10-year government bond yield). What we found is that, on average, the U.K. scores in its 55th percentile (using the MSCI UK Index) relative to its own history.

This means that, about half the time in the past, the U.K. has been more expensive than it is today. By way of comparison, the U.S. equity market (using the MSCI US Index) ranks in its 86th percentile. Note, too, that even the metric the U.S. scores the best on — the equity risk premium — favours the U.K. market.

Now, one obvious rebuttal is that the U.S. market has historically had superior dividend and earnings growth and therefore deserves to trade at a premium. There is undoubtedly truth to this argument. In fact, U.S. companies have consistently grown their profits at a faster rate, which has also led to superior growth in payouts to shareholders.

For example, over the last 20 years, the annualized pace of dividend growth in the U.K. is just 2.9 per cent and its earnings growth is fractionally negative (-0.5 per cent) over this period. In contrast, the MSCI U.S. Index has seen annualized dividend and earnings growth of 6.9 per cent and 5.7 per cent, respectively.

But it is worth remembering that the U.K. went through a more challenging period, economically speaking, than the U.S. in recent history. Notably, there was the European debt crisis and

Brexit, both of which provided considerable shocks to the economy. This, of course, flowed through to corporate earnings, which can at least partly explain the divergent path for profits.

However, the path forward looks better for U.K. earnings, at least based on analyst estimates. According to data from Bloomberg, the expected longterm earnings growth for U.K. stocks is 8.5 per cent annualized, which is comparable to Canada (8.6 per cent), Emerging Markets (nine per cent), and Asia Pacific (7.9 per cent). That said, the U.S. (13 per cent annualized) is still expected to be the star performer on this front, but the divergence is less pronounced than has been the case in recent history.

We can account for the expectation of superior earnings growth in the U.S. by comparing PEG ratios (P/E ratio divided by the expected earnings growth rate) across countries/regions. On this basis, the U.K. once again scores the most favourably (PEG ratio of 1.5) followed closely by Emerging Markets. Importantly, the U.S. (PEG ratio of 1.8) looks less overvalued based on this metric, but is still in the middle of the pack on our list.

For investors that, like us, see the U.K. as a compelling story in a world where valuations are rich, we have done a deeper dive on which sectors, in particular, look the most attractive. Based on forward P/E ratios, this would include, in order: materials, energy, financials and consumer staples.

One note of caution about this list — it is generally very pro-cyclical/value-centric at a time when the market is increasingly moving away from this trade (at least in the near-term). As such, investors should only view this as a long-term theme, and be mindful that better entry points may emerge down the road if the pro-cyclical/value trade continues to move out of favour.

THE PATH FORWARD LOOKS BETTER FOR U.K. EARNINGS.