The return of the total return kings

As you will have gathered from previous Temple Bar newsletters, we have spent the last few years demonstrating how cheap the UK equity market has become, both in absolute terms, but particularly when compared to the US equity market.

Whilst there are many theories to explain the lacklustre returns from UK equities (for example, sector composition, Brexit, political uncertainty), they can be more simply explained by money flows. Many UK pension funds have spent the last few decades selling equities to buy bonds and reducing their UK holdings in favour of global equities. Meanwhile, large wealth managers have also typically been allocating money towards globally-diversified portfolios. Since the UK represents just 3% of the MSCI World Index, compared to the US weight of 70%^[1], this has inevitably meant selling UK equities and buying US equities. In both directions, these trades have paid little heed to valuation.

When we highlight the very low valuations on offer in the UK equity market, however, the first question we are asked by many clients is, “what is going to change this?”. This is a fair question and, although it may be hard to envisage a scenario in which all the money that has departed the UK suddenly comes back in, there are two mechanisms currently at play that can potentially realise the value in UK equities without the need for large money flows back into the market.

Catalyst 1: corporate takeovers

The relentless selling of UK equities has driven valuations to such low levels that overseas corporates have spotted an opportunity to acquire UK assets at prices that offer serious future return potential. The chart below shows the number of annual takeovers in the UK market, with 2023 becoming a record year. This momentum has accelerated in 2024, with a series of bids for high profile UK businesses including Currys, Direct Line, Redrow, IDS (Royal Mail), Anglo American, Hargreaves Lansdown and Britvic, several of which we have held in the Temple Bar portfolio.

Catalyst 2: share buybacks

Meeting the CEOs of the companies we invest in has been quite a depressing experience in recent years since many feel that they are doing a very good job of running their company and yet continue to watch their share prices fall. Our advice has been to not take the low share price personally, but rather to use it to the advantage of the company’s shareholders through share buybacks.

The chart below suggests that this message is finally starting to hit home as half of UK companies bought back shares in the last twelve months, the highest percentage of any market in the world.

As we explained in our January 2023 newsletter, share buybacks represent an excellent use of capital for creating shareholder value, as long as those shares are bought back at a price that is lower than their intrinsic value. We used Next as a case study, demonstrating that, by buying back two-thirds of its shares in issue since 2000, it has produced a total return for investors of 16% per annum, and seen its share price rise from £5 to £80, despite only growing sales at 5% per annum.

The return of the total return kings?

We believe that the conditions today are reminiscent of those that existed in 2000. Then, like now, the majority of investors were focusing on the growth prospects of technology companies and paying very high valuations for them. Conversely, they had seemingly little interest in investing in old economy sectors such as energy, financials and autos and had driven the valuations of these parts of the market to very depressed levels.

So, which companies today look well placed to be the “next Next”, and thus have the potential to reward their shareholders with attractive total returns in the future? The table below contains some of the companies we hold in the Temple Bar portfolio, which we believe could produce attractive total returns for their investors.

Column one shows the earnings that these companies have generated in the last two years as a percentage of their current market capitalisation. It is worth noting that some of these companies have generated between 40-50% of their market cap during this time (20-25% per annum), placing them in a favourable position to return cash to their shareholders.

The second column looks at whether they have been doing that by showing the dividends that these companies have paid as a percentage of today’s market cap. Several of these companies have paid out between 10-14% in the last two years, which in its own right, is an attractive return.

Column three shows share buybacks as a percentage of market cap and, again, some of these figures strike us a truly impressive. BP and Shell have bought back 17% of their market cap in two years, whilst NatWest has bought back nearly 30% of its market cap in just two years.

The final column then adds together the dividends plus share buybacks to show the total cash return these companies have given their shareholders over the last two years as a percentage of today’s market cap, with a range of figures from 19-39%.

We hope that it should be fairly obvious that, if these companies continue to buy back shares at the rate of the last two years, it seems likely that their share prices will eventually respond. Buying back shares increases their earnings and dividends on a per share basis and, eventually, the market must take notice of this.  If their share prices do not rise, then their price-to-earnings ratios and dividend yields will eventually reach ridiculous levels. Some investors would argue that they already have – indeed, with the likes of Barclays and Natwest up 40% and 49% respectively year-to-date^[2], we may have already seen the start of this value realisation process unfolding.

Conclusion

We believe that the market is currently offering up some incredible opportunities for investors, not because there is anything fundamentally wrong with these businesses, but rather through neglect. What we have hopefully demonstrated, however, is that companies have the ability to use this low valuation to change the fundamentals of their business.

Just as in 2000, investors are so entranced with the potential growth being offered by US technology companies, that they are ignoring some of the real bargains to be found in sectors such as energy and financials, which are the two largest sectors in the Temple Bar portfolio. By taking advantage of their low valuations and buying back their own shares, businesses such as BP, Shell, Barclays and Natwest have the potential to become the “new total return kings”.

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^[1] Source: MSCI as at 5 April 2024

^[2] Source: Koyfin over six months to 30 June in capital return, UK sterling terms. Past performance is not a guide to future returns.

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Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so.

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Nothing in this document should be construed as advice and is therefore not a recommendation to buy or sell shares. Information contained in this document should not be viewed as indicative of future results. The value of investments can go down as well as up.

This article is issued by RWC Asset Management LLP (Redwheel), in its capacity as the appointed portfolio manager to the Temple Bar Investment Trust Plc. Redwheel, is authorised and regulated by the UK Financial Conduct Authority and the US Securities and Exchange Commission.

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