Despite the recent slide in the markets, UK equity valuations are attractive in the medium term and are likely to add ‘alpha’ to pension funds, observed a fund manager.
Simon Murphy – UK Select Equity Fund Manager for Old Mutual Asset Managers, said UK stock markets are among the most diversified in the world with 75 per cent of FTSE earnings coming from outside Britain. Additionally, the FTSE100 does not face currency risk typically attached to other stock markets, he added.
The earnings yield, a ratio of earnings to the price of the stock, derived from the FTSE is far superior to yields from other asset classes, such as bonds, said Mr. Murphy.
The present earnings yield of FTSE listed companies is about 12 per cent, much higher than the present ten year gilt-yield of about 2.4 per cent. In a potential economic recession scenario, the earnings yield is unlikely to fall below 6 per cent, observed Mr. Murphy.
When dividends are paid out, institutional investors can benefit from them, he added.
“12% is attractive; pension funds are not going to rush in, but there are attractions in the medium term,” said Mr. Murphy.
The fund manager’s observation comes when UK pension funds are moving to global equities over UK stocks and in some cases exiting equities altogether.
UK equities look attractive, agreed Nick Sykes, director of Mercer Europe. However, dividend yield is a better metric than earnings yield since that is what investors ultimately earn, he added.
If the dividend yield of UK equities is 3.6 per cent in the All Share index and yield of 10 year maturity bonds 2.5 per cent, then it would require a 30 per cent cut in dividends and zero growth in payouts for the next ten years for the returns to be equal, provided market valuations remained at current level, explained Mr. Sykes.
“On a dividend yield basis you would have to say UK equities look remarkably cheap against bond yields,” he added.