What do UK stocks and Silver have in common?

Welcome back from the Easter break. I hope you got some rest.

With the US stock market, Gold, Bitcoin, Cocoa, and even Japan's stock market (after almost 35 years) all hitting all-time highs this year; it makes you wonder, what is cheap today? The Financial press seems to think UK stocks and silver are cheap relative to US (and perhaps European) stocks and gold respectively. Let's examine why they think this is the case.

UK stocks

UK stocks are trading close to a record discount relative to their peers in the US.

The MSCI UK and US indices are designed to measure the performance of medium and large companies publicly traded in the UK and US respectively. The MSCI UK index currently consists of about 83 companies while the US index has 609 constituents.

The above chart is a ratio of the MSCI UK's 1 year forward price to earnings multiple to the US'.

A ratio of 0 means that investors (and other market participants) are willing to pay the same multiple for $1 of earnings irrespective of whether it's traded in the US or the UK.

However, as the chart shows, the ratio of the 2 indices has never been 0. Infact the discount has been increasing and is now close to 50%.

This means on average, if 2 companies expect to make $10 in profits per share next year;

• If the company was trading in the US, an investor would be willing to buy a share of that company for $100 (i.e. 10 times earnings)
• but if it were in the UK, they will only be willing to pay about $53 (i.e. 5.3 times earnings)

In an increasingly globalised world where companies listed in the UK are not just selling to UK customers and US companies are not just catering to US customers, you'd expect such stark differences to not exist.

However, the current difference is explained by 2 things

1. Politics: As we can see from the chart, around 2016, the discount was closest to 0. However, post Brexit, the discount has continued widening to date.
2. Less high growth tech: The UK market has more "old economy" stocks such as banking and energy which have not kept pace with the high growth tech stocks that have driven the US' stock market growth

To further show the lack of interest in UK stocks, Bank of America conducts a monthly global fund manager survey which basically shows where global investors are putting their money. Global investors appear to be more underweight the UK than any other asset class, industry or country. I.e. Global investors are avoiding UK stocks.

The above evidence seems compelling that UK stocks are out of favour, but is this an opportunity to be greedy because others are fearful?

Is the UK discount justified?

Here are 3 justifications for the UK discount:

1. Globally, over the last decade and half, investors have been paying more for growth than for value. The UK appears to have more value stocks than growth stocks. While the definition of growth and value depends on who you ask, one definition could be that growth stocks are companies expected to grow their earnings and revenues faster than the overall market, while value stocks are companies with less revenue growth who are more mature i.e. they often return large amounts of cash to shareholders. For example, UK small caps trade at a 25% discount to US stocks, but offer a dividend 2.5 times higher than the 1.6% offered in the US
2. Investors are willing to pay more for American stocks relative to the rest of the world: i.e. this is not a UK problem. The US has captured the interest of investors far and wide. For example, the US stock market represents about 70% of the world's stock market value (even though the US economy only accounts for 17.8% of global GDP)
3. American companies tend to be larger than British ones. The average S&P 500 company is more than double the size (in terms of market cap) of the average FTSE 100 company. I mean, look at the constituents: the UK index has 83 constituents vs the over 600 in the American index.

So, the UK has smaller companies, who are more tilted to value and are outside the US. Triple whammy!

Whether you believe that UK stocks are cheap or not, private equity firms, sitting on a record $2.6trn of dry powder, are looking at UK companies as possible acquisition targets. 49 firms left the UK public market between November 2023 and January 2024 through acquisitions.

In 2022 and 2023 there were 27 acquisitions of companies in the UK’s Numis Smaller Companies Index. Half went to private equity on a median premium of 51%.

As with all things, this cheapness may not apply to all British companies. Buyer beware.

To stir some interest from the British public in UK stocks, the British government is flirting with the idea of a Brit ISA (Individual Savings Account) - a tax efficient allowance that can only be invested in UK-Listed stocks.

An ISA is an account which allows people living in the UK to save or invest up to £20,000 each tax year without paying taxes on any of the gains the money earns. This proposal would require British residents to invest all or some of that £20k in UK traded companies.

Silver

Silver, like gold, is a precious metal often used in jewelry. But unlike gold, it has some industrial uses such as in solar panels, computing, health, etc. That means, unlike gold, its price is influenced by economic growth prospects. A booming or recovering economy should be good for silver. 

"More silver is being used each year than is being dug out of the ground" - Michael Hsueh, Deutsche Bank

In other words, there is more demand for silver than supply can meet i.e. silver is running at a supply deficit.

However, Hsueh notes that there’s still a “vast stock of silver above ground” in the form of scrap silver that could easily make its way to market at the right price. Thus, if demand reaches a certain level (flies to the moon), scrap silver supply will come online and bring the price of silver back to earth.

Outside of demand and supply dynamics, silver used to play a junior role in the monetary system. This means that while the economic cycle affects silver prices (unlike gold), the monetary backdrop also affects prices (like gold).

Put more simply, silver tends to follow gold on its way up or down.

Based on the gold-to-silver ratio, silver is currently cheap.

The chart below shows that one ounce of gold will buy you roughly 88 ounces of silver. The 30-year average is more like 67. 

Gold has recently soared to all-time highs. The expectation is that silver should catch up.

However, the gold-to-silver ratio can be telling us one of 2 things.

1. Silver is cheap (undervalued)
2. Gold is expensive (overvalued)

To correct this discrepancy, gold prices could fall or silver prices could rise or both gold and silver prices could fall (or rise) as long as gold price falls (or rises) faster (or slower) than silver.

Final Thoughts

The key difference between gold and silver boils down to this: gold is viewed as a form of disaster insurance against broad economic collapse. While gold is volatile, it tends to behave differently to any other asset class.  

Silver is slightly different. If gold is going up, silver tends to go up too (often but not always). Depending on the starting point and the economic backdrop, silver may go up faster than gold. But it’s slightly more volatile than gold. 

How to own silver

1. Buy silver: in antique, bullion, or coin form. Unfortunately for UK investors (unlike gold bullion) silver bullion, coins or bars are subject to VAT at 20%
2. Buy an exchange traded product backed by physical silver
3. Buy stocks of silver miners or exchange traded funds that track silver miners

Do you think silver and UK stocks are cheap?