London Calling: Investing in the United Kingdom

08/10/2020 5:00 am EST


Gavin Graham

Chief Strategy Officer, INTEGRIS Pension Management Ltd

iShares MSCI United Kingdom ETF (EWU) tracks the FTSE100 Index of the largest companies in the U.K.; it has had a torrid time since we first recommended the fund nine months ago, asserts Gavin Graham, contributing editor to The Income Investor.

The ETF initially rose to over US$34 as uncertainty that had dogged the British economy since the Brexit referendum in 2016 was dispelled. The share price then plummeted during the pandemic-triggered selloff in March and has not rebounded as much as the North American indexes.

In part, this is due to the composition of the index, which has very little (5%) in technology and utilities, which were the best-performing sectors through the March selloff.

Instead, the UK ETF had its largest weight in financials (17.9%), which were told by the U.K. government to suspend their dividends for this year to preserve capital. It has 30% in economically sensitive energy, industrials, and materials (10% in each sector).

The U.K.’s open globally linked economy is also seen as being especially vulnerable to the rise of trade barriers and the inevitable additional difficulties of international travel and business after the pandemic fades. Given these negatives, it’s unsurprising that the ETF is down 18% from last fall (down 15% including income).

However, the U.K. does have some strengths. The top two holdings in the ETF are world-class pharmaceutical companies AstraZeneca at 8% and GlaxoSmithKline, at 5.4% — both of which are involved in developing therapies and vaccines to counter COVID-19. Pharmaceuticals and healthcare comprise 14.5% of the index.

Meanwhile, defensive stalwarts like consumer staples, such as food and beverage and personal care, are the largest sector, making up 18.9%. Drinks giant Diageo (4.3%), British American Tobacco (4.1%), and personal care and food groups Reckitt Benckiser (3.4%) and Unilever (3.3%) are amongst the top 10 holdings.

The remaining members of the top 10 are energy with BP (4%) now remarkably larger than Shell (3.4%), HSBC (5%), and Rio Tinto in materials (3.7%).

While the performance has been disappointing, and the forward yield probably closer to 2.5% as a consequence of the cuts and suspensions, the original reason for the recommendation remains. The U.K.’s largest companies get over 70% of their revenues from exports or overseas subsidiaries and are therefore not particularly exposed to the domestic U.K. economy.

They are natural hedges against the weakness of sterling with foreign currency earnings and are world class global companies that just happen to be headquartered in the U.K. 

Finally, their underperformance since the Brexit referendum means that they sell at a major discount to the U.S. and European markets, even after the 50% reduction in dividends for 2020.

The ETF remains a Buy for its low valuation, reasonable yield, and exposure to world-class companies, many of them in attractive post-COVID-19 sectors, such as healthcare and consumer staples. Should the world economy recover from the effects of coronavirus by 2021, the economically sensitive sectors in the U.K. index should benefit more than most.

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