December 11, 2020

Countdown to Brexit: U.K. Earnings Growth in 2021?

by Tajinder Dhillon.

The Brexit transition period will end on December 31, 2020.  This deadline may have taken a backseat throughout most of the year due to COVID-19.  The duopoly of COVID-19 and fears of a no-deal Brexit has caused the FTSE 350 index to fall 14.3% year-to-date, making it one of the worst performers globally.

However, the outlook for 2021 will certainly be somewhat improved irrespective of a Brexit deal as Britain has begun inoculating its population with a COVID-19 vaccine.  Britain was the first country to approve a COVID-19 vaccine and has ordered 40 million doses from Pfizer.

In the United States, we saw a sharp rotation into value since late October, as hopes of a vaccine would provide some form of normalcy in 2021 and a gradual re-opening of the global economy.  We saw a similar picture in the U.K.  Since September 30th, the FTSE UK Value Index has gained 16.1% compared to a decline of 2.3% in the FTSE UK Growth Index.

Looking at U.K. earnings data for 2021 shows that value, cyclical, and small-cap are expected to outperform on a relative basis.

According to Refinitiv I/B/E/S data, 2021 year-over-year (YoY) earnings growth for the FTSE 350 is expected to be 51.1%.   Looking in more detail, cyclical sectors including Industrials (5,708.3%), Energy (907.0%) and Consumer Discretionary (135.4%) have the highest expected YoY earnings growth rate in 2021.  In contrast, Technology (6.3%) has one of the lowest expected YoY growth rates.  The Energy sector would be a source of value, as it is the worst performing sector year-to-date, falling 43.6% while at the same time providing the second highest dividend yield of 6.6%.

We also find that small-cap is expected to outperform large-cap in 2021 as shown in Exhibit 1.  The FTSE 250 YoY earnings growth rate is expected to be 94.9% in comparison to a 46.2% YoY growth rate for the FTSE 100.  The FTSE 250 growth rate sharply accelerated during the U.K. recession which lasted from May through July.

Exhibit 1: U.K. 2021 EPS Growth Rates

A rotation into value will bode well for U.K. index performance in 2021 given the large tilt towards value-oriented sectors as shown in Exhibit 2.  Using Refinitiv Datastream, we determine that 56% of FTSE 350 index is comprised of value-oriented sectors including Financials, Consumer Staples, Industrials, and Energy.  Growth sectors like Technology and Communication Services have a small weight in the FTSE 350 index, having a combined weight of 5.9%.  For comparison, these two sectors have a 37.9% weight in the U.S. Russell 1000 index.

Looking at valuation levels, the forward P/E on the FTSE 350 index is trading at 15.6x compared to a forward P/E of 23.2x for the Russell 1000 index.  This results in a significant P/E discount of 32.9% vs. the Russell 1000 which nears a 12-year low.  The impact of the Brexit vote (June 2016) has caused the FTSE 350 to underperform the Russell 1000 on an annual basis since 2017, providing a deep area of value.

Exhibit 2: FTSE 350 Index Composition

Combining expected growth rates alongside sell-side analyst sentiment can be a powerful method to paint an overall picture of where growth will come from in 2021.  Using the Aggregates app in Refinitiv Eikon, we can load any index or portfolio and utilize the vast data library to create a customized table.  In Exhibit 3, we are looking at the FTSE 350 broken down by sector and ranked from highest to lowest based on the StarMine Analyst Revision Model (ARM).

ARM Scores are ranked on a percentile basis from 1-100 (100 being most bullish).  Value and cyclical sectors have the highest analyst sentiment.  Materials has the highest ARM score (82) followed by Energy (66) and Financials (58).

Exhibit 3: FTSE 350 Aggregates App


Source: Refinitiv Eikon.

Materials also has the highest change in the aggregate 2021 EPS estimate.  The FY2 (2021) mean estimate percent change has increased by 16.3% over the last 90 days.  The app allows users to drill-down into any of the figures to provide constituent-level data.  When doing this, we find companies Rio Tinto PLC, Glencore PLC, Anglo American PLC, and BHP Group PLC with the largest upward revisions.  This can be attributed to a strong price environment in base metals such as iron ore and copper.

Value sectors such as Materials, Energy, and Financials also provide high levels of free cash flow (FCF).  Energy has the largest FCF yield at 10.6% followed by Financials at 10.1%.  Financials are trading at a 16.7% discount relative to the broader index on a forward P/E basis (12.9x vs. 15.6x) and U.K. banks will be allowed to pay dividends again in 2021 (under strict guidelines) which will be a positive for the sector.

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