Is the weak pound making UK stocks a bargain for foreign investors?

Sterling has weakened against all major currencies in 2022. Amid the unrivalled strength of the US dollar this year, the pound has slipped over 16% against the greenback in 2022 and at one point sank to its lowest level since 1985 in the wake of the disastrous UK ‘mini’ budget last month, when it also dropped to two-year lows against the euro.

The pound, which, like other currencies, is a gauge of how the world view’s a country’s strength and prospects, has rebounded recently but could struggle to recoup its losses anytime soon. A poll of 35 analysts conducted by Reuters this week showed just under half believe sterling could reach parity with the dollar for the first-time ever before the end of this year. 

UK M&A: Will a weaker pound spur on foreign takeovers?

One consequence of a weaker currency is that it can make a country a bargain for foreign investors. A US company, for example, scouring the UK for a target can get much more bang for its buck because the dollar has strengthened so much against the pound. Stock markets have also plunged in value amid the global selloff this year, enhancing the appeal as this as it means the valuations on offer are also more attractive. The fact many companies in the FTSE 350 make their money outside the UK is a bonus as this means there are plenty earning money in dollars (or other currencies) but seeing their valuation in sterling slide.

The FTSE 100 is down over 6% in 2022, which is relatively mild considering the Nasdaq 100, S&P 500, DAX and CAC 40 have all plunged in the region of 16% to 26% this year. However, while US indices are already back above where they sat before the pandemic started, European peers are back below pre-pandemic levels, including the UK’s blue-chip index which is still worth over 5% less now than back in early 2020. The more domestically-focused FTSE 250 has plunged over 26% this year and remains over a fifth less valuable than it did before the Covid-19 crisis started.

Read more: A guide to trading stock market corrections

The FTSE 100 trades at a PE ratio of 13.5x based on earnings delivered over the last 12 months, according to data from Bloomberg. That is down starkly from the two-year average PE ratio for the index of 53.7x, although this reflects inflated valuations during the recovery from the pandemic. Still, Britain is a bargain right now considering the 10-year average sits more than double current levels at 31.8x. The FTSE 250 has experienced an even greater fall this year from even more bloated valuations.

Read more: Understanding the PE ratio and how to use it

‘M&A is being driven by UK companies being bid for by overseas companies getting the double benefit of weakened sterling and lowly valued equity markets,’ said Ross Mitchinson, one of the chief executives of stockbroker and corporate adviser Numis, in late September.

With this in mind, data from the Office for National Statistics shows overseas companies spent over £27 billion on acquiring UK businesses in the first half of 2022. That was almost four times the £7.1 billion spent by British businesses buying foreign companies. As a result, a number of big names have disappeared from exchanges this year and more are set to follow before 2022 is out.

HomeServe, the home warranty and repairs giant, is set to be one of the most notable departures from the stock exchange this year once its takeover by a Canadian investment group is completed. Power plant operator ContourGlobal is being bought by US investment giant KKR, while waste management firm Biffa will also de-list after its takeover by an American private equity firm completes. Elsewhere, Ted Baker is now owned by the same US company that owns Reebok, while healthcare software maker EMIS is about to be taken over by American giant UnitedHealth. 

AVEVA, one of only a handful of tech stocks left listed in the UK, has become the latest to be targeted after French outfit Schneider Electric launched a £9.5 billion bid for the industrial software giant.

UK M&A: Lessons from Brexit

The chasm between the rate of inward and outward M&A in the UK has widened this year, but the trend is not new. Foreign companies have been much more active in UK markets than British businesses have been overseas for years but there is no doubt that a weaker pound has been a factor.

For example, GBP/USD traded just under $1.50 before the Brexit referendum back in June 2016 – a level that has not reappeared on the radar since the UK voted to leave the European Union – and has gradually lost ground to today trade closer to $1.12.

That has had some major consequences. Foreign companies have spent a whopping £527 billion on UK companies since the Brexit vote, according to ONS numbers, almost 2.5 times the sum spent by British businesses overseas.

That has seen the UK lose some of its biggest and brightest businesses and cede control to investors outside the country. Japan’s Softbank launched its controversial £24 billion bid for semiconductor kingpin ARM just months after the referendum caused the pound to freefall. Many still believe that sale was a mistake considering Softbank is considering listing ARM again at a valuation that could be over three times what it paid for it. One of ARM’s founders, Herman Hauser, said at the time that the takeover of his company was ‘sadly one of the unintended consequences of Brexit’, showing how conditions like this can put companies in a difficult position. Others also boasted about the opportunities provided by the weaker pound in the wake of the referendum result. The president of French firm Vinci, which bought a controlling stake in Gatwick Airport in late 2018, said he ‘would not even have dreamed’ of being able to buy such a prized asset for so cheap when the bid was launched because of the fall in the pound.

A recent report from Schroders adds further colour and suggests the UK has been bleeding companies to foreign buyers for an even longer period. It said 126 companies worth £441 billion have left the London Stock Exchange since 2011 and that around half of all UK businesses to sell up in the last decade have been bought by overseas bidders, mostly in the US and Canada. That, the investment manager says, is alarmingly high considering the US M&A market is driven more by domestic deals (US firms buying other American companies) and that European counterparts in Germany and France typically see foreign takeovers account for 25% to 30% of all deals.

What does this mean for UK markets and the economy?

There are reasons to cheer heightened interest in UK companies. It suggests the UK is constantly producing quality companies that boast appeal around the world and sends a signal that there is still a high level of confidence behind the country’s prospects. These takeovers see foreign investors inject cash into British businesses (and therefore the economy). There is an argument that some sectors, such as the UK steel industry, would have collapsed altogether without foreign investment.

However, it also has its drawbacks. Foreign owners can take profits and decision-making abilities outside of the country, which is a particular concern for those working in vitally important industries such as technology or healthcare. There are also concerns about where the foreign money comes from, with UK ministers having revamped the rules on foreign takeovers just this year amid fears about the growing interest in British businesses from Chinese buyers.

For the stock exchange, it poses a different problem. The rampant interest from overseas means more British businesses are de-listing.

That wouldn’t be such a big problem if there was a steady flow of new companies signing up to go public to replace them, but the IPO market has dried up this year as businesses delay or cancel their listing plans amid the highly uncertain environment. New companies have raised just £574 million in the UK during the last nine months, according to data from Dealogic, marking the biggest lull in the IPO market since the financial crisis in 2008.

Read more: What is an IPO and how do they work?

It is worth noting this is a global problem and not contained to the UK. The US IPO market is experiencing its quietest period since 2003, according to EY, and the explosion in popularity of Special Purpose Acquisition Vehicles, or SPACs, is also unwinding as it becomes harder for them to find a suitable target to buy.

Read more: What is a SPAC and how do they work?

The IPO market is likely to remain quiet for the rest of this year and possibly into 2023 depending on how market conditions fare, but the poor performance seen from the biggest names to have gone public before the turmoil hit markets this year, such as food delivery firm Deliveroo, DNA sequencing firm Oxford Nanopore, semiconductor firm Alphawave, boot maker Dr Martens and online card seller Moonpig, have demonstrated that now is not the best time to become a publicly-listed company. However, the lengthy pause in activity could mean there will be a flood of new entrants ready to launch IPOs once conditions improve.

The stark imbalance between the number of companies being lost to foreign buyers and new listings is ultimately weakening London’s position as a global financial hub and the action of short-term opportunists could have long-term consequences for the UK economy. The UK tightened its rules and ability to intervene in foreign takeovers this year as it looks to safeguard key areas, but it has not flexed much muscle since then. For example, it added transport as a new sector it wanted to protect but we have seen foreign firms pounce on the weakness of UK travel stocks this year with overseas buyers snapping-up train operator Go-Ahead Group and bus company Stagecoach, the latter of which opted for a German bidder after turning down an opportunity to merge with domestic rival National Express.

Will foreign firms continue to target UK stocks?

There is growing anticipation that there could be a new wave of foreign takeovers heading for the UK because of current market conditions. However, the number of overseas takeovers this year is still down compared to the rush of foreign buyers that pounced on the market after the Brexit vote. This is partly because businesses are in a far more cautious mood and coping with tighter financing conditions. Companies are dealing with a clouded and uncertain outlook that makes it more difficult to make big M&A decisions. Plus, their ability to fund deals is much harder as the slump in valuations rules out the option of raising equity while the cost of debt is also spiralling higher as interest rates rise. That means appetite among buyers may be more limited even if valuations look attractive, especially if they don’t have deep pockets to dip into, and raises the likelihood that any deals will need to be funded with stock over cash.

Read more: What stocks perform well when interest rates are rising?

What UK stocks are contenders for a foreign takeover?

Like at any other time, foreign companies are looking for businesses that can help them expand and improve their financial performance. The difference now is that they have the opportunity to buy at much lower valuations than what has been on offer in recent years.

In light of the weakness in sterling, the top contenders are likely to be those that earn the most overseas as earnings can get a boost when translated into a weaker pound. Over 75% of the FTSE 100’s revenue comes from abroad, driven by the large weightings given to energy and mining stocks that sell commodities in dollars. The balance between domestic and overseas revenue is more balanced for the FTSE 250, but the fact so many UK companies offer global exposure should make them appealing to foreign buyers in the current environment.

With this in mind, those with the greatest exposure to overseas earnings could be worth watching. For example, analytics firm RELX and safety equipment outfit Halma both make over 80% of their sales outside the UK. Distributor Bunzl, medical device maker Smith & Nephew, pharmaceutical firm Indivior and industrial specialists like engineer Spirax-Sarco and material maker Morgan Advanced Materials all make an even bigger proportion of their sales abroad.

Currency exposure isn’t everything. Foreign buyers also look to the UK for other reasons, such as buying a company to break into a new geographical market, get their hands on lucrative assets, generate efficiencies and savings, or because they believe something is too cheap to ignore.

For example, the UK telecom sector looks prime for a shake-up. Vodafone revealed just this week that it is in talks with CK Hutchinson about merging their businesses in Britain amid a wave of consolidation across the European telecoms sector. Vodafone and Hutchinson’s Three are the third and fourth largest networks in the UK, respectively, but together boast around 27 million mobile customers. Sky News said a deal could be agreed before the end of 2022. That comes after investment vehicle Atlas Investissement, run by French titan Xavier Niel, bought a 2.5% stake in Vodafone this year and signalled it is looking to shake-up things. That comes amid reports this week that Virgin Media O2 has considered launching a takeover of TalkTalk. Meanwhile, BT Group’s largest shareholder, investment group Altice, owned by French billionaire Patrick Drahi, increased its stake in the company to 18% last year from 12% the year before, fuelling speculation something larger could be at play.

How to trade UK stocks

You can trade UK stocks with City Index in just four easy steps:

1. Open a City Index account, or log-in if you’re already a customer.
2. Search for the stock you want in our award-winning platform
3. Choose your position and size, and your stop and limit levels
4. Place the trade

Or you can try out your trading strategy risk-free by signing up for our Demo Trading Account.