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Why are FTSE 100 stocks still potentially undervalued?

The London Stock Exchange sign on a glass window

The UK stock market was one of the hardest hit during the coronavirus outbreak in 2020. Despite the FTSE 100’s recovery so far this year, some stocks are still trading at a significant discount.

The FTSE 100 continues to claw back last year’s losses, when it fell 14.3%. The UK’s successful Covid-19 vaccination rollout, stronger economic performance, higher oil prices and the easing of lockdown restrictions have helped the index’s value climb 4.55% in the year to date, despite having slipped lower in recent days.

However, a plethora of undervalued stocks remain in the index, attracting M&A interest from private equity groups looking for opportunities in the post-pandemic era.

Are UK stocks a potential bargain?

Market sentiment towards the FTSE 100 has improved so far this year, as Brexit and Covid-19 economic concerns fade. Roland Arnold, a fund manager at BlackRock, has said that investors are now equal weight on the UK market for the first time in five years, having previously been underweight.

However, the UK stock market remains at a significant discount to others. According to broker Peel Hunt, its 12-month forward P/E is 40% cheaper than the US market and 25% cheaper than the eurozone. Pitchbook states that S&P 500 firms typically trade at 23 times earnings, compared with just 14 times in London.

One of the main drags for the FTSE 100 has been investors’ fears over the economic impact of the UK leaving the European Union. Another factor is the amount of old-economy FTSE 100 companies, such as BP, that are on the wrong side of the new carbon economy. The London benchmark index also suffers from a lack of high growth stocks.

Private equity targets FTSE 100 stocks

These low valuations are attracting the attention of global private equity firms armed with record dry powder of $1.9tn as investors seek high returns. A low interest-rate environment and new opportunities as societies reopen have been other drivers.

According to Dealogic, the first half of 2021 in the UK saw 124 takeovers and acquisitions of minority stakes by private equity firms, totalling £41.5bn in value. For London-listed firms, there have been 21 announced and possible bids to a value of £24.4bn. These include the AA and John Laing Group [JLG].

“This is not surprising, given the deep pockets of private equity, combined with improving market dynamics and the relatively low valuations of UK assets,” Charles Hall, head of research at Peel Hunt, wrote in a note to clients.

The big buy: Morrisons share price  

One of the most high-profile FTSE 100 private equity deals this year has been the proposed £6.3bn takeover of supermarket Morrisons [MRW] by Fortress Investment Group. Morrisons’ share price rallied 48.6% in the month to 15 July, climbing to 262.60p.

Despite strong sales during the pandemic, Morrisons has been hit by rising costs, such as more online deliveries and staff bonuses. Indeed it's expected to post a £342m net profit this year, half of what was achieved 10 years ago.

Discounted FTSE 100 stocks

Other undervalued UK stocks that could be potential targets include retailers Tesco [TSCO] and Kingfisher [KGF]. Tesco’s share price has dropped from 301.72p at the close on 5 January to 231.20p at Monday 19 July's close. The group had a price-to-earnings (P/E) ratio of 27.08 as of 16 July.

Meanwhile, the Kingfisher share price has climbed from 284.40p at the close on 5 January to 356.70p on 19 July. It had a P/E ratio of 13.15 as of 16 July.

Will the M&A frenzy continue?

Some analysts expect there will be more deal activity ahead targeting the FTSE 100's constituents. According to data firm Preqin, global private equity firms control companies worth £3.6tn. The value of all the firms on the FTSE 100, it says, is £2tn.

KKR said recently that it’s stepping up its UK operations in the hunt for cheap deals. In addition, Bridgepoint is planning to list its own shares in London in an IPO to raise £300m and seal more deals in areas such as real estate and infrastructure.

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