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The ex­perts say BUY NOW

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Bar­gain UK stocks

The broader UK stock mar­ket is very cheap on mul­ti­ple met­rics as a re­sult of in­vestors wor­ry­ing how Brexit will im­pact the UK econ­omy and do­mes­tic earn­ers.

The fear has spread so that many in­vestors are ner­vous about UK eq­ui­ties in gen­eral, even though a lot of the com­pa­nies gen­er­ate their earn­ings over­seas. This sit­u­a­tion presents an op­por­tu­nity to buy some real bar­gains.

Many fund man­agers and in­vest­ment ex­perts say the time to buy is now rather than wait­ing for more cer­tainty over the di­rec­tion of Brexit.

In this ar­ti­cle we look at UK eq­ui­ties in the con­text of other mar­kets and re­veal five stocks cur­rently ex­cit­ing fund man­agers.

WHY THE EX­PERTS ARE BULLISH

‘It might be coun­ter­in­tu­itive to think that the UK mar­ket could be among the top per­form­ers glob­ally in the year that we leave the EU (if in­deed we do). But mar­kets have a way of con­found­ing ex­pec­ta­tions and sur­pris­ing the con­sen­sus,’ says Alex Wright, fund man­ager of in­vest­ment trust

Fidelity Spe­cial Val­ues (FSV).

He is con­fi­dent that clar­i­fi­ca­tion in the re­la­tion­ship be­tween the UK and EU would act as a cat­a­lyst for in­vestors to re­visit the UK eq­uity mar­ket.

Ster­ling be­gan to rise last week on talk that the EU would wave through the draft Brexit deal, and in­deed that was con­firmed on 25 Novem­ber. How­ever, the deal is not yet set in stone.

Get­ting par­lia­men­tary ap­proval is the big hur­dle still to clear and suc­cess would be the real, ma­te­rial cat­a­lyst for in­vestors to take an­other look at the UK mar­ket.

There is no guar­an­tee that MPs will vote in favour of Theresa May’s Brexit plan and fail­ure could cause an­other stock mar­ket wob­ble. In­vestors must there­fore con­sider the neart­erm risk to any UK-re­lated in­vest­ments they make in the run-up to the par­lia­men­tary vote, con­firmed to hap­pen on 11 De­cem­ber.

The price you would pay from wait­ing is the loss of po­ten­tial gains from the mar­ket re­bound­ing upon a smooth Brexit agree­ment.

WHY BUY NOW?

‘One thing I have learned from in­vest­ing in unloved com­pa­nies is that you shouldn’t nec­es­sar­ily wait for good news to be­come ob­vi­ous be­fore in­vest­ing. By in­vest­ing when all the bad news is “in the price” and no good news is ex­pected at all, you put the odds in your favour. I think this is a sit­u­a­tion we are in in the UK at the mo­ment,’ says Wright.

Paul Mum­ford, a fund man­ager at Cavendish As­set Man­age­ment, be­lieves there is a good chance for UK do­mes­tic earn­ers to bounce on the stock mar­ket in 2019.

He is lit­tle sur­prised that ‘Red Oc­to­ber’, the big sell-off in eq­ui­ties last month, took as long to ma­te­ri­alise as it did. His view is that the un­cer­tain­ties cre­ated by long-winded and com­plex Brexit ne­go­ti­a­tions, plus the drop in ster­ling, could have trig­gered some­thing sim­i­lar ear­lier in the year.

The plus side of Oc­to­ber’s mar­ket ad­just­ment is that it has cre­ated a host of good op­por­tu­ni­ties on UK eq­uity mar­kets. ‘There’s great value out there,’ he says, par­tic­u­larly among com­pa­nies with strong UK do­mes­tic earn­ings if the pound strength­ens through 2019.

HOW CHEAP IS THE UK MAR­KET?

At the start of the year we were pay­ing al­most 16 times for­ward earn­ings for the broad UK eq­uity mar­ket (as dic­tated by the FTSE All-Share in­dex), now we’re pay­ing less than 13-times, equiv­a­lent to a 20% dis­count. The same per­cent­age gap is noted on the FTSE 100 and FTSE 250 in­dices.

Ap­prox­i­mately half of the FTSE 250’s con­stituents gen­er­ate their earn­ings from the UK and about one quar­ter of the FTSE 100 is con­sid­ered to be UK do­mes­tic.

In ad­di­tion to Brexit in­vestors have been spooked by ris­ing in­ter­est rates (par­tic­u­larly in the US) and US bond yields ex­ceed­ing 3%. ‘Ris­ing bond yields tend to de­press the mul­ti­ple we are will­ing to pre­scribe to earn­ings, which causes an eq­uity de-rat­ing. They also place pres­sure on stretched bal­anced sheets,’ com­ments Henry Dixon, a fund man­ager at Man GLG.

He says in­vestors should con­sider the cur­rent state of af­fairs with re­gards to earn­ings ex­pec­ta­tions, as they are a ‘cru­cial part of the in­vest­ment game’, namely the fact that up­grades or down­grades are ma­jor share price cat­a­lysts.

The ac­com­pa­ny­ing ta­bles show the earn­ings ex­pec­ta­tions at the start of cer­tain years and then how the mar­ket per­formed over the re­spec­tive 12-month pe­riod.

The first ta­ble shows the years where the mar­ket was most op­ti­mistic – oc­ca­sion­ally re­sult­ing in a neg­a­tive re­turn. The sec­ond ta­ble shows years where the mar­ket was most pes­simistic in terms of earn­ings ex­pec­ta­tions and, low and be­hold, most of the pe­ri­ods had a strong pos­i­tive re­turn.

‘The mar­ket is look­ing for 5% to 6% earn­ings growth in 2019 from UK eq­ui­ties which is the low­est data point we’ve had over the past 30 years,’ says Dixon. As you can see from the his­tor­i­cal ex­am­ples be­low, low ex­pec­ta­tions could lead to de­cent re­turns as­sum­ing Brexit doesn’t get messy.

LOWER VAL­U­A­TIONS VER­SUS FOR­EIGN PEERS

An­other way of mea­sur­ing the level of cheap­ness

in the UK mar­ket is to com­pare big Lon­don-listed stocks with their over­seas coun­ter­parts. Here are some ex­am­ples:

• Con­struc­tion group CRH (CRH) is trad­ing on 11.4 times 2019 fore­cast earn­ings ver­sus New York-listed Vul­can Ma­te­ri­als which is on 21-times.

• Aerospace en­gi­neer Meg­gitt (MGGT) is trad­ing on 13.9 times 2019 fore­cast earn­ings ver­sus New York-listed United Tech­nolo­gies which is on 16.2-times.

• Bank­ing group Lloyds (LLOY) is trad­ing on 7.2 times 2019 fore­cast earn­ings ver­sus Euronextlisted KBC which is on 10.6-times. • In­sur­ance and as­set man­age­ment group Aviva

(AV.) is trad­ing on 6.9 times 2019 fore­cast earn­ings ver­sus Xe­tra-listed Al­lianz which is on 9.8-times.

‘The FTSE All-Share PE (price-to-earn­ings ra­tio) is trad­ing at an ap­prox­i­mate 15% dis­count to the FTSE World in­dex PE. That is cheaper than dur­ing the fi­nan­cial cri­sis a decade ago, and you would have to go back to the late 1980s and then to the mid1970s to find sim­i­lar sit­u­a­tions,’ says Dixon.

LOW AP­PETITE FOR UK STOCKS

Bank of Amer­ica Mer­rill Lynch asks fund man­agers around the world every month how they are po­si­tion­ing their port­fo­lios and UK stocks have been con­sis­tently out of favour for a long time.

The lat­est sur­vey finds that 27% of fund man­agers are un­der­weight UK as­sets as the ap­proach­ing Brexit dead­line ‘stokes re­newed uncer­tainty’. Un­der­weight means hold­ing a smaller amount of cer­tain as­sets com­pared to their weight­ing in a bench­mark in­dex.

‘In­vestors know that UK-fo­cused stocks are cheap (many on sin­gle-digit PEs) and they are un­der­weight. With growth else­where slow­ing down and GBP sta­bil­is­ing they are look­ing to re­duce that un­der­weight slowly,’ says Steve Davies, fund man­ager at in­vest­ment trust Jupiter UK Growth (JUKG)

WHAT COULD HAP­PEN NEXT?

It seems fair to sug­gest that Theresa May’s Brexit plan may not be ap­proved first time by par­lia­ment, thus re­quir­ing re­vi­sions. Such news could cause a stock mar­ket wob­ble but we don’t be­lieve it would cause long-last­ing pain for in­vestors.

No-one knows for sure at the mo­ment so in­vestors must take on board the risk that buy­ing UK stocks could re­sult in a loss be­fore a gain.

In­vestors must also con­sider a far worse out­come. ‘I don’t think a hard Brexit out­come is an im­pos­si­bil­ity,’ says Oliver Brown, fund man­ager at MFM UK

Pri­mary Op­por­tu­ni­ties (B8HGN52). ‘The ram­i­fi­ca­tions are un­known for the UK in terms of trad­ing agree­ments, so a hard Brexit could cause a sharp de-rat­ing in UK stocks. As such, it feels a roll of the dice with some eq­ui­ties at present.’

A Brexit deal ap­proved with­out a ma­jor hitch may trig­ger a rally in the pound which would be neg­a­tive for the FTSE 100’s large num­ber of over­seas earn­ers as their share prices are ster­ling­de­nom­i­nated.

You must also con­sider that the Brexit deal could lead to a rise in in­fla­tion if the terms re­sult in it be­ing more ex­pen­sive to buy goods from abroad. That could prompt the Bank of Eng­land to raise in­ter­est rates which the­o­ret­i­cally would be neg­a­tive for eq­ui­ties.

There are so many vari­ables that in­vestors should not con­sider buy­ing UK eq­ui­ties to­day to be an easy win. Our view is that you should em­brace the cur­rent state of fear to buy de­cent busi­nesses as long-term hold­ings. There may be bumps along the way, but that al­ways comes with the ter­ri­tory of in­vest­ing.

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