The experts say BUY NOW
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.