The undervalued UK market is poised for a comeback
British shares are cheap, raising the possibility that there is profit to be made by far-sighted investors
Acontrarian investor understands that “actual risk is the inverse of perceived risk”. This adage expresses one of the key differences between being successful in the markets and in the rest of our lives. In most situations, if something looks dangerous, it’s because it is. For investors, however, it’s a prompt to take a closer look.
No one would deny that things look risky in the UK right now. We may have put late September and the mini-budget behind us, but we sit between the rock of last week’s gloomy Bank of England rate-setting meeting and the hard place of next week’s Autumn Statement. Monetary and fiscal policy are now pulling in the same direction, and both point to a challenging road ahead.
The biggest interest rate hike in more than 30 years captured the headlines but it was the predicted 1.4pc fall in GDP next year that should worry us more and the fact that the downturn could continue for a couple of years. This will be a painful, grinding slowdown that will chip away at investor confidence.
The silver lining may be that the cost of borrowing peaks at a slightly lower level than feared but the Bank is still in the unenviable position of being forced to tighten policy even as we head into an inevitable recession.
However, we may, in fact, already be there. The risk is that both the Bank and the Government are tempted to overdo it to restore tarnished credibility.
Both the Halifax and Nationwide housing surveys now point to falling house prices. Outside of the pandemic we are already experiencing the largest fall since 2011. With nearly half of fixed rate mortgages coming up for renewal over the next couple of years, a further correction in prices is unavoidable.
Next week’s Autumn Statement will attempt to fill a gaping hole in the public finances. How to split the near £60bn bill between spending cuts and tax rises is a political rather than an economic decision but from a market perspective it might make little difference. The size of the shortfall means the cost will have to be borne well down the income scale, where it feeds most directly into slower activity.
Of course, all this bad news has been reflected in real investment behaviour for some time now.
Cumulative flows into UK equity funds are more negative with a month to go than in any of the last 10 years. And while global investors’ net purchases of UK shares are just about in positive territory over the 15 years since the financial crisis, that’s all about flows into passive funds which track the internationally focused FTSE 100. Active funds, which focus more on domestic stocks, are deeply out of favour. In terms of valuations, too, you could argue that plenty of the pain has already been felt. The valuation of the FTSE 250 index has only been lower than it is today in one year out of every 10 during the past three decades. The same mid-cap index stands at a 30pc valuation discount to the MSCI World index. Putting your money into the FTSE 100 at the low point of the 2009 bear market would have seen it double over the past 13 years; but the same amount in the S&P 500 would have grown five-fold.
That underperformance means you now have to pay just nine times expected earnings for the average share in the FTSE 100 and 11 in the FTSE 250. That compares with 17 times for the average US share. Such is the level of anxiety about the UK that you can earn a 4.5pc dividend yield here, compared with just 1.8pc in America.
So British shares are cheap. But do they deserve to be so? That depends on where you are looking.
The coming recession is going to hit different parts of the market in different ways. Some areas, most obviously leisure and retail, are likely to be hit hard. There is vast oversupply in these sectors and reducing it will be extremely painful. Just as there was no need to rush back into technology stocks in 2003 or banks after 2009, there might be no reason to look at these businesses for years to come.
But there are four parts of the market where investors can find high-quality businesses at attractive prices. The first group includes high-quality growth companies that have been out of favour as interest rate-sensitive value stocks have enjoyed one of their periodic moments in the sun. Aveva, a provider of software to the engineering sector, is often mentioned by growth-focused UK fund managers.
The second group holds defensive stocks that have been sold off on widespread fears about the ability of companies to pass on rising costs. Cranswick, a meat processor, with an enviable reputation as a large, trusted supplier to the big supermarkets, and pricing power to match, is a favourite.
The third group offers investors access to high-quality domestic companies whose valuations have been dragged down by the gloomy UK outlook. This is where uncertainty hits a share’s price without having any meaningful impact on the long-term value of the company. As Warren Buffett said: price is what you pay, value is what you get.
The final group benefits from the tendency to trade down in a recession.
As Michael O’leary, Ryanair’s chief executive, pointed out earlier this week, people don’t change their habits in a slowdown, they just become more price aware, whether they are flying on holiday or doing the weekly shop.
It may be counter-intuitive, but when the perceived risk is as high as it is today in the UK, the actual risk may be surprisingly low.