The hunt for good-value UK stocks

Imagine, for a moment, that the chancellor’s plans to create the UK Isa have been fast tracked. With little over a week until the end of the tax year, you’ve been granted an additional £5,000 allowance to invest in UK stocks. Would you seize the opportunity and, if so, where might you be tempted to deploy your cash?

The malaise in the UK equities market must be serious when the government is considering the carrot of tax incentives for retail investors, as well as the stick of forcing institutional investors to “buy British”.

Yet as US stock market valuations break record after record, many argue that British companies are looking more bargain basement by the day.

Not so, says Robert Armstrong, author of the FT’s Unhedged newsletter. In an article this week he argues that UK stocks are cheap for a reason.

However, he also laid down a challenge to FT readers. If the UK stock indices are so staggeringly cheap, where are the staggeringly cheap UK companies? Are there really bargains to be had for the shrewd and patient stock picker and, if so, where should they be looking — and what could prove the catalyst for any re-rating?

Takeover targets

With UK stocks trading at about half the forward earnings ratios of US companies, “potential takeover target” was a frequently cited theme in FT Money’s annual stock picking competition. Just under half of readers who entered this year were long on at least one UK-listed stock (see below) believing low valuations will continue to attract predators.

Certainly, the number of live takeover deals at substantial share price premiums would suggest the UK market rout is overdone — at an individual stock level at least.

So far in 2024, the nine takeover deals that have been struck or are in progress were at an average 49 per cent premium to the pre-bid price, calculates Russ Mould, investment director at AJ Bell, a brokerage platform.

“The target companies are from different sectors, are as much domestic as international, have different types of suitors, and some deals are for stock, not cash. But the one thing they all have in common is a downtrodden share price and a very big premium,” he says.

UK paper and packaging group DS Smith entered a bidding war this week, with an approach from International Paper valuing its shares at a 48 per cent premium to the level it was trading at in February before rival Mondi made an approach.

While bids for Direct Line and Currys have fallen away, interest in UK companies from international investors, private equity and trade buyers is expected to continue, offering a short-term fillip for investors holding targeted stocks.

Aside from predatory buyers, the other group who believe UK shares are dramatically undervalued are company boards. Investors point to the huge volumes of share buybacks that companies are undertaking, using their excess cash to buy up and cancel their own shares, which should help to shore up UK equity valuations. Some of the biggest have come from the banks, such as Barclays’ £10bn capital return plan, but this week’s £1bn announcement from Scottish Mortgage shows investment trusts also hope to close the valuation gap.

In the medium term, other supportive factors include falling inflation, the expected turn in the interest rate cycle and the hope that the UK’s economic performance will improve. Fund managers are not fazed by the prospect of a change of government; some even believe Labour’s pro-growth agenda could boost the housing and infrastructure sectors.

Data from the Investment Association shows that UK equities have suffered £14bn worth of outflows since 2016, yet fund managers believe these factors, combined with share buybacks and M&A activity, mean the turning point is getting closer.

“Any change in sentiment towards the UK could have quite a dramatic effect, and share prices could move very quickly,” predicts Simon Gergel, chief investment officer of UK equities at Allianz, and lead manager of the UK-focused Merchants Trust.

Hunting grounds

Although the UK market is geared towards lower-growth sectors, plenty of FT readers who responded to the Unhedged newsletter believe companies in the FTSE 250 index offer better long-term growth prospects than the FTSE 100 — though they require a bit more searching out.

“The more you go into the mid-cap and smaller-sized companies — the more idiosyncratic areas of the UK market — the more value emerges,” says Gergel. “It’s a great market for stock pickers.”

Georgina Brittain, manager of the JPMorgan UK Small Cap Growth & Income trust, notes that in the past, mid-caps have traded at a premium to the FTSE 100 as they are considered more nimble and faster growing. “That premium now is minimal,” she notes, adding that historically, interest rate cuts have proved more positive for the FTSE 250.

She says that valuations on some of the 80 holdings in her fund are getting “close to distress levels — and believe me, that is not what we own”.

Although plenty of internationally facing companies are listed on the FTSE, some believe a London listing is weighing unfairly on share prices.

“People definitely mistake the UK market for the UK economy,” says Alex Wright, manager of the £3bn Fidelity Special Situations fund.

Financials account for 27 per cent of his fund’s weighting (“it’s the best value part of the UK index”) but he stresses that businesses listed in the UK have varying degrees of exposure to the domestic economy. While he holds Barclays and NatWest, he also holds Standard Chartered. The latter trades on a price/earnings (p/e) ratio of 5.8 times, which he argues compares very favourably to US banks such as Citibank, which trade at more than 10 times.

The fund also holds Cairn Homes, the Irish housebuilder with a London listing, which trades on a p/e of 8.7 times, compared with US housebuilders such as Lennar, trading at nearly 11 times. “We believe growth at Cairn will be better as the Irish market is so undersupplied,” he adds. He has recently built a stake in Crest Nicholson, the cheapest UK housebuilder when valued on a price to book basis, predicting that volumes will come back faster than the market expects.

Housing is also a core theme for the Merchants Trust, which owns housebuilders Bellway and Redrow as well as Marshalls, the paving and tiling specialist, and Tyman, the UK-listed international supplier of door and window components. “Tyman has a huge market share in the US, but because it is listed in the UK it trades at a significant discount,” Gergel says.

The trust also has high exposure to the UK’s unloved reinsurance market, via holdings in Lancashire Group and Conduit Reinsurance, which Gergel argues trade on a modest rating compared with their European peers, even though they have been able to push up pricing aggressively as climate change fears increase.

It’s true that the growth prospects in these sectors don’t have the slick appeal of tech. But as Wright points out: “The bigger question for investors is whether the increasing degree of tech outperformance is going to continue.”

Steady income

Dividends are a major attraction of UK shares. As one FT reader comments: “The key is to find the companies that are trading cheaply and handing back their excess capital to shareholders. In some cases you’re going to get nearly the whole investment back in the relatively near future and still own the business.”

This desire is well evidenced in lists of the most popular shares traded on UK investment platforms. “It’s almost a roll call of the old economy,” says Jason Hollands, managing director of wealth manager Evelyn Partners, noting the popularity of banks, financials and oil majors — in stark contrast with the most popular funds, which tend to be passives focused on tech and US markets.

FT columnist Lord Lee, who wrote the playbook on holding a portfolio of dividend payers with takeover potential, has been on the receiving end of more than 60 bids in his investing lifetime. However, he would be loath to lose some of his current crop such as Aviva, M&G and Taylor Wimpey, as they are “such marvellous tax-free income generators within my Isa”.

The ability to generate tax-free income from an Isa portfolio is a huge added attraction for British retirees. However, dividend-paying stocks can also have a growth story attached. One FT reader points out that British American Tobacco looks cheap on a like-for-like basis, compared with Altria in the US, and offers a dividend touching 10 per cent.

Other UK opportunities don’t have a direct US comparator. Fidelity’s Special Situations fund has targeted UK life insurers, seeing growth potential in the bulk annuities market as companies buy out defined benefit pension schemes. Fund manager Wright says Just Retirement has the strongest growth potential but the weakest dividend, whereas Phoenix Life and Aviva yield 11 and 7 per cent respectively.

While the FTSE 100 index has a slightly better yield advantage, Tom Stevenson, investment director at Fidelity, says the FTSE 250 has performed much better over time.

He calculates that when the Isa was first launched in 1999, an investor who placed £100 in the FTSE 100 and reinvested their dividends for 25 years would now be sitting on £288. However, someone who did the same with the FTSE 250 would now have just over £700.

“Smaller companies have more capacity to grow, but this is a reminder of how in the UK market in particular, reinvesting that dividend yield is a major contributor to total returns,” he says, adding that this is important for investors of all ages to grasp.

Smaller horizons

Possibly the most unloved part of the unloved UK market? Smaller companies. As someone who has spent 25 years searching out good value companies, Brittain’s past successes include buying Arm when it was a small-cap stock (the UK chipmaker abandoned the London market last year to relist on Nasdaq).

She advises armchair stock pickers running the rule over UK companies to pay particular attention to three things, starting with levels of free cash flow.

“This metric demonstrates the health of the company. It could use that cash to make an acquisition, buy back its own shares or pay out as a dividend — but crucially, it has that choice,” she says.

To gauge quality, scour company reports to find the company’s return on equity (sometimes called return on invested capital). “The higher the number, the better, although what is considered to be a good number will depend on the industry sector,” she says.

Finally, investors’ antennas should be twitching for indicators of momentum — the chances of a company beating market expectations. “When we meet management teams, we always ask them ‘What is going better than you thought?’ and then it’s our job to work out whether that’s going to be a lever in the long term or the short term,” she adds.

Concluding that UK small-caps are “a fascinating pool to go fishing in”, she cautions that private investors need the time for in-depth research, adding that current levels of liquidity are a serious problem.

Nevertheless, Rosie Carr, editor of Investors’ Chronicle, argues this is the perfect time for buy and hold investors to look at the UK market.

“The best time to buy shares is when they are unloved,” she says, noting that while the broader index may continue to lag behind the Nasdaq, individual shares can still deliver record returns. “Shares in Rolls-Royce delivered a return on a par with those from AI darling Nvidia in 2023, for example. Plus, it’s so important for every portfolio to have diversification across geographies and sectors.”

There are plenty of opportunities outside the US. “London is stuffed full of quality companies offering a real mix to investors, from solidly performing household names such as AstraZeneca, well-run businesses such as Relx, smaller innovators such as hVivo and downtrodden sectors such as consumer discretionary, where popular stocks like Games Workshop are now on reasonable valuations.”

Retail investors can afford to take a longer-term view on the UK’s prospects, and unlike professional managers, don’t have to worry about short-term performance figures.

What’s more, those tempted to start hunting for keenly priced UK shares don’t have to wait another year for the launch of the UK Isa — they can set aside some of their £20,000 allowance to seize the choicest opportunities.