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UK stocks: contrarian opportunity or value trap?

Sentiment has turned negative – is this justified or should investors sense an opening?
June 7, 2018

UK investors have been shunning their home market ever since the vote to leave the European Union (EU). More than £1.8bn flowed out of funds in the Investment Association UK All Companies sector in 2017 and outflows have continued this year. International investors also remain wary. A recent Bank of America Merrill Lynch survey of 176 global portfolio managers ranked UK equities the least attractive asset class in the world. But could the doom and gloom present a contrarian and value opportunity?

The sentiment is understandable. Investors are wary, particularly of those domestic-focused stocks that would be worse affected by dampening economic growth and confidence from a bad Brexit. These stocks also tend to trade only in sterling, so unlike many FTSE 100 international companies have not even benefited from the revenue boost created by a weaker pound.

Tim Stubbs, consultant at TS Investments, says: “Many UK domestic stocks are priced for very bad news. Based on their share prices, as one fund manager I met said ‘they’ve already had their Brexit’. So if anything less bad [than the market expects] takes place, the shares would have to rise as expectations are so negative. And even if there’s a bad outcome the downside is lower than it otherwise might have been.”

Many of these UK-focused companies have actually performed well in terms of profit generation and fundamentals, but their share prices are just hindered by this poor sentiment. As a result, there are plenty that think the stocks remained artificially undervalued and eventually could re-rate.

"For contrarians, the unfashionable status of UK shares could throw up some interesting event-driven opportunities", says Jason Hollands, managing director of Tilney Group.

He adds: "A more upbeat outlook for the oil and gas sector is also supportive for UK equities, as these account for almost 13 per cent of the FTSE All-Share Index, and so there are plenty of reasons why the market could surprise on the upside and potentially re-rate if a sensible accommodation is reached between the UK and EU on trade.”

John Chatfeild-Roberts, head of strategy, independent funds at Jupiter, believes the UK market is moving towards offering more of these value-driven opportunities over typical growth investing – where investors buy companies that are expected to expand and thus see the share price rise as well.

“Value is often found in stocks that are particularly hated,” he says. “[In the UK] the thing people hate now is the high street. A couple of years ago, everybody hated oil and commodities, but today the oil price has virtually quadrupled from where it was two years ago.”

Alongside the retail sector, energy and pharmaceuticals also look cheap he adds.

Meanwhile Hugh Sergeant, manager of River and Mercantile UK Equity Long Term Recovery Fund (GB00B614J053), thinks the best value remains in banks. His fund has positions in HSBC (HSBA), Lloyds (LLOY), Standard Chartered (STAN) and Barclays (BARC).

 

Political pitfalls

Thus it seems simple – the UK is cheap and the potential for a re-rating is good, so investors should consider weighting towards UK-domestic companies with good fundamentals to find returns. But value investing is rarely that easy. While value-style investing can do well, there is always the risk you or your fund manager could end up buying stocks that are cheap for a reason – so-called value traps.

There is also the wider UK market to consider as this will affect all stocks. International stocks in the FTSE 100 may not have as depressed valuations are their domestic counterparts, but their outlook should be considered in the context of the entire UK market.

Mr Hollands says that although the UK looks cheap compared to other markets, it is not cheap on an absolute basis. In fact, the market is trading at fair value viewed on a cyclical adjusted/price earnings (CAPE) ratio basis.

According to John Husselbee, head of multi-asset at Liontrust, other areas of the world offer better value opportunities than the UK.

He says: “UK equities make up 6.6 per cent of MSCI World Index and in global economy terms the UK represents 3.4 per cent, so although we are living here and understandably focused on UK news, the UK represents a small amount of opportunities globally. There’s only been a few occasions in the past 20 years where UK equities have been the best performing region.”

Investors also need to consider the the UK's exit negotiations with the EU – the main reason behind depressed sentiment and valuations – and any follow-on political effects. The economy faces several potential pitfalls over the impact the final deal or a possible no-deal outcome could have.

It is far from clear how the FTSE 100 would react to the potential outcome of the EU and UK’s negotiation as the market consists primarily of international companies, which earn most of their revenues overseas. Any agreement perceived to be good for future trade could increase the value of sterling, negatively affecting foreign currency revenues.

“I’m not quite sure a negotiation outcome that [was perceived favourably by the market as a] softer Brexit would accelerate the [value] of the FTSE 100, given its international make-up,” says Mr Husselbee.

In addition, he suggests that if Labour came to power in the wake of a negotiation outcome that was perceived to be a bad deal, markets could suffer a double whammy of weaker sterling and a weaker FTSE 100 as the party's policies could be viewed as bad for large businesses.

Given the potential risks, seeking exposure to any potential contrarian opportunity in UK stocks is only suitable for investors with a high risk appetite and an investment horizon of at least five years.

 

Funds seeking value in the UK

To get exposure to this UK value theme, Peter Walls, manager of Unicorn Mastertrust (GB0031218018), recently bought Aberforth Smaller Companies Trust (ASL). This investment trust aims to beat the Numis Smaller Companies Index over the long term by investing in small, UK-quoted companies that represent relatively attractive value. “The ratings of the companies in the underlying portfolio are at quite a big discount to the overall market and to growth stocks in particular so they offer fundamentally better value,” says Mr Walls. The trust has an active share (a measure of how different a fund is compared to its index) of 75 per cent, with overweight positions in industrial and consumer stocks. It has a total of 87 positions and an ongoing charge figure (OCF) of 0.76 per cent. As of 31 May, it was trading at a discount to net asset value (NAV) of 8.7 per cent, among the tightest it has been over the past three years.

Another trust Mr Walls likes is Fidelity Special Values (FSV), managed by highly regarded value manager Alex Wright. Although value-style investing has been out of favour for most of the past decade Mr Wright has delivered a cumulative return of 453.2 per cent against 155.5 per cent for a composite of his peer group over 10 years, according to FE Analytics. And over one and five years, Fidelity Special Values is among the best performing in the Association of Investment Companies (AIC) UK All Companies sector.

The trust has high weightings in financials, industrials and consumer services stocks. It has an OCF of 1.06 per cent. But as of 31 May it is trading on a premium to NAV of 3.2 per cent, one of the few times it has done so over the past five years. However, Mr Wright also runs an open-ended fund using a similar process: Fidelity Special Situations Fund (GB00B88V3X40). It has an OCF of 0.93 per cent.

Mr Hollands’ firm has been adding Jupiter UK Special Situations (GB00B4KL9F89) in expectation that value-style investing will be back in favour. Managed by Ben Whitmore, this fund looks to buy stocks that are out of fashion. To identify value stocks, Mr Whitmore conducts fundamental research such as analysing their 10-year average earnings as he believes this to be a more reliable indicator of a company’s true value than just looking at short-term earnings or forecast future earnings. He aims to avoid value traps by steering clear of businesses with weak balance sheets and poor competitive positions. The portfolio is relatively concentrated with 37 holdings, and financials and consumer services stocks make up more than 50 per cent of the fund. It is mostly invested in large-cap companies – 72 per cent of the fund, but also has mid-cap exposure that represents around 16 per cent. It has an OCF of 0.76 per cent.

Mr Stubbs likes Man GLG Undervalued Assets Fund (GB00BFH3NC99), which is managed by Henry Dixon and Jack Barrat. They aim to find companies with strong cash holdings and assets but are unloved by the market. The managers believe conventional equity valuation principles place too much emphasis on forecasting earnings into the future. So instead they focus on the current shape of the balance sheet, and look for companies that can achieve a sharp rise in valuation compared with the wider market. As of the end of April the portfolio consisted of 65 stocks, representing an active share of 71 per cent. Financials and materials stocks make up the biggest sector weights. Man GLG Undervalued Assets ranks among the best performing funds in the IA UK All Companies sector over one, three and five years. It has an OCF of 0.90 per cent.

Mr Dixon also manages Man GLG UK Income Fund (GB00B0117D35), which is also among the top performing funds in its sector – the IA UK Equity Income sector – over one, three and five years. This fund uses the same strategy applied within Man GLG Undervalued Assets to identify undervalued companies with strong dividend prospects. Mr Dixon seeks companies with good balance sheets and potential dividend growth of more than twice the market average. Companies must also have a dividend yield that at least matches the market, to help ensure attractive income and growth potential. The fund has an OCF of 0.90 per cent and a yield of 4.82 per cent.

Mr Husselbee holds Old Mutual UK Alpha Fund (GB00B946BX62), run by veteran UK investor Richard Buxton. He also holds Fidelity Special Situations. Mr Husselbee thinks investors seeking value-style managers look for evidence of consistency in their approach. “Both these managers are highly experienced and shown an ability to outperform in value markets,” he adds. Old Mutual UK Alpha aims to grow capital with a portfolio of mostly large-cap UK equities. It runs a concentrated portfolio of 35–40 companies that the manager believes have strong business models, healthy balance sheets and unrecognised potential. The fund has an OCF of 0.78 per cent.

Fund / Sector / Index1-year total return (%)3-year cumulative return (%)5-year cumulative return (%)Ongoing charge (%)
Aberforth UK Small Companies Trust**8.217.768.40.76*
Fidelity Special Situations 8.133.265.00.93
Fidelity Special Values **16.336.181.11.06*
Jupiter UK Special Situations 5.928.758.70.76
Man GLG UK Income 14.238.178.80.90
Man GLG Undervalued Assets 16.437.8-0.90
Old Mutual UK Alpha 9.019.745.80.78
River and Mercantile UK Equity Long Term Recovery13.840.389.71.15
AIC UK All Companies sector**6.619.240.1-
AIC UK Smaller Companies sector**8.242.288.3-
IA UK All Companies sector7.023.651.0-
IA UK Equity Income sector4.219.847.8-
FTSE All-share index6.525.145.9-
FTSE 100 index6.224.741.5-
FTSE Small Cap ex Investment trust index5.930.776.9-
     
Source: FE Analytics as at 04.06.2018  *Association of Investment Companies **Share price return