Why UK-focused stocks look their cheapest in a decade

Uncertainty about the country’s long-term relationship with the European Union, its biggest trading partner, has left many international investors nervous about investing in UK companies.

One recent poll showed that UK stocks were the least popular asset class among global fund managers.

I disagree. I can see bright spots in the UK stockmarket that offer a decent balance of risk and reward – and contrarian though this might seem given all the recent gloom about the pressure on household spending, some of the most attractive opportunities are among companies that focus on the domestic consumer.

Why do I think that negativity about the UK is overdone? First, because it is starting to look like concern about the impact of Brexit is already priced into the UK market.

In share price terms, domestic companies started to underperform internationally-focused UK companies in early 2016, as the EU referendum drew closer, and that trend strengthened after the vote. But since last November, the political background has grown a bit less discouraging and domestically focused shares have stabilised.

Second, although these are not boom times, the UK does not appear to be heading for recession. We have seen upward revisions to the economic growth figures, which are now running at closer to 2% a year than 1.5% – not brilliant, but certainly not disastrous.

Similarly, the pound is stronger than it was after the referendum. Sterling’s slide – which pushed up the price of imports and therefore the rate of inflation – was a big part of the reason why shares in domestically-focused UK companies fell so far out of favour. Now a slightly stronger pound is helping to dampen price rises and make imports more affordable.

I believe inflation is near its peak and that, coupled with strong employment and reasonable wage growth, will be enough to start easing the squeeze on UK household spending. Companies that serve the UK consumer should be among the main beneficiaries of that trend.

This is why I am arguing in favour of domestic UK stocks.Their valuations suggest I am in a minority, which is why I think that for investors taking a two or three-year view this might be a good time to buy high-quality domestic companies.

Their shares are trading at their biggest discount to UK exporters in almost a decade and are near their widest discount to the overall UK stockmarket since the financial crisis of 2008-09.

As a group these companies are cheap on valuation measures including price/earnings multiple and dividend yield, and within that group we have identified three consumer-facing companies where there is a strong investment case.

The first is Tesco, which we expect to rebuild its profit margins towards a target of 3.5%-plus over the next two years. It is also rebuilding its position with customers and gaining market share, according to the latest supermarket industry sales data.

Couple those factors with gradually rising interest rates and bond yields, which should help to reduce the size of Tesco’s pension deficit, and we believe that over the next couple of years the company should have significantly more cash available to invest in its operations and distribute as dividends to shareholders.

The second is Pets At Home, the UK’s number one pet retailer, which offers a current dividend yield of 4%. This company has about 700 stores, mainly large outlets on retail parks, but the thing that stands out to us is its growing position in services – more than half its stores now include vet practices and grooming parlours.

These increase footfall for the stores and they also earn very attractive returns in their own right. We believe they should command a premium valuation, but our analysis suggests the current share price does not reflect the long-term value of these in-store services.

The final example is Hollywood Bowl, the UK’s leading tenpin bowling operator. This is a smaller company that has invested steadily in improving its customer experience while emphasising value for money: the food and drinks offer is better and they’re trying ways to give users more plays in their time slot. It’s a growing business that generates a lot of cash and has a dividend yield of just under 4%, which the management has supplemented with special dividends. We think there will be scope to do this again in future.

These are three cases where we were able to invest in strong businesses with an improving outlook at a price that we feel tilted the odds in our favour. Amid the gloom about UK shares, there are bright spots if you know where to look.

The above companies have been mentioned for illustrative purposes only and are not to be considered a recommendation to buy or sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

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