Experts say tide is turning on UK shares – now the world’s cheapest

Bag a bargain: Investors who have snubbed the UK for some time may be looking to wade back in

Investors in British companies have had a tough time this year. They have endured a rollercoaster ride of stomach-lurching rises and falls if they invested in the FTSE 100 list of the UK’s 100 largest companies – and all they would have to show for it is a return of just 1.93 per cent. If they had invested in the 350 largest UK companies, they would have fared no better.

In contrast, investors in US or European companies have had a much easier journey. Investors in the S&P 500 – an index of the 500 biggest US companies – would be sitting on an impressive 20 per cent return. Germany’s index of 40 biggest companies – known as the DAX 40 – is up 15 per cent.

It is small wonder that Jason Hollands, managing director at investment platform Bestinvest describes the UK as ‘incredibly unloved’.

But the tide may be turning.

Better than expected figures the week before last suggest that the UK may finally have inflation – at 7.9 per cent – under control.

Investors who have snubbed the UK for some time may be looking to wade back in.

Earlier this month US investment bank Morgan Stanley went as far as to say that British stocks are ‘the cheapest in the world’ and could rally if inflation subsides.

The outlook may be brightening, but the negativity that is still pervasive means the UK stock market could be significantly undervalued. Therefore there may be some bargains to be had by investors who know where to look.

Mike Stimpson, partner at wealth manager Saltus, believes that the UK market ‘creates opportunities for us to purchase excellent businesses at discount prices’.

Picking British winners needs careful research though. There may be good reasons why prices of some companies remain weak.

And if prices bounce back, the recovery is unlikely to be uniform. So there could still be a difficult road ahead.

Here we investigate what you need to consider if you want to bag a British bargain.

Why are British shares unloved?

To work out whether UK shares are set to spring back, you need to understand why they ended up in the doldrums in the first place.

Ian Lance, who manages the Temple Bar Investment Trust, believes the negativity is driven by what he calls ‘macro pessimism’ – in other words worries about the economic big picture in the UK compared with elsewhere.

‘Investors think that central banks in general and the Bank of England in particular are going to raise interest rates until they drive the economy into recession,’ he says.

‘As inflation is remaining higher in the UK than elsewhere, this risk is more of an issue.’

If you believe these fears are overblown, you may think the UK is therefore undervalued.

However, if you think a recession could still be on the horizon, you may be more cautious.

Stimpson at Saltus warns that a recession would ‘undoubtedly knock UK share prices down further.’

Hollands adds that in this difficult climate, investors should ‘exercise a little discretion rather than buy up UK stocks indiscriminately’.

He believes that investors in UK companies may wish to seek out those that serve international customers, rather than simply serving British ones.

That way, your investments will be less sensitive to the state of the UK economy and consumer spending levels – and less likely to suffer if they weaken further.

Is this a buying opportunity?

The state of the UK stock market may sound depressing. But Stimpson says that it is an opportunity. The UK looks cheap compared with rivals when you run the numbers.

One common way to measure how expensive a company’s shares are is by looking at the price-to-earnings (P/E) ratio. This shows how much investors are willing to pay for every pound of profit that a company generates.

You can calculate it by taking the company’s share price and dividing it by the earnings per share.

A high P/E ratio can mean that a stock’s price is high relative to earnings and possibly overvalued. A low P/E ratio can indicate a stock price is low relative to earnings.

Using this measure, the UK’s FTSE 100 is about 50 per cent cheaper than the US’s S&P 500. In other words, you get double the profit for each £1 of shares you hold.

‘The gap between UK equity valuations and US equities has never been wider,’ says Hollands.

‘Buying UK equities at such bombed-out levels has scope for significant improvement.’

There are three ways that investors can make money from UK companies that are looking cheap.

One is by buying shares that seem underpriced and hoping they increase in value as sentiment improves.

Another is by investing in cheap companies that still pay out strong dividends as income.

Laith Khalaf, at investment platform AJ Bell, points out that, for example, UK insurance business Legal & General, is yielding 9 per cent, which is better than any savings account.

There is no guarantee that it will continue to pay an income at this level, but the company hasn’t cut its dividend in the past decade.

Third, venture capitalists and other private investors from around the world have been sniffing around Britain’s relatively cheap companies for some time.

If you are an investor in a company that is taken over, you may get a good payout. However, some investors do not like the idea of overseas companies buying up British firms on the cheap.

Where are the bargains to be had?

Some of the biggest UK bargains are in what are known as ‘cyclical’ sectors – those that do well when times are good and that perform badly in a downturn when people and companies rein in spending.

Cyclical shares are currently cheap because investors are pessimistic about how these stocks will function in a recession.

Those wanting to take the biggest opportunities should look at banks, energy, mining, insurance and retailers, says Stimpson.

Some possibilities for UK share fans wanting a bargain include fuel business BP, which is trading on five times its forecast earnings. In comparison, rival Exxon trades on 11 times forecast earnings.

Shares in Diageo, the drinks business that owns Gordon’s Gin, are down about 5 per cent this year due to slowing growth in the US.

Zoe Gillespie at wealth manager RBC Brewin Dolphin says that Diageo’s increasing focus on more-profitable premium drinks should help it grow revenues.

‘Diageo also has the benefit of a high degree of international exposure, so is less reliant on the UK economy,’ she adds.

Gillespie also likes Croda, a speciality chemical group that recently issued a profit warning, causing shares to tumble. The company is suffering from clients running down their stockpiles rather than buying new, and by less need for Covid testing chemicals.

But Gillespie says the share price fall is an opportunity, adding: ‘It remains a quality business, which is highly innovative and has returned capital to investors through share buybacks and special dividends.’

The shares are down 11 per cent since January.

These are all larger stocks, but there are bargains beyond the FTSE 100. Homeware business Dunelm is in the next tier of UK stocks by size, known as the FTSE 250.

Guy Anderson, who manages the Mercantile Investment Trust, believes Dunelm shows potential as it continues to shift to online sales while boosting in-store services. He believes it will fare well despite the rising cost of living forcing consumers to rein in spending.

How to select some great British funds

Picking the companies that show potential is tough, even for experts. Most investors prefer to invest through a fund, where an expert manager picks a selection of companies on your behalf.

There are also tracker funds that are constructed by an algorithm rather than a fund manager – and these tend to be significantly cheaper in terms of annual fees.

There are plenty of funds and investment trusts to choose from for those who would rather pool their cash with others and buy a portfolio of British stocks.

Jason Hollands likes Lance’s Temple Bar investment trust, which is up 4.8 per cent this year. The trust has plenty of financial and energy stocks, and holds BP, Shell and Centrica, as well as M&S.

It yields more than 4 per cent and is trading on a 5 per cent discount – which means the shares are being traded at less that the value of companies that the trust owns.

Hollands also likes Murray Income Trust, where the shares are trading at an 8 per cent discount and yielding 4.2 per cent.

Brave British backers might want to consider the Schroder British Opportunities Trust, which invests in companies before they are listed on the UK stock market. Such firms are higher risk as they are less tried and tested, but also offer greater opportunity for significant growth, as they tend to be in their early stages.

It’s important to note that this isn’t the old Woodford Patient Capital, also run by Schroders, but a separate fund investing in everything from water dispenser makers to insurance underwriting.

Darius McDermott, at fund information service Fund Calibre, points out that it is trading on a 35 per cent discount, though he adds this is hard to value as it holds companies that are not listed on a stock exchange so don’t yet have a publicly listed share price.

Khalaf, at AJ Bell, suggests Jupiter UK Special Situations, up 8.3 per cent over a year and up 44 per cent over three years. This is because manager Ben Whitmore invests in firms that look like good value, but screens out those that do not have strong balance sheets.

James Carthew, at investment trust business QuotedData, suggests Baillie Gifford UK Growth, a smaller fund on a 14 per cent discount. This fund holds everything from Auto Trader to Games Workshop. The fund yields 2.2 per cent, is up 10 per cent over 12 months but down 5.7 per cent over six.

There are also a number of low-cost funds that track indexes such as the FTSE 100 or FTSE 350. These are available from all investment platforms for as little as 0.12 per cent in annual management fees.

This post first appeared on Dailymail.co.uk