Are Investors Right to Ignore UK Equities?

Pessimism towards UK equities hit an all-time high in March, according to Bank of America Merrill Lynch

David Brenchley 22 March, 2018 | 9:28AM

Reckitt Benckiser brand Dettol Finish consumer staples pricing power equity stocks UK market

UK stocks continue to remain out-of-favour with investors, as uncertainty over Brexit weighs on sentiment. Pessimism towards UK equities hit an all-time high in March, according to the most recent Bank of America Merrill Lynch fund manager survey. It found 42% of investors surveyed are underweight the region. The UK remains the consensus short amongst fund managers, it adds.

It’s well established that investors are pulling cash from UK equity-focused funds. Morningstar Direct data show more than £6 billion has been pulled from funds in the Investment Association UK Equity Income, UK All Companies and UK Smaller Companies sectors in the year to 28 February.

Valuations of UK stocks are currently at extremely low levels. As a result, some contrarian investors now believe there are opportunities. Daniel Needham, chief investment officer at Morningstar Investment Management, recently outlined the case for the UK from a contrarian perspective.

Brexit Transition Deal Brings Hope

After Monday’s announcement of a 21-month transition period between the UK and EU, the pound rallied against both the US dollar and the euro. While the agreement was seen as positive for domestically exposed UK firms, sterling’s inverse relationship with the FTSE 100 means its strength is a headwind for larger overseas earners.

The deal doesn’t mean Brexit risks have disappeared, mused Bill McQuaker, multi-asset portfolio manager at Fidelity International, and a bad deal would still be negative for the economy. “But with the status quo now in place for at least another three years, and the UK traditionally a defensive market, UK equities might begin to look more attractive again.”

Some UK-focused investors think this has been the case for a while, though. “I’m not going to sit here and tell you that the UK is a massive bargain,” says David Goldman, co-manager of the BlackRock UK Income Fund, “but there are definitely opportunities emerging within that.”

Goldman says he’s becoming intrigued with utilities and car insurers, while Stephen Message, manager of the L&G UK Equity Income Fund, likes certain retailers, media firms and leisure businesses. “A number of domestically focused companies have been out of favour for some time. From a contrarian instinct these are becoming more interesting,” says Message.

4 Undervalued UK Stocks

There are four UK companies that Morningstar analysts rate five star, meaning they currently look undervalued. We outline the quartet below.

Babcock (BAB)

Like many companies in its sector, Babcock has suffered from others’ misfortunes at times. The collapse of Carillion and mis-management of Capita and Mitie have hurt support service firms. But Babcock is a different beast, and Janus Henderson’s Laura Foll says it’s unfairly lumped in with its aforementioned peers.

At 670p, the share price is currently 40% below its previous peak of 1,110p back in September 2016, and almost half its level from early 2014. Babcock provides engineering services and support in sectors like marine, land and aviation. It also decommissions nuclear submarines. It is one of the largest suppliers to the UK Ministry of Defence, so will benefit from an increase in defence spending.

Its recent third-quarter trading update reveals a mixed picture through the second half of 2018, according to Morningstar analyst Jeffrey Vonk. However, he reckons there’s a buying opportunity after the recent sell-off and thinks shares are worth 1,060p.

Unlike Carillion and Capita, which both had exposure to low-margin areas of outsourcing, Vonk sees scope for Babcock to expand its margins from 8.1% in 2018 to 9.1% by 2022.

Imperial Brands (IMB)

Imperial Brands is another that has seen its share price decline 40% since September, with a move against smoking on both sides of the Atlantic weighing on sentiment towards the owner of brands such as Gauloises and Winston.

A number of asset managers have made the move to not invest in tobacco companies, which has not helped with momentum.

But Morningstar analyst Philip Gorham says Imperial’s strong intangible assets at the premium end of its portfolio give it a wide moat. This will help it catch up with competitors, despite its likely slower growth profile than the likes of Philip Morris and British American.

His fair value estimate of £39 gives Imperial brands a forward dividend yield of 5%, which is one of the attractions of tobacco stocks in general for investors.

Reckitt Benckiser (RB.)

Shares in Reckitt Benckiser, a favourite of fund managers like Terry Smith, have slipped to a two-and-a-half-year low in recent weeks. The stock fell almost 7% last month after disappointing numbers and it’s continued to decline.

We noted at the time that The Share Centre’s Graham Spooner reckoned this was a buying opportunity. Well, you can add Gorham to the list of Reckitt fans. While the Morningstar analyst kept his fair value estimate of 7,400p intact, the share price plunge saw its star rating upgraded to five.

He said 2017 was a “year to forget”, but its brand portfolio, which includes Durex condoms and Nurofen pain relief tablets, is increasingly skewed to pricing power, which is a key reason why it has a wide moat rating.

“After a significant retracement over the past nine months, we think the stock is now trading close to an attractive margin of safety, and we recommend investors kick the tires,” says Gorham.

Shire (SHP)

Having hit a four-year low earlier in the year, Shire shares have picked up slightly in the past couple of weeks, but not by much. The stock has almost halved over the past three years.

There’s been speculation of the Irish firm being a takeover target recently, with Pfizer having been rebuffed back in December, but recent guidance on increased competition has seen the drugmaker pare back.

Morningstar analyst Karen Andersen thinks potential growth of its ADHD products in Japan is undervalued currently and that its rare disease focused portfolio supports a narrow moat.

Her fair value estimate of 4,890p suggests upside of almost two-thirds

It’s a contrarian call the International Biotech Trust (IBT) has been taking recently. The managers recently told Morningstar they had been adding to their position in recent weeks due to it having slipped to a “very, very cheap” level. “We think this might be the trough,” says manager Carl Harald Janson.

“Valuation is very important to us, but sometime it becomes ridiculous. Shire’s had some problems, but I still think they have a sustainable business, can generate a lot of cash and pay down the debt,” he adds.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Babcock International Group PLC531.40 GBX-1.96
Imperial Brands PLC2,371.50 GBX-2.09
Reckitt Benckiser Group PLC6,264.00 GBX-0.57
Shire PLC4,673.00 GBX0.33

About Author

David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk