5 Overvalued UK Stocks

THE VALUE INVESTOR: Investors might need to keep an eye on the following stocks as Morningstar analysts see them trading at significantly more than their fair value 

Karen Kwok 11 January, 2016 | 3:34PM
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Morningstar star ratings can help investors determine which stocks are overvalued. Whereas the fund and ETF star ratings are both backward-looking quantitative measures of a fund's risk versus reward profile, the stock star rating is completely different. It's both quantitative and qualitative, for starters, and it's meant to be forward-looking.

If a stock has a low star rating, that means Morningstar equity analysts think the shares are overvalued, and the share price could drop in the future.

There is currently one stock in the U.K. that Morningstar analysts rate one star, and we highlight it with four stocks with a two-star rating.

Associated British Foods PLC (ABF)

Associated British Foods is a diversified international food, ingredients, and retail group with 124,000 employees and operations in 48 countries across Europe, southern Africa, the Americas, Asia, and Australia.

Some 42% of sales are in the UK, and Primark, the deep-discount clothing retailer, is ABF’s largest profit contributor which generates 62% of operating profit. Primark is arguably ABF's best asset: it has the highest operating margins and returns on capital, along with the best growth prospects. Primark is adding 11% more floorspace annually, and it has tremendous growth potential, which will likely drive earnings growth for years to come, Morningstar analyst Adam Kindreich says. Online sales are a future opportunity to generate higher sales, as Primark currently is not, analyst thinks that Primark will eventually decide to exploit this additional channel.

However, the shares look overvalued, with Primark’s strong growth prospects having been more than baked into the current ABF share price, Kindreich says. The company faces exposure to volatile commodity prices, including sugar, grain and fashion risk, along with exposure to earnings and currency volatility, especially the U.S. dollar and euro, which increases uncertainty.

BT Group PLC (BT.A)

BT Group, formerly known as British Telecom, is the incumbent phone operator and largest supplier of fixed-line phone services in Britain, with about 38% market share. BT is the largest supplier of high-speed Internet lines, including lines it wholesales. The stock is currently rated at two stars by Morningstar analyst, which is a fairly overvalued stock.

While BT struggles to increase its revenue, it is doing a fantastic job of improving efficiency, Morningstar analyst Allan C. Nichols says. The company continues to reduce costs, enabling its margins to improve despite revenue declines. The firm raised its dividend for the fifth year in a row in fiscal 2015 and plans to increase the dividend by further 10%-15% this fiscal year, Nichols says.

BT's global services division's revenue declines have eased, but Morningstar analysts project it is still two years away from returning to growth. The division is fighting both a weak global economy and the headwinds of corporations moving to lower-cost Internet-based services.

Nichols thinks that BT will struggle to earn a decent return on the capital it has invested on sports channels, which BT giving away for free to its broadband customers.

Also Nichols thinks that the market forgets to adjust its valuation of BT for its pension deficit. The company continues to struggle with its pension deficit. Despite making extra payments the deficit remains at GBP 5.6 billion after tax.

Imperial Tobacco Group PLC (IMT)

Imperial Tobacco Group PLC is a tobacco company that holds a leading global position in the fine-cut tobacco and hand-rolling paper categories and is a leading seller of cigars in several countries. The firm is the world's fourth-largest international tobacco company (excluding China National Tobacco) with total 2014 volume of 294 billion cigarettes sold in more than 160 countries.

Recent acquisitions in the United States make Imperial the third-largest manufacturer in that market, and gives it the financial flexibility to reposition the brands and attempt to gain market share. The firm also has a logistics platform in Western Europe. Morningstar analysts view the stock as fully priced at current levels.

Morningstar analyst Philip Gorham believes that the firm can meet its goal of 10% dividend growth in the medium term due to its profitability gains. Imperial Tobacco is well positioned to exploit the emerging trends of trading up in developing regions and trading down in some of its more mature markets, Gorham says. Uncertainty rating for the firm is low, as the industry fundamentals remain stable throughout the recent economic volatility.

However, government intervention is a potential threat that investors should be aware of, Gorham says. One-time large tax increases can disrupt volume and elasticity temporarily.

The company’s reporting currency is sterling. However, Britain is not a major supplier of raw tobacco, so very little of the company's input costs are denominated in sterling, meaning it is highly exposed to an appreciation of the British pound.

National Grid PLC (NG.)

National Grid PLC owns and operates the electric and gas transmission system in England and Wales along with the U.K.'s largest natural gas distribution network, serving 10.9 million customers. It also owns regulated transmission and electricity generation in the United States, metering services, merchant transmission lines in the U.K., and the Grain (U.K.) liquefied natural gas facility. Morningstar analysts have reduced their fair value estimate for the energy provider but still believe the shares offer an attractive dividend and total returns.

National Grid offers transparent earnings and dividend growth, with the company’s U.K. rate structure set through 2021, Travis Miller, Morningstar analyst says. Even though the dividend likely won't grow at the 10% annual clip it did between 2005 and 2012, Miller thinks it can grow in line with or faster than inflation.

However, rising bond yields would make the company a less appealing investment choice for income-oriented investors. Yet the company might face a tough round of regulatory negotiations in the north-eastern U.S. during the next few years. Some of the company’s U.S. growth relies on single large projects that might or might not go forward.

RELX PLC (REL)

RELX PLC, formerly known as Reed Elsevier, is a diversified publisher and information provider. A majority of its revenue is generated in North America and Europe. The firm's various segments include Scientific, Technical, and Medical; Risk Solutions; Legal; and Exhibitions. RELX Group, plc is owned equally by two parent companies, RELX PLC, traded in London and with a 52.9% economic interest in the parent, and RELX NV, traded in Amsterdam and with a 47.1% economic interest.

Morningstar analyst Philip Gorham thinks RELX is a solid business. About 80% of its operating profit is generated in publishing and industry data categories that Morningstar analyst consider to provide natural defences against competition. Analysts approve of the strategy to shed no-growth or structurally disadvantaged businesses, and believe this has the potential to improve the company's long-term competitive positioning.

The firm has also successfully digitized its legacy journal holdings, which should stabilize revenue as its print platforms continue their long-term decline, Gorham says.

However, as a material portion of the firm’s sales were derived from businesses that relied on academic or government budgets, cuts in funding could lead to pressure on revenue and pricing. Advertising spending is highly cyclical and it can cause sharp disruptions to turnover growth. Morningstar analyst continue to see RELX as fairly valued with two stars ratings. 

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.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Associated British Foods PLC1,614.00 GBX2.18Rating
BT Group PLC185.00 GBX3.01Rating
Imperial Brands PLC1,790.50 GBX-1.57Rating
National Grid PLC1,210.50 GBX0.29Rating
RELX PLC2,265.00 GBX1.12Rating

About Author

Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk