UK stocks look cheap on so many different valuation metrics, not just one or two, suggesting a robust, genuine investment opportunity is available to long-term investors. So why does nobody seem convinced?

This article explores the scepticism surrounding the UK’s market’s attractive valuation and examines the underlying evidence to support it. Shares concludes UK stocks really are a compelling investment opportunity.

Later we reveal a selection of stocks sitting on attractive discounts which have the greatest return potential should the discount narrow, as well a UK value-focused investment trust sitting on a big discount to NAV (net asset value).

THE DOUBTING THOMAS VIEW

There are plenty of objections to the premise that UK stocks are cheap, the biggest being cheapness does not necessarily equate to undervaluation.

Fund manager Terry Smith is fond of reminding investors not to confuse a cheap PE (price-to-earnings) rating with undervaluation or a premium rating with overvaluation. That is because the market prices different fundamental characteristics (earnings growth, return on equity, balance sheet strength) differently.

Lower-quality businesses with modest growth prospects tend to trade at a PE discount to their higher-quality, higher-growth compatriots. Taking an extreme example, British American Tobacco (BATS) is never going to attract the same PE rating as Microsoft (MSFT:NASDAQ).

The former has grown EPS (earnings per share) and free cash flow by around 6% and 3% a year respectively over the last six years while the latter has grown EPS by 20% a year and free cash flow by 14% a year.

Another criticism of the UK market is its indices are comprised of ex-growth sectors such as tobacco, consumer staples and ‘old economy’ stocks while also lacking exposure to quality  growth stocks.

Compounding negative sentiment surrounding the UK is the effect of fund flows. Investors have been broadening their global exposure at the cost of reducing their UK exposure, and this persistent selling has provided a tough headwind for markets. 

Lastly, the ‘killer’ objection for giving any credence to UK cheapness is valuation alone is not sufficient to warrant buying the market today. The argument goes something along the lines that the same observations could have been made at any time over the past five years, so why should today be any different?

In other words, there is no level of ‘discount’ which magically heralds a change in fortunes.

The sum of these objections is enough to keep some investors from pulling the trigger on buying UK stocks on worries it may be a value trap.

THE UNDERLYING EVIDENCE

On closer inspection the reality may be very different to the popular narrative. Research by Rathbones analyses the data on an ‘apples-to-apples’ basis to account for the sectoral composition of UK indices as well as growth and profitability factors.

The results show the UK trades at a 22% discount to the US and a 9% discount to Europe. What this means is companies trading in the same sector with the same growth and quality characteristics are cheaper simply because they happen to be listed in the UK, which looks anomalous.

Rathbones concludes: ‘The UK market contains global businesses that — on a level playing field, after adjusting for sector and quality and growth characteristics — appear significantly undervalued relative to international peers.’

Fidelity’s Alex Wright, who manages the Fidelity Special Situations Fund (FUND:B88V3X4) and Fidelity Special Values (FSV), has a similar view. 

He points out that on a sector-neutral basis, the UK is extremely attractive compared with the US and relatively attractive against Europe, Japan, and the Pacific ex Japan based on forward PE multiples.

Addressing the argument the UK has been cheap for some long time, Wright explains what has changed to tilt the balance and make the UK a compelling buying opportunity today compared with a few years ago.

First the UK’s valuation discount has widened to its biggest in over 10-years, but just as importantly, other regions of the world and especially the US have become more expensive. This means the UK offers better relative value today than two years ago while at the same time investing outside the UK brings risks which were not apparent before.

Similarly, new research from Liberum analysts Joachim Clement and Susana Cruz shows the UK’s valuation discount to the US widening out to a new all-time high of 31.4% at the end of March.

Redwheel fund managers Ian Lance and Nick Purves, who manage Temple Bar Investment Trust (TMPL), highlight that based on research by Hussman Strategic Advisors looking at implied future returns, the US stock market has only been as extremely valued as it is today on two previous occasions – at the end of December 2021, and at the end of August 1929, a particularly inauspicious precedent.

In contrast, investors can buy UK listed companies with similar prospects on cheaper valuations, reducing their overall portfolio risk. Just for good measure, UK stocks are also cheap relative to their own history trading on a forward PE of around 11 times compared with a long-term average around 14 times.

Alex Wright also highlights an encouraging development many investors may have overlooked, and which may be supportive for the UK given its value bias.

UK value stocks have continued to outperform growth (based on MSCI indices) stocks over the last year, reflecting further momentum in the trend which began shortly after the first vaccine was developed in 2020.

In terms of sectors, Liberum highlights the healthcare and basic materials sectors as trading at the deepest discounts to US peers.

While historical performance is no guarantee of future performance, when these sectors were trading at similar discounts in the past the following 12 months saw mining stocks rally 25% on average, energy stocks rally 20% and healthcare stocks gain 16%.

SHARES’ BEST PICKS

Logically, with UK stocks trading at a deep discount it makes sense to invest in value-focused UK investment trusts which themselves are trading at deep discounts to NAV. This approach may allow investors to benefit from both a rebound in UK shares as well as the narrowing of a trust’s discount.

Two thirds of UK income trusts have dividend yields above the 3.8% offered by the FTSE All-Share index with many of them delivering at least 3% dividend growth over the last five years, according to analysis from Stifel.

Investment trusts have been suffering from the same negative investment flows as individual shares.

The Times newspaper recently reported investors have withdrawn around £2.5 billion from UK trusts over the last four months while pouring £6.7 billion into US equity funds over the same period.

This avalanche of money chasing US stocks may be one reason the broad market trades on such a big valuation premium.

Conversely, money flowing out of the UK has contributed to widening discounts which analysts at Stifel believe presents investors with a genuine buying opportunity.

Poor recent performance can magnify the widening of discounts, but this has not been the case over the year to 5 April when two thirds of UK equity trusts have outperformed the FTSE All-Share index total return of 7.8%.

Temple Bar (TMPL) 244p

Market cap: £708 million

Discount to NAV: 10%

Value-driven Temple Bar has outperformed the FTSE All-Share by 15% over the last year and trades at an undeserved 10% discount to NAV while offering an historic yield of 3.9%.

Since Redwheel took over management of the trust in October 2020, the managers have delivered an NAV total return of 82% and price total return of 88.5% compared with the FTSE All-Share total return of 48%.

Co-managers Nick Purves and Ian Lance have worked together for over 20 years, during which they have added significant value for clients.

The managers focus on neglected areas of the market which potentially offer the biggest discounts to intrinsic value. Sometimes also referred to as business value, this metric is a fundamentally-based estimate of a company’s underlying economic value.

While in the short term a company’s share price may fall further, over the longer term intrinsic value should be recognised by investors prompting the discount to narrow and the shares to rise as business value increases.

The manager’s underlying investment philosophy is that starting valuations determine long-term shareholder returns. That is, the lower the starting valuation the higher the long-run shareholder total return.

To reduce risk, the managers look to weed out companies which trade on a cheap valuation for a good fundamental reasons. The bottom line is a belief that good-quality, undervalued companies with strong cash flows and robust balance sheets offer the best potential for attractive long-run returns.

The current portfolio is heavily weighted towards energy companies and banks which comprise around 44% of the fund’s value. Top holdings include Shell (SHEL) whose shares recently made new all-time highs, NatWest (NWG), Aviva (AV.), Marks & Spencer (MKS) and ITV (ITV).

The trust has an ongoing charge of 0.53% a year.

Card Factory (CARD)

Share price: 94.3p

Market cap: £325 million

A single digit PE (price-to-earnings) ratio, double-digit earnings yield - the inverse of the PE ─ and a plump free cash flow yield suggest Mr. Market underappreciates the earnings power, growth potential and cash generation of Card Factory (CARD).

The value-focused greeting card-to-party supplies retailer’s revenue has returned to above pre-pandemic levels and the business has positive momentum under chief executive Darcy Willson-Rymer’s new growth strategy.

Wakefield-headquartered Card Factory’s value-focused product offer continues to serve it well during a cost-of-living crisis and heap pressure on arch-rival Clintons, which is heading for a restructuring with potentially a fifth of its stores to close.

As the consumer backdrop brightens, Shares expects the group’s expanded gift offer could feel the benefit ─ at present it only has a 1.7% share of a UK gifting market worth £13.4 billion.

While the UK greetings card market in which Card Factory has the leading value and volume share is considered low-to-no growth, the birthday cards-to-balloons purveyor is cannily developing partnerships to sell through other retailers, which currently include Aldi and Matalan in the UK and The Reject Shop in Australia.

The acquisition of SA Greetings in South Africa and a franchise deal with Liwa in the Middle East mean there is an interesting overseas growth angle too.

Back in January, Card Factory delivered yet another upgrade to its earnings guidance following strong Christmas sales across stores and online; Liberum Capital cautions that ‘when (not if) Card Factory get its online business moving, one should maybe be concerned for the likes of Moonpig Group (MOON) and Funky Pigeon’.

Results for the year to January 2024 are slated for 30 April, with the consensus pointing to a 21.5% rise in pre-tax profits to £61.4 million following a series of upgrades.

With Card Factory’s balance sheet in a much healthier position, dividends ─ which were put on pause due to Covid ─ could even be restarted during the year to January 2025. [JC]

ITV (ITV)

Price: 73.25p

Market cap: £2.95 billion

Broadcaster and media company ITV (ITV) looks very unloved given the shares trade on a single digit forward PE (price to earnings) ratio of 8.5 times and an estimated 15% free cash flow yield.

These valuation metrics look anomalous and undemanding for a business which is expected to grow its EPS (earnings per share) by double-digit percentages over the next couple of years and generate strong cash flows.

The shares also trade at a 15% discount to global peers according to Idata from research provider Infront.

ITV is one of the largest global content creators, producers and distributors and generates 55% of its revenue from outside the UK.

At the recent 2023 results (7 March), management expressed confidence in achieving medium-term financial targets which would see ITV studios delivering 5% average organic revenue growth per year out to 2026 and achieving margins between 13% and 15%.

For the media and entertainment division (58% of revenue), the firm said it was on track to deliver £750 million of digital revenues by 2026.

At the same time, the company positively surprised analysts by announcing it would reach its £150 million cost savings target a year ahead of schedule in 2025.

The sale of ITV’s share of Britbox will see all the cash proceeds returned to shareholders via a new £235 million share buyback.

Further demonstrating shareholder-friendly policies, the board proposed a final dividend of 3p per share taking the total dividend to 5p per share, equivalent to £200 million for the full year.

Combining the proposed share buyback and 2023 dividend equates to roughly 15% of the current market capitalisation, demonstrating the clear value on offer.

JET2 (JET2:AIM) 

Price: £14.54

Market cap: £3.2 billion

Analysts have struggled to keep pace with UK package holiday business and travel operator Jet2’s (JET:AIM) earnings momentum post the pandemic resulting in double-digit upgrades to forecasts over the last year.

Therefore, despite the shares gaining 13% over the last 12 months, the valuation remains attractive with a one-year forward PE ratio of 8.6 times.

The fundamental driver of the upgrades is people are still booking holidays despite the cost-of-living crisis and the associated strain on household budgets.

At the same time, the group is expanding its UK footprint with a new Liverpool base at John Lennon airport, its eleventh base so far, with Bournemouth airport to follow.

Analyst Damian Brewer at Canaccord Genuity believes Jet2 shares are ‘over £5 too cheap’, citing the strength of the group’s holiday product and ‘strong repeat custom’.

‘The annual holiday is a priority that consumers cherish – and for families seeking a stress-free break in-resort support is important,’ says Brewer.

‘We believe Jet2’s key differentiators are variable-duration stays to suit each customer’s budget; all-in holiday cost certainty in a ‘one-click’ purchase; repeat customer base; stand-out attentive service; capital to meet off-season cash outflows; access to competitive wholesale hotel inventory and prices; and access to peak season UK and overseas airport slots.’

In February, the company raised its group pre-tax profit outlook for the financial year to March to between £510 million and £525 million (from £480 million to £520 million previously) on the back of strong winter 2023/2024 forward bookings – up 17% - for both flight-only and package holiday products.

In addition, on-sale seat capacity for summer 2024 is currently 12.5% higher than summer 2023 at 17.2 million seats. [SG]

Morgan Sindall (MGNS)

Buy at £22.25

Market cap: £1 billion

Infrastructure, affordable housing and urban regeneration group Morgan Sindall (MGNS) is a typical example of a UK stock with an above-average growth rate selling at a discount not only to its international peers but also relative to its own history.

The group’s construction arm is expert in physical infrastructure and complex regeneration projects, while its fit-out division is the UK market leader generating consistent cash flows which support the group’s investment in affordable housing and mixed-use redevelopments.

Using almost 30 years of historic data, we estimate the firm has grown its earnings by an average of more than 11% per annum with lower volatility than either mainstream construction firms or housebuilders.

The firm posted record results in what was a challenging year for the construction sector as a whole to December 2023, with revenue up 14% to £4.1 billion and adjusted pre-tax profit up 6% to £145 million.

The order book as of December stood at £8.92 billion or more than two years’ worth of work, with management taking a selective approach to bidding and spreading its risk across suppliers and subcontractors.

Management also has a strong capital allocation discipline, the priority being to maintain a strong balance sheet, including an element of downside protection in the event of a macro downturn, followed by maximising its investment in its regeneration activities to drive sustainable growth and then bolt-on acquisitions to accelerate growth.

Only when these priorities are satisfied would the board consider special returns to shareholders, which to us seems eminently sensible.

The shares trade on a 2024 price to earnings multiple of less than 10 times which seems cheap for a business with a proven track record, a return on capital employed of more than 20% and a prospective dividend yield north of 5%. [IC]

 

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