With commentators warning that valuations on mid and small caps look toppy, Tim Gregory, head of global equities at Psigma, says he is increasing his weighting to this area of the market in his portfolios. Gregory explains that sterling strength has held back many of these companies, which derive a large proportion of their earnings from abroad.
They also tend to be geared to growth in developing parts of the world, and as that starts to pick up they should start to make up the valuation gap.
He picked out three UK stocks that he believes are seriously undervalued by the market.
Rio Tinto
Gregory describes mining giant Rio Tinto as “very, very cheap”. The manager says the stock is likely to re-rate as the outlook for this mineral improves.
“It’s one of the world’s largest mining companies, very heavily biased towards iron ore, which everybody has been very bearish about because of the slowdown in China and India,” he said.
“But iron ore, having been below $100, is now at $140. We think if the price stays at $110 dollars, where the consensus is, we think it will be around 10 times earnings, yielding 3 per cent and we think that dividend is likely to grow – management are now more careful with their capital.”
The mining sector is widely regarded as having over-expanded in the boom years thanks to short-sighted management.
A series of new teams is in place in many different firms and Gregory gives a vote of confidence to the turnaround job at Rio.
“Rio Tinto have been very aggressively cutting costs and cutting back on unprofitable projects to focus on cash-flow and paying down debt.”
Gregory says he also likes rival BHP Billiton, but Rio gets the nod for its exposure to iron ore, which Gregory thinks will be supported by a recovery in China.
“We have a preference for Rio Tinto because of the story with respect to iron ore,” he said. “BHP Billiton has a much broader spread, is much more diversified with oil and gas as well as mining.”
Data from FE Analytics shows that Rio Tinto has started to recover in recent months, edging ahead of BHP Billiton and being picked up by many big-name fund managers.
Performance of stocks vs index in 2013
Source: FE Analytics
Gregory says he likes both stocks for the change in management attitude and notes that BHP Billiton is also yielding close to 4 per cent.
Unilever
Gregory agrees with FE Alpha Manager Nick Train that investors should be snapping up shares in Unilever after its recent weakness.
The company announced a profits warning in October, saying that sales growth was slowing off the back of weakness in the developing world.
“It is one of those companies that has suffered from the slowdown in emerging markets,” Gregory said.
Relative performance of developing markets to developed over 3yrs
Source: FE Analytics
“Emerging markets are growing more slowly right now, but if you are taking a three- to five-year or longer time horizon to your investments, we think they will get back on the front foot.”
Data from FE Analytics shows that Unilever has suffered relative to the FTSE All Share in 2013, making just 7.12 per cent to the benchmark’s 17.28 per cent.
Performance of stock vs index over 3yrs
Source: FE Analytics
It has significantly outperformed over the medium-term, however, returning 43.02 per cent to the index’s 29.45 per cent over the past three years.
Diageo
Gregory also thinks investors should be snapping up shares in Diageo, another emerging markets-facing growth stock to have come off since the summer.
“From at least 2015 and beyond, we see greater growth in emerging markets supported by population growth,” he said.
“Businesses like Unilever and Diageo are the businesses that are really well positioned to benefit.”
Diageo, the brewer of Guinness, Johnnie Walker and Smirnoff, has more than doubled the returns of the FTSE All Share over the past decade, having done particularly well in the low-growth environment since the 2008 crisis thanks to its exposure to the growing middle classes in emerging markets.
Performance of stock vs index over 10yrs
Source: FE Analytics
The stock has underperformed the index in the year-to-date, however, returning just 10.32 per cent to the benchmark’s 17.28 per cent. Concerns about emerging markets growth have weighed on it in the latter part of the year.
Nonetheless the company continues to be highly rated by a number of fund managers and Gregory thinks investors should stick with it for when emerging markets growth picks up.
