UK equities have been unloved for many years, which has pushed their valuations to cheap levels relative to their US and even European peers.
For instance, the UK energy sector is valued at a forward price-to-earnings (P/E) of 6.7x while the US equivalent is at 10.1x according to Schroders.
The forward P/E is a valuation measure in which a stock market’s value is divided by the earnings per share of all the constituents. The lower the P/E, the better value a market is.
More broadly, the median industry discount between the US and UK markets is 26%, while it is 4% between Europe and the UK.
Jason Hollands, managing director of Bestinvest said: “UK equity valuations are currently very cheap, both compared to other developed markets and their own history.
“An awful lot of negative sentiment is factored into current pricing, and history suggests this should present significant upside potential for those prepared to invest and sit tight.”
For investors wanting to snap up undervalued UK stocks, Hollands suggested Artemis UK Select, Fidelity Special Situations and Temple Bar Investment Trust.
The Artemis UK Select fund, managed by FE fundinfo Alpha Manager Ed Legget and Ambrose Faulks, is a best ideas fund that targets large- and mid-cap firms with strong growth potential that isn’t yet reflected in their valuations.
Hollands said: “It might better be described as investing in unrecognised growth stocks rather than a value fund. The fund has the flexibility to take short positions, though the strategy is overwhelmingly long equities.”
Performance of fund over 10yrs against sector and index
Source: FE Analytics
The fund sits in the top quartile in the IA UK All Companies sector over 10 years. Notable overweight positions are financials and consumer cycles, while the portfolio is underweight healthcare and consumer defensive stocks.
Fidelity Special Situations has a more classic contrarian approach, with the manager Alpha Manager Alex Wright looking for unloved businesses with the potential for a re-rating.
Those re-ratings can happen through turnaround plans, restructurings, new management, mergers and acquisitions (M&A) or an improving competitive environment.
Performance of fund over 10yrs against sector and index
Source: FE Analytics
The fund has also been in the top quartile of the IA UK All Companies sector over 10 years but shorter term performance has been negative.
Hollands said: “This is a multi-cap fund with significant smaller companies exposure (40%) and only 29% in large-cap stocks. Small-cap exposure has negatively impacted shorter-term performance because of the de facto greater domestic exposure in the portfolio.”
In the investment trust space, the Temple Bar Investment Trust has another approach to the low UK valuations.
Hollands said: “The managers pursue an approach focused on identifying businesses that are attractive based on their intrinsic value, rather than just having a low price/earnings multiple. This helps avoid poor-quality businesses that may deserve a low rating.”
Performance of trust over 10yrs against sector and index
Source: FE Analytics
Unlike the previous funds, the trust managed by RWC duo Ian Lance and Nick Purves has failed to beat the FTSE All Share index and is fourth quartile over 10 years in the IT UK Equity Income sector, although the new managers only took charge in 2020.
Rob Morgan, chief analyst at Charles Stanley, said he is wary of pure value or recovery funds, as they might encounter too many value traps. He highlighted Man GLG Undervalued Assets.
Run by Alpha Managers Henry Dixon and Jack Barrat, the pair adopt a disciplined approach to value investing with an emphasis on financial strength.
Morgan added: “By focusing more on the current shape of the balance sheet, as well as cash generation and positive operating momentum, the managers target firms whose share prices do not fully reflect their ‘intrinsic’ value and those whose profit streams are undervalued by the market.
“Importantly, this should weed out the majority of firms likely to fall victim to shaky balance sheets.”
Performance of fund since launch against sector and index
Source: FE Analytics
The fund was launched in November 2013 and has made a third-quartile return in the IA UK All Companies sector over 10 years.
For a more aggressive strategy, Morgan suggested targeting small- and mid-caps where there is even more pessimism and depressed sentiment among investors. This means that there is therefore more potential for gains if the UK economy surprises on the upside. For this purpose, he highlighted the Mercantile Investment Trust.
Morgan said: “It balances quality and value in the investment process so should similarly avoid major value traps. The trust trades at a 15% discount to NAV presently, which is an attractive level by its own historic standards and versus other UK equity trusts. Some modest gearing also adds to the risk but also the potential return as and when things improve.”
Performance of trust over 10yrs against sector
Source: FE Analytics
The trust has been a top-quartile performer over 10 years in the IT UK All Companies sector but has recorded negative performance in more recent periods.