Are UK stocks a value trap or a screaming buy?

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December’s failure (so far) to deliver a Santa rally means the FTSE 100 is trading at a two-year low and now also stands below the 6,930 level at which it peaked on 31 December 1999, just before the technology, media and telecoms bubble burst.

This means advisers and clients are now left to decide whether this is a chance to buy on what is now becoming a big dip in the UK’s premier index, which topped out for the year, on a closing basis, at 7,877 on 22 May.

Tops and bottoms

Technical analysts, who look for signals from charts and market price action, may well be sceptical, especially if they are adherents to the old saying that ‘market tops are a process, while market bottoms are an event.’

This can be seen from the FTSE 100 chart going back to the start of 1999.

The three tops that are clearly visible, in 1999, 2007 and 2015 were all preceded by a series of minor peaks, with each upward move less convincing before the last, as dip-buyers were lured to what proved to be their doom.

Chartists may see worrying echoes of that pattern now. (By contrast, the second half of the adage rests upon how the bottoms of 2003, 2009 and 2016 were sudden as the FTSE 100 moved into recovery mode very quickly.)

Previous cyclical tops in the FTSE 100 have taken time to develop (in contrast to market bottoms)

Source: Refinitiv data

Prices and pessimism

Advisers and clients who prefer to focus on fundamentals such as profits, cash flow, dividend and yield and valuation may take a different view, especially if they have a long-term time horizon and are able (and willing) to sit out what could prove to be further Brexit-related volatility in UK equities.

They may argue that UK stocks are cheap, because of the gloom which currently surrounds the Brexit process, Sino-US trade relations and the prospect of yet more interest rate increases in the USA.

As master investor Warren Buffett once put it:

‘The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It is optimism that it the enemy of the rational investor.’

There does not look to be too much optimism surrounding the UK economy at the moment, or its stock market, which has been the worst performer (in sterling, total-return terms) among the eight major geographic options available to investors since 23 June 2016, when the British electorate voted to leave the European Union.

UK stock market has lagged its global peers since the EU referendum vote

Source: Refinitiv data. Total return data in sterling terms from 23 June 2016 to 5 December 2018

Price and value

That begs the question of whether value is emerging from the UK stock market – and some investors may be tempted to think so, with 31 FTSE 100 firms trading on a forward price/earnings ratio for 2019 of less than 10 times and 38 of the index’s members offering a dividend yield of more than 5% for next year, according to analysts’ consensus forecasts.

Twenty cheapest FTSE 100 stocks, based on 2019 price/earnings ratio (PE)

Source: Digital Look, Refinitiv data, consensus analysts’ forecasts

Twenty highest forecast 2019 dividend yields from FTSE 100 stocks

Source: Digital Look, Refinitiv data, consensus analysts’ forecasts

While such numbers may represent a little too much detail for time-poor, information-rich advisers and clients, they do raise two issues which advisers and clients may wish to address with their chosen fund managers.

  • The first is whether analysts’ forecasts are reliable. Estimates of 8% growth in earnings and 4% in dividends across the whole of the FTSE 100 might not sound like much, but if the UK economy slips into an unexpected recession, and is joined there by say the USA, then such figures are likely to prove wildly optimistic. Equally, the numbers could prove to be too low if the British and global economies prove more resilient than the current consensus amongst analysts and economists would have us believe.
  • The second is what could be the catalyst to persuade money, be it from domestic or overseas sources, to revisit UK stocks once more. Even if they are unloved, have underperformed and could be undervalued, you could have said the same a year ago, to no particular effect, as it turned out.

Some – any – visibility on what Brexit will look like and what it may mean could be one possible answer.

Once advisers and clients know what they are dealing with, whatever it may be, then they have a chance to rationally assess earnings and dividend forecasts and thus valuations.

As such, any would-be dip-buyers may have to be brave and patient – but then the darkest hour always comes before the dawn.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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