Britain’s sunny disposition – is it finally time to buy back in?

The numbers are looking up for Britain's economy, says David C Stevenson. Here, he picks the best ways to play the UK's domestic recovery.

It's not just optimism the numbers are looking up too. David C Stevenson explains why he's backing Britain.

Is it time for investors to turn patriotic and buy British? You might think Andy Murray's victory and the glorious heatwave have gone to my head and it's fair to say that I'm taking a different view to the majority of the MoneyWeek team here. But for me, the logic behind nudging your portfolio towards Britain's domestic economy is based on hard numbers. In recent weeks, several pieces of macro-economic data have turned decisively positive. Many analysts worry that this is just a rebound from 2012's dreadful numbers. But optimists are adamant Britain looks in much better shape than we might have imagined earlier this year.

For instance, Morgan Stanley's economists just released a paper looking at a much-debated weak point British productivity. While employment has held up surprisingly well, productivity growth has stalled. This is a worry, because faster economic growth and higher corporate profits are heavily dependent on increased productivity. However, the Morgan Stanley analysts reckon this productivity problem is cyclical, not structural (in other words, it's down to short-term conditions rather than a more serious flaw). They expect productivity to start rising again as GDP growth accelerates which it is now!

If they are right about productivity, we could experience faster growth without inflation shooting up. The Morgan Stanley team also reckons sterling will weaken, giving Britain another shot in the arm. They aren't the only (cautious) UK bulls BNP Paribas's UK economist Dave Tinsley is also in buoyant mood. He highlights the June Purchasing Managers Index survey of business confidence in Britain's key services sector. The measure rose to 56.9, from 54.9 in May, beating market hopes and hitting a level not seen since March 2011.

Optimism about future business volumes rose to a 14-month high, while outstanding business volumes rose too. "This data underlines that UK GDP in the second quarter looks set to be expanding at a solid rate," Tinsley said.

Keep the champagne on ice?

Before we break out the champagne, it's best to note some important caveats. Many of Britain's structural issues and challenges have yet to be addressed not least our over-dependence on housing as a form of wealth, something my MoneyWeek colleagues are particularly concerned about. The outlook for the housing market might seem a tiny bit more positive, but new housing starts are still at low levels. Government debt continues to rise (although this could turn around rapidly if growth surprises on the upside) and sterling could come under sustained attack if the new Bank of England governor overindulges the financial markets.

Despite this, sentiment seems to be turning in favour of Britain. Many optimists myself included would argue that even this swing underestimates the possibility that mainland Europe might stage a small recovery towards the end of this year, with a bigger recovery in 2014. If that does happen I'd say the odds are 50/50 Britain would be in a very positive place indeed. If I'm right, then focusing on stocks that are orientated towards Britain's economy might be worth a small bet. But how do you do this as part of a portfolio?

Morgan Stanley follows up its macro-economic analysis with a saunter through the British stockmarket, focusing on stocks with lots of UK exposure. According to London-based analyst Graham Secker, firms that derive all of their revenues from Britain's domestic economy include the following (in descending order of market capitalisation): utility groups SSE (LSE: SSE) and United Utilities (LSE: UU); commercial real-estate plays Land Securities (LSE: LAND) and British Land (LSE: BLND); supermarkets Sainsbury's (LSE: SBRY) and Morrisons (LSE: MRW); outsourcer Capita (LSE: CPI); and Costa Coffee owner Whitbread (LSE: WTB).

If this stock-specific approach is too risky for you, you could look at sectors instead. Promising ideas include local banks, housebuilders and retailers. The bad news is that too many of our big banks are globally focused, so a simple UK banking tracker wouldn't deliver what we'd want. But UK-focused housebuilders might still have a little bit more oomph left in them. And British retailers might even stage a modest rally from here, although the high street is currently wrestling with its own structural, internet-related demons.

How to play the domestic recovery

Perhaps the best way to play any nascent domestic recovery is via a local stock market index the FTSE 250 is seen by most analysts as the most dependent on the British economy. In technical terms, the FTSE 250 is a traditional market capitalisation-based index, which tracks mid-cap' stocks (ie, those that are neither big blue chips, nor tiddly little small caps). Some of the top companies in the index include housebuilders such as Taylor Wimpey and Barratt, which will clearly do well from a resurgent British economy, although it's worth remembering that many FTSE 250 stocks are still large enough to be internationally diversified.

I think the FTSE 250 has a great deal going for it, even though it has already had a stellar 12 months. The key benefit is that the FTSE 250 is much more diversified than the blue chip, larger cap FTSE 100. For instance, highly cyclical resources' stocks (miners and big oil companies) form a far less significant chunk of the FTSE 250, which has everything from oil explorers to specialist financials, as well as lots of industrial and consumer-focused companies. This range means the index is typically very diversified, rather than being dominated by a small number of big banks and oil majors.

I also like the fact that the FTSE 250 is currently a higher beta' index (it'll do much better in upwards-trending markets), because it's full of growth stocks that want to get into the FTSE 100. That means it's attractive if you expect growth to beat hopes. In short, if you are bullish on equities, the share prices of companies in the FTSE 250 are likely to rise by more than those in other indices.

Better yet, even though beta has been higher, volatility hasn't. Looking at recent data, the FTSE 250 has only been as volatile as the FTSE 100 not more. That means you've enjoyed higher returns with the same volatility. Effectively, you've got a higher return, while taking the same amount of risk you can't often say that.

The fact that the FTSE 250 is full of fast-growing stocks does have clear downsides. Investors tend to overpay for growth (the multiples in terms of price/earnings ratios are nearly always higher for FTSE 250 stocks than for FTSE 100 constituents). Dividend yields are also lower. So the FTSE 250 is not for value investors looking for cheap stocks. With that in mind, I've looked at the best ways to invest in the column above. Next time I'll take a look at funds investing in British smaller companies.

Four investments to buy into now

If you want to take a view on the FTSE 250, you have four main ways to invest.

A passively managed exchange-traded fund (ETF)

There are two main types. The ETF can use physical replication (where the tracker buys the underlying shares). Both iShares and HSBC do ETFs of this type, with total expense ratios of 0.40% and 0.35% respectively. Or there's synthetic replication, where derivatives supply the return (although these ETFs are still backed by assets). Lyxor and Deutsche DBX each do one of these ETFs, charging 0.35% and 0.30% respectively.

An actively managed unit trust

There's a range of high-quality options here, including in no particular order Franklin's UK Mid Cap, Old Mutual UK Mid Cap, Schroder UK Mid Cap and Neptune UK Mid cap fund.

An investment trust

There's a smaller number of excellent investment trusts. JPMorgan Mid Cap Trust (LSE: JMF) and Schroder UK Mid Cap (LSE: SCP) are both managed by highly regarded managers and are very cost effective. I'd also consider Henderson Smaller Companies Investment Trust (LSE: HSL), which has a mid-cap bias at the moment.

For adventurous bears

If you don't buy into my optimism, you might want to have a look at a brand new short tracker from Boost ETP. A couple of weeks ago the firm launched the FTSE 250 1x Short Daily ETP (LSE: 1MCS). For every 1% the FTSE 250 falls in a day, this should rise by 1%, and vice versa. For the even more aggressive, there's a twice daily leveraged version, under the ticker 2MCL (in other words, a 2% daily fall in the index should translate to a 2% increase in the fund). Just ensure you understand how daily pricing works before you invest.

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