UK stocks are more expensive than they look – there’s better value elsewhere

At first glance, the UK stock market looks attractive at the moment. But dig a little deeper and you’ll see that it's not so cheap after all.


UK stocks: be ready to bail out

There's a growing amount of bubble' chat around at the moment. That's mainly because the US stock market is looking rather expensive.

But there's no such problem over here, you might think. At first glance, the UK stock market looks pretty attractive at the moment.

The dividend yield is 3.4% and the price/earnings ratio is 14, according to Bloomberg.

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Even better, the ten-year cyclically adjusted price/earnings ratio (Cape) for non-financial shares is 15. That compares very favourably with the US where the Cape ratio is well over 20.

(We're big fans of the Cape ratio at MoneyWeek because it looks at how much profit a company makes over the whole business cycle and cuts out temporary noise.')

The trouble is, if you dig a little deeper, you'll see that UK shares aren't so cheap after all

Strong oil and gas earnings have flattered the UK's valuation

With the oil price booming, it's been a great decade for explorers and producers. Research group Capital Economics points out that oil and gas shares have delivered earnings growth of 15% a year over the last decade. That compares to an average of 9% a year for the market as a whole, excluding financials.

So even if you average out earnings over ten years, it's fair to say this has been an unusually profitable period for oil and gas shares. And you could argue that this has artificially boosted the e' side of the price/earnings ratio.

Now I wouldn't normally complain about strong profits growth. But the problem is that oil and gas profits are now going into reverse Shell's latest results revealed a 27% fall in earnings.

Poor performance by oil and gas companies will have a big impact on the wider market because the sector comprises 18% of the London market, excluding financials.

What's more, Capital Economics reckons there's a decent chance the oil price will start to fall soon, and if that happens we will probably see further profit falls at the oil majors.

All other beings equal, that will boost the market's price/earnings ratio (if prices stay flat, and earnings fall, the p/e will rise). All of a sudden, the UK market's valuation might not look so attractive.

As Capital Economics notes: "[The low CAPE ratio] of the UK stock market could well reflect a view that the average level of earnings during the past decade which has largely stemmed from the strong profitability of listed oil and gas companies is not a useful guide to a normal' level of earnings."

Of course, bulls could argue that other sectors are ready to pick up the slack from the oil and gas sector. And yes, there's a good chance that George Osborne's pre-election boom will boost the performance of housebuilders, retailers and other consumer-based businesses. Indeed, I've been pretty bullish on retail stocks for precisely this reason.

Both the UK economy and household spending grew by 0.8% over the last quarter. On top of that, rising house prices are beginning to trigger an uptick in construction.

But let's not forget that a large chunk of the UK stock market's profits is generated outside the UK. Weak economies in the eurozone will hurt plenty of FTSE 100 companies.

And when I look at the UK economic data, I worry when I see that exports fell by 2.4% over the last quarter. This feels like a fairly superficial recovery built on those old favourites: consumption and rising house prices. There's a big question mark over whether the chancellor (and the Bank of England) will be able to sustain this recovery beyond the next election.

Britain might be a short-term bet, but it's not cheap now

There are probably short-term profits to be made in consumer-facing sectors such as retail and construction. Especially if you focus on businesses that are predominantly UK-based that way you can make the best profits from any Osborne boom. We looked at some potential plays in a MoneyWeek magazine cover story a few months ago.

However, any purchases you make in these sectors shouldn't be buy and forget' investments. You should be ready to bail out if you see signs that the UK economy is once again about to hit the wall.

But if you're looking to make a long-term investment, don't fall into the trap of thinking the UK is cheap. The current Cape ratio is misleading, and that means the FTSE All-Share index is unlikely to deliver more than modest gains over the medium term.

My colleague John Stepek looks at some more attractive if riskier - markets in the latest issue of MoneyWeek, out tomorrow. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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Ed has been a private investor since the mid-90s and has worked as a financial journalist since 2000. He's been employed by several investment websites including Citywire, breakingviews and The Motley Fool, where he was UK editor.


Ed mainly invests in technology shares, pharmaceuticals and smaller companies. He's also a big fan of investment trusts.


Away from work, Ed is a keen theatre goer and loves all things Canadian.


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