A second wind for UK stocks

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Chris Burvill, manager, Henderson Cautious Managed Fund.

We've seen quite a few investors cut their exposure to stocks recently. They're worried that valuations look high, after something ofa golden period for the UK stock market.

They argue that, without earnings growth to justify these gains, investors should take profits. We can understand their concerns and it is certainly possible we'll see some short-term weakness.

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Share prices have come a long way since the second half of 2011. The slump in emerging markets and tensions between Russia and the West have added more uncertainty.

And it could be a very tough year for the Bank of England's Monetary Policy Committee,faced with the issue of when to raise interest rates. Even if everyone on it agrees that rates need to rise, they won't necessarily agree on the right time to do so, or by how much.

Even so, we believe that equities are still the asset class of choice for UK investors in today's environment. When you consider asset allocation, you have to look at relative value as well as the economic backdrop.

Looking at equities solely on their valuations using price/earnings (p/e) ratios, cyclically adjusted p/es, or price-to-asset ratios misses the common factor behind these measures.The fact is that UK interest rates have been at a record low of 0.5% for more than half a decade, so it should come as no surprise that most asset classes look pricey.

Given that, it's a mistake to single out equities as the potential weak link'. Compared with the uncompetitive yields on offer from bonds, equities should be valued higher, even if earnings growth continues to disappoint.But valuations are only part of the story.

The UK is recovering well and beating growth expectations, while further fiscal stimulus (government spending) as we near the 2015 election could also provide something of a second wind'.

Lastly, tempting though it may be, we should not entirely rule out some better economic news from Europe towards the end of the year. That could boost the tough earnings outlook we have faced so far this year. More importantly, there are still plenty of individual stocks where we can see good upside.

One example is propulsion and power systems manufacturer Rolls-Royce (LSE: RR). We've taken a bit of a contrarian stance on the company, which we bought in April, following a turgid few months.

We believe that recent disappointing results and Emirates' decision to cancel its major Airbus contract are temporary challenges. The Emirates order constituted roughly 3.5% of Rolls-Royce's order book other airlines are expected to take up the newly free delivery slots.

Also, the company benefits from significant, predictable long-term revenues from engine maintenance and repair contracts.

Medical devices group Smith & Nephew (LSE: SN) is another firm we like. It operates in a consolidating industry, where the big players feel the need to assert their position via acquisitions. The company is being courted by two US rivals, yet the stock still seems underappreciated. We suspect that there might be a great deal of hidden value here.

Finally, holding a position in Barclays (LSE: BARC), to which we have added in recent months, is all about valuation. The management team is taking action to rationalise its investment-banking arm the cause of most investor apathy towards the stock.

Once that part of the business is streamlined or stabilised, we believe investors will start to appreciate the underlying value of the business.