Why you should own UK stocks – and what to buy

The UK’s stockmarkets are unusually cheap compared with the rest of the world. If you don’t have substantial holdings in UK stocks, you should, says Merryn Somerset Webb.

Brexit Brings Only Pain for FTSE 100 Without Pound Magic

UK stocks are cheap

© 2019 Bloomberg Finance LP

In 1984, Ronald Reagan ran a TV campaign known as "Morning in America" for his second term as US president. In it, a calm-sounding voiceover noted that things were pretty good in the US, the implication being that you'd be mad to vote for a leftie who would upset the status quo. The US agreed.

Reagan's huge victory confirmed that US voters believed in democratic capitalism. The same has just happened in the UK. Employment is at a record high; inflation is low; interest rates are low (too low, but we will leave that for now); real wages are rising at their fastest rate for ten years; and real UK house prices have fallen over the past ten years.

It's not perfect and it comes with a Brexit overlay that scares some people, but UK voters Scotland's residents included clearly think it isn't something to hand over to a group of crazed socialists. This week's vote, then, is pro-democracy (getting Brexit done) and pro-capitalism (no to uncontrolled money printing, asset expropriation, nationalisation and super taxation). This is good news all round, given that history shows us that this is the best route to prosperity.

Reagan's ad came with a secondary theme of renewal, something that Boris Johnson will surely also be picking up. With a bit of luck, his majority can be used not just to get Brexit done, but to start a real focus on addressing the UK's deep-seated and interconnected problems: not enough housing, low productivity and extreme dependency on in-work welfare.

The Budget expected in February should begin to address all these things along with, I hope, knotty long-term micro-issues such as pension reform, the skewed nature of our tax burden and even, finally, social care. Maybe it's "morning in the UK".

Add in the removal of at least some Brexit uncertainty and the inevitability of fiscal (and possibly monetary) loosening to lift the remaining fog and I think that one more thing is completely clear: if you don't have substantial holdings already, you really must buy some UK equities.

UK stocks are at a global discount

At the turn of the month the UK was trading on an average price/earnings (p/e) ratio of 12.8 times and a price to book ratio of 1.4 times. Combine these numbers with a few other valuation measures such as a FTSE 100 dividend yield of 4.1% against a long-term average of 3.6 and that puts the UK market at a 16% discount to its 30-year average, says Simon French of Panmure Gordon.

The rest of the world is trading at a 5% premium to its 30-year average, and on an average p/e ratio of 15.6 times. This isn't just about sector composition, either. It is fashionable in critical circles to point out that the UK is light on listed technology companies. But if you control for that, you still end up with a valuation divergence of 20% or so, French says.

Another striking point is just how badly domestically focused companies have done relative to internationally focused companies, returning 0% versus 40% in the past three years, and how badly small businesses have done relative to big. The UK small-cap index went into the week on a p/e of just 10.9 times, says French.

It isn't normal for the UK market, that of the sixth-largest economy in the world, to decouple from the rest of the world like this. The last time it did so to such an extreme was 1989-90. Brexit is the obvious villain here. The decoupling begins abruptly after the 2016 vote and the huge uncertainty it created. Before the Brexit vote, the US and UK markets had "almost identical" forward p/e ratios, said Capital Economics. Since then, the UK's has been 25% lower.

But if huge uncertainty around the idea of Brexit and the horrible political division it caused was the trigger to devaluation, surely the beginning of the end of that uncertainty will cause valuations to normalise?

What to buy

Look to Friday's markets and you will see this beginning to happen. The domestically focused FTSE 250 rose 4% on Friday morning and the FTSE All Share rose 1.9%. The gains were led by domestically orientated companies banks, housebuilders and utilities and many of the UK-focused trusts I have looked at over the last few years were big beneficiaries. Law Debenture (LSE: LWDB), Henderson Smaller Companies (LSE: HSL), Temple Bar (LSE: TMPL) (all three of which I own), Diverse Income (LSE: DIVI) and Mercantile (LSE: MRC) jumped by between 4% and 8%. The Miton UK Microcap Trust (LSE: MINI), another of my holdings, is up 4.7%.

So have you missed your moment? Far from it. Global and domestic investors have been hugely bearish about the UK. Today everyone who isn't busy buying houses (estate agents predictably report phones ringing off their hooks) will be taking off their short positions and moving into liquid stocks. Over the next few months they'll be thinking about it properly and moving money into more equities and into smaller equities.

The UK discount isn't going to disappear in its entirety this week. Sure, the end of Corbynism makes the UK investable again and it is true that the City and most big business completed their Brexit contingency planning long ago, so they are not as bothered as they once were. And yes, Johnson's majority means that he doesn't have to listen to extremists on either side of the Brexit fence something that could mean a softer Brexit than many now expect.

But it will take a while for the levels of hysteria we have seen over the past three years to settle. The Brexit negotiations have a long way to go, which will mean more bouts of market madness. Regardless of the risks ahead, however, the point in the UK this week is that we voted for democratic capitalism. Now, given the discount, it's time to get out there and buy it too. All the trusts I mention above are good places to start.

This article was first published in the Financial Times

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