The new case for buying British (and five funds to consider)

Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

The consequence of that underperformance has been a wide valuation gap between the US and UK stock markets. The US trades on more than 20 times expected earnings; the UK is valued at just 11 times forecast profits. One market is frothy, perhaps in the early stages of a bubble. The other is undeniably cheap. Two questions arise. Is the discount justified by the fundamentals of each market? And, if it is not, what might trigger a narrowing of the gap?

The most common justification for the UK’s lowly rating is the sectoral composition of the market. We don’t benefit from the fast-growing, high-quality tech firms that have led the US market higher. Instead, we are weighted towards lower-growth old-economy sectors like mining and energy. This is part of it, but it doesn’t tell the whole story.

Rathbones did some useful work on the valuation gap recently in a bid to compare the two markets on an apples-to-apples basis. It concluded that the gap narrows only slightly when adjusted for both sector differences and other factors like quality, growth potential and balance sheet strength. Even after accounting for these, a significant discount remains. Firms in the same sector with identical growth and quality characteristics are cheaper if they are listed in the UK than in the US.

Rathbones also took on the Brexit question by running the same analysis using 2015 data. As the performance figures already mentioned suggest, they found no statistically significant discount relative to the US before the referendum. Increased uncertainty about the UK’s economic outlook justifies the shortfall to an extent, but the analysis also found that the discount applies to multinationals as much as it does to companies earning all their revenue at home. It looks like there is another reason for the gap.

One that’s often cited is falling structural demand for UK shares thanks to legal and regulatory changes that have discouraged UK pension funds from holding UK equities. The shift has been dramatic. Defined benefit pension funds, which hold the majority of pension fund assets in the UK, now hold more than 70% of their portfolios in bonds. Before 2000, 70% was invested in shares, with a high weighting to UK stocks.

Again, that doesn’t tell the whole story. It does not explain the relatively strong performance between 2009 and 2016, despite the fact that the asset allocation shift was well underway throughout this period. So, the more likely reason is that in the past eight years there has simply been a general pessimism about the UK economy and stock market, triggered by years of political uncertainty.

The good news is that the UK is starting to look reassuringly boring on both the economic and political fronts. Whatever you think about the likely result of the election later this year, it is probably not going to change much from a policy perspective. The debate has shifted to competence rather than the direction of travel. On most questions of substance, you can’t slide a cigarette paper between the two sides today. That’s reflected in the relative strength of the pound so far this year, with sterling being just about the only currency to have appreciated against the dollar.

There’s lots of hand wringing about the health of the UK stock market. It is certainly shrinking as it fails to persuade companies that it is a good place to list their shares. At the same time, overseas investors are taking the opportunity to snap up businesses on the cheap and take them private. There are lots of reasons why that might be a problem for UK plc, but it is less of an issue for investors in the UK stock market. The significant premium at which takeovers are being struck, compared to pre-bid market prices, is a measure of the opportunity under our noses.

As I’ve written here already, I don’t think the launch of a British ISA is the solution to the problems facing the UK stock market. I don’t even think it will necessarily direct a huge amount of new capital towards UK-listed companies. But at the margin I do think it has the potential to highlight the valuation advantage of British shares. It is not just about earnings multiples either. As and when interest rates start to fall later this year, the 4% dividend yield available on both the FTSE 100 and FTSE 250 will also seem increasingly attractive to investors. Please note this yield is not guaranteed.

As markets around the world push further into uncharted territory, it is easy to dismiss the attractions of a market that has been off investors’ radars for the best part of a decade. But as the risks of a correction rise elsewhere, and with the UK seemingly emerging from a very short and shallow recession, the case for our unpopular stock market is compelling.

Past performance is not a reliable indicator of future returns

Source: Refinitiv, 28.2.19 to 29.2.24, total returns in local currency.

UK fund ideas from our Select 50

If you’re looking for fund ideas for your ISA or SIPP this year, our Select 50 features five funds that focus on the UK. Three of the funds are actively managed, while the other two track a stock market index.

1. Fidelity Special Situations Fund

This actively managed fund was first launched in 1979 and aims to invest at least 70% in UK companies. There’s a focus on companies that the manager believes are undervalued.

Our experts like this fund because the manager is a “seasoned UK investor.” There’s also a willingness to invest in smaller companies, an area in which Fidelity brings expertise.

The fund’s top holdings include DCC, a sales company that operates across energy, healthcare, and technology, consumer staple Imperial Brands, insurance firm Aviva, facility management firm MITIE Group and pharmaceutical company GSK.

This fund may be suitable if you’re looking for a sensibly managed UK equity fund.

The fund’s ongoing charge is 0.91%.

2. FTF Martin Currie UK Equity Income Fund

This actively managed fund aims to generate an income that’s higher than the FTSE All-Share Index.

Its top holdings include oil giant, Shell and BP, consumer goods company Unilever, pharma company, AstraZeneca and GSK, miner Rio Tinto, British American Tobacco, and utilities firm National Grid.

Our experts like this fund as it invests primarily in companies listed in the UK, although the investment manager has the freedom to invest up to 10% outside the FTSE All-Share Index.

The manager is also committed to UK equity investing, which can be a rarity, as most investment firms tend to focus on global investing.

This fund may be suitable if you’re looking for dividend income from companies primarily listed in the UK.

The fund’s ongoing charge is 0.51%.

3. iShares Core FTSE 100 ETF

This passively managed fund tracks the FTSE 100 Index - which includes the 100 largest companies listed in the UK.

Its top holdings include some familiar names, including Shell, AstraZeneca, HSBC, Unilever, BP, and GSK.

Our experts like this fund as it is views BlackRock as a seasoned investor in passive funds, and the fund’s costs are low.

This fund may be suitable if you’re looking for exposure to large UK equities, have a long-term horizon and you’re cost-conscious.

The fund’s ongoing charge is 0.09%

3. Liontrust UK Growth Fund

This actively managed fund invests at least 90% in companies that are incorporated, domiciled, or conduct significant business in the UK. 

Shell, AstraZeneca, BP, Unilever, GSK, beverage company Diageo, analytics firm RELX and foodservice company Compass Group make up some of the fund’s top holdings.

Our experts like this fund as the managers seek to identify companies that possess intangible assets or other durable competitive advantages.

It’s worth noting that this fund’s approach has a ‘quality’ bias, meaning it will buy companies that tend to be more expensive than others. Due to this, the manager takes a very long-term view when investing.

This fund may be a suitable addition to your portfolio if you’re looking to invest for ten years or more.

The fund’s ongoing charge is 0.82%.

5. Vanguard FTSE 250 ETF

This passively managed fund tracks the performance of the FTSE 250 Index and invests in medium-sized UK companies.

Its top 10 holdings include budget airline easyJet, property developer British Land, renewable infrastructure company Greencoat UK Wind, property developer Bellway and financial services firm Alliance Trust.

This may be a suitable addition to your portfolio if you want to seek exposure to medium-sized UK companies, have a long-term horizon and are cost-conscious.

Given that the fund invests in medium-sized companies, there may be more volatility and risk arising compared to larger sized companies. If you’re concerned about risk, the iShares Core FTSE 100 ETF may be more suitable.

The fund’s ongoing charge is 0.11%.