Investors can locate high-quality businesses at attractive rates in four areas of the market.
Contrarian investors understand that “actual risk” is the opposite of “perceived risk.” This saying explains one of the main differences between success in the markets and the rest of your life. If something seems dangerous, it is because it is. Investors should take this as a signal to look at the situation more closely.
There is no denying that the UK is at risk right now. Although we may have left behind late September and the mini-Budget, we still find ourselves between last week’s dark Bank of England rate-setting meeting (which was a disaster) and next week’s hard landing at the Autumn Statement. Both fiscal and monetary policies are moving in the same direction and point to a difficult road ahead.
Although the biggest interest rate increase in over 30 years grabbed the headlines, it was the 1.4pc predicted fall in GDP next year that should concern us more and that the downturn could last for a few years. Investor confidence will be affected by this slowdown, which will be painful and grinding.
Although the cost of borrowing is now at an eminently lower level than expected, the Bank remains in the unfortunate position of having to tighten its policy as we enter a recession. In fact, we may be already there. There is a risk that the Bank and Government will try to restore their tarnished credibility by overdoing it.
Both the Halifax and Nationwide housing surveys point to falling home prices. We are already seeing the biggest drop in house prices since 2011, excluding the pandemic. A further correction in the prices is inevitable as nearly half of fixed-rate mortgages will be up for renewal within the next two years.
The Autumn Statement next week will attempt to plug a huge gap in public finances. Although the decision to divide the nearly PS60bn bill among spending cuts and tax increases is not an economic one, it may make little difference from a market perspective. Because of its size, the cost must be paid well below the income level. This is because it directly impacts slower activity.
All this bad news has had an impact on real investment behaviour for some time. With one month remaining, cumulative flows into UK equity funds have been more negative than at any time in the past 10 years. Global investors have bought UK shares in net purchase over the last 15 years, but that is not the case for flows into passive funds that track the internationally-focused FTSE 100. Active funds that are more focused on domestic stocks are out of favour.
You could also argue that valuations have already suffered a lot of pain. In the last three decades, the FTSE 250 index’s valuation has been only one-tenth of what it was in the previous 10 years. This same mid-cap index is valued at 30% less than the MSCI World index. The FTSE 100 would have doubled in value since the 2009 bear market. However, the same amount would have grown five times in the S&P 500.
This underperformance means that you will now need to pay only nine times the expected earnings for an average share of the FTSE 100 or 11 in the FTSE 250. This compares to 17 times for an average US share. This is because of the anxiety level about the UK. You can earn a dividend yield of 4.5pc here, as opposed to just 1.8pc in America.
British shares are so cheap. But are they really so cheap? It all depends on where you look. Different parts of the market will be affected by the coming recession in different ways. Certain areas, such as retail and leisure, will be hardest hit. These sectors are in great oversupply and it will be very difficult to reduce it. These businesses might not be worth your time for many years, just as it was wrong to invest in technology stocks after 2003 and banks after 2009.
Investors can still find quality businesses at affordable prices in four areas of the market.
This first group includes high-quality growth companies, which have not been in favour since interest-rate-sensitive value stocks had their occasional moments in the sun. Growth-focused UK fund managers often mention Aveva as a provider of software for the engineering sector.
The second group holds defensive stock that was sold due to widespread concerns about companies’ ability to pass on rising prices. Cranswick is a favourite meat processor with a prestigious reputation as a trusted, large supplier to big supermarkets and a pricing power that matches.
This third group provides investors with access to domestic high-quality companies whose valuations are being impacted by the uncertain UK outlook. This is when uncertainty affects a share’s value but has no significant impact on its long-term viability. Warren Buffett once said that price is what people pay and value is what they get.
This last group is the one that benefits from the tendency for businesses to sell down during a recession. As Michael O’Leary (Ryanair’s chief executive) pointed out earlier this week people don’t have to change their routines in a recession. They just become more price-conscious, whether they’re flying on holiday or shopping for groceries.
Although it may seem counterintuitive, when the perceived risk in the UK is so high, the actual risk could be surprisingly low.
