We've heard it before. When there is greater volatility and more dispersion in the market, canny investors should be able to beat the index.
The great rotation in equities which markets are anticipating due to looser fiscal policy and higher interest rates under Donald Trump is filling active managers with optimism that they can use derivatives, hedging strategies and old-fashioned stock-picking to win a victory against the passive products which have bested them in recent years.
But the market is already very high, so which stocks look undervalued?
“The market is still frightened of what Brexit is going to mean for the long-term health of the economy, whether that’s inflation or overall trade and economic activity,” says Russ Mould, investment director at AJ Bell.
Since June, blue-chip UK equities which make their earnings overseas have looked like good insurance against the threat of a post-Brexit recession which might damage consumer confidence in the UK and dissuade businesses from spending. But the expectation that the UK economy would fall into recession after the vote has been proved wrong so far.
Housebuilders and real estate investment trusts have lagged the rally in UK equity markets over the last six months, and can be picked up for a reasonable price.
And any rise in the value of the pound would benefit retailers, he says, picking out Next as one which is “getting into value territory”. A disappointing Christmas trading statement showed how the high street clothing giant is struggling in the mid-market. “But its management is rigorous with a clear cash and returns policy,” says Mould. And at a price to earnings ratio of 8.87, it is trading at an attractive discount.
Barring HSBC, UK financials are also trading on a discount to book value. Adrian Lowcock, investment director at Architas, highlights Standard Chartered, Barclays and Lloyds (which he owns) as good purchases.
Inflation could rise to 3 per cent this year, and banks are well-placed to benefit, especially if this leads the Bank of England to increase interest rates. This is because they would be able to widen the margins between the rates at which they borrow, and those at which they lend to their customers.
Good buys whatever
However, the best companies are those which will do well regardless of cyclical factors, either because of strong management or because they dominate their sector.
Mark Wharrier, manager of the BlackRock UK Income fund, points to Rentokil, which operates in very fragmented industries such as hygiene and pest control, and which has been using cheap finance to buy smaller companies. Darius McDermott, managing director of Chelsea Financial Services, recommends Pets At Home, which is domestically focused but in a “big growth area and it has a great business model. Even if we go into recession, people still spend on their pets.”
Ibstock, the brick company, also suffered after the Brexit vote, but “given the limited supply in the UK and few national competitors, this stock continues to offer value,” says Lowcock.
Read more: Housebuilders give Ibstock a Brick-xit boost
Value investing, which is the selection of companies which look undervalued, requires a steady nerve, thorough research and the ability to screen out the noise. Alexandra Morris, chief investment officer at Skagen Funds, admits that she was scared when battery fires started occurring in Samsung’s Galaxy Note 7 smartphone last year. A large holder of the Korean electronics brand, Skagen did not short the stock. “Fifty per cent of Samsung is semiconductors,” says Morris. “As value investors, we know that.”
Helal Miah, investment research analyst at the Share Centre likes Rolls Royce, which has failed to perform well in recent years because of its exposure to the oil and gas market.
However, the aerospace division’s order book looks healthy and he is encouraged by the direction of Warren East, appointed as chief executive in 2015 from British chip designer Arm. “He is looking to implement a more efficient operating structure and move from a fixed cost base to a variable one, which should help Rolls Royce go through economic cycles better.”