Why the UK is the holy grail for investors

The holy grail for an investor is the overlooked opportunity, the investment whose merits have somehow passed everyone else by. Perhaps these were more plentiful in a pre-internet age where a well-informed stock picker could gain a profitable edge. Today we are swamped with information and hidden gems are rare.

More common is the growth story in which the good news is already in the price. US tech stocks and Indian equities fall into this category. Or the troubled market, which is cheap for a reason. Chinese shares might fit this description. More unusual, and exciting from an investor’s perspective, is the UK stock market - and particularly the mid-caps that make up the FTSE 250 index - where it feels as if there may be a lucrative gap between perception and reality.

UK shares have been cheap versus their peers for a long time now. A few reasons are usually offered in explanation. First is the sector make-up of the UK market - we just don’t have enough of the high-quality growth stocks that make the US market so attractive. Second are the structural reasons why domestic investors, particularly pension funds, have significantly reduced their exposure to the UK market. Third is the decline in UK listings. And fourth a general concern about the political instability of the past ten years or so.

The consequence of this lengthy charge sheet has been a shrinking and undervalued market. UK shares are priced at little more than half the valuation of their US counterparts, measured against their earnings. And the market has seemingly drifted towards irrelevance as too few companies have wished to float on the London Stock Exchange while too many have been taken private by acquisitive foreign investors.

The good news today is that, while the UK remains cheap relative to other comparable markets, the reasons to dislike it are getting thinner on the ground and the reasons to be cheerful more plentiful. We are in that short-lived sweet spot where everyone is talking about the great value in UK shares without quite plucking up the courage to do something about it.

I sat down this week with Alexandra Jackson, manager of the Rathbone UK Opportunities Fund, to discuss the domestic investment landscape. She gave me a long list of reasons to be optimistic about our home market, and in particular the mid-cap segment where she finds the best combination of growth, value and liquidity.

But first she stressed that in many cases there’s a good reason why US shares are more highly valued than their UK counterparts. American companies are often better at generating high returns from the capital they deploy. They are better businesses. It’s a good reason not to settle for an exposure to the UK via a passive fund, especially one that tracks the relatively stodgy FTSE 100. You’ve got to dig a bit deeper in the UK for businesses with a competitive advantage and high margins but there are enough of them to repay the effort.

The first reason to be positive on the UK is the improving macro backdrop. Having been an inflation outlier for the wrong reasons 18 months ago, we are back in the pack. Yesterday’s inflation reading for June was the second in a row to hit the Bank of England’s target. The first interest rate cut in the upcoming easing cycle is now likely to be delivered at the beginning of August, even if persistent service sector inflation and wage growth remain a concern.

The consumer picture is improving quickly, with Asda’s income tracker rising faster than at any point in the past eight years. Unlike in the US, where higher-for-longer interest rates are starting to bite, Citi’s economic surprise index is trending higher. The previous government’s national insurance tax cuts are boosting disposable incomes, utility bills have fallen fast and wages are growing more quickly than inflation. Mortgage rates will follow interest rates lower. The shallow recession at the turn of the year is now firmly in the rear-view mirror.

The second positive is the relative political stability of the UK in an increasingly unstable world. In the wake of this month’s election, Britain is looking reassuringly boring. And the new government’s growth focus, while harder to achieve than to promise, offers the prospect of a meaningful boost to sectors such as housebuilding and infrastructure. A more constructive relationship with Europe will provide a more positive backdrop for investment and growth.

A third reason to favour UK shares is the uptick in takeover activity off the back of the low valuations in our domestic market. A further trigger for more takeovers could be the turn in the interest rate cycle. Dealmakers have had to contend with rising rates for two and half years. More mergers and acquisitions will favour the mid-cap segment of the market as this is where the most digestible companies, on the most attractive valuations, reside.

There are other reasons why someone looking to increase their exposure to the UK market should begin their search in the FTSE 250. Historically, this is where the best growth has always been, and looking forward it remains the best hunting ground for high growth businesses. According to Goldman Sachs the FTSE 100 is expected to grow its earnings by 2% this year and 9% next while the equivalent numbers for the FTSE 250 are 15% and 20%. Despite this, both indices are valued almost identically at just under 12 times expected earnings.

Jackson describes the FTSE 250 as a ‘coiled spring’, because its performance relative to the FTSE 100 is so closely correlated to movements in the global cost of borrowing, which is poised to fall. When the yield on US government bonds declines, the FTSE 250 outpaces the FTSE 100 and vice versa. The imminent interest rate pivot should be catnip to mid-cap investors.

The UK may well be the most undervalued stock market in the world today. Sometimes the holy grail is hiding in plain sight.

This article was originally published in The Telegraph.

Select 50 UK fund ideas

Fidelity’s Select 50 list of recommended funds features five that are focused on the UK - three actively managed fund options and two index trackers. You can find out more by clicking on the factsheets below.

Select 50 UK actively managed funds

• Fidelity Special Situations Fund
• FTF Martin Currie UK Equity Income Fund
• Liontrust UK Growth Fund

Select 50 UK index tracker funds

• iShares Core FTSE 100 ETF
• Vanguard FTSE 250 ETF

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Select 50 is not a personal recommendation to buy or sell a fund. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.