These UK stocks look even more undervalued after pound sterling’s fall

In a recent interview, Ian Lance, joint-manager of the Temple Bar Income trust which focuses on value investing, explained that he feels London-listed stocks are now even more undervalued compared to international peers than over recent years:

“We think Britain’s stock market looks very cheap compared with the rest of the world. It is at a discount of around 45pc to the global market, compared with a long-run average of around 17pc. This is partly because of weakness in the pound as investors grow more fearful of a recession.”

It has been argued for a decade that companies have seen their valuations penalised for the simple fact of being listed in London. International investors started taking a cautious approach to exposure to the UK as a result of the sluggish recovery from the international financial crisis over a decade ago. That trend intensified over the Brexit period with investors taking their traditional approach to uncertainty by avoiding it.

The recent weakening of the pound against especially the dollar but also most other major international currencies is now reinforcing the discount that London-listed companies trade at compared to international peers. Even London-listed companies that make the lion’s share of their revenues and profits internationally have not escaped the London discount.

A further factor acting as a drag on the LSE is that it is dominated by cyclical companies like retailers of consumer discretionary products, financial services companies, hospitality and construction.

Source: WallStreetPrep.com

With it broadly accepted we are on the cusp of a recession across much of the developed world, investors are dumping exposure to cyclical stocks, further suppressing valuations. The result is that cyclical stocks are looking cheap again as markets follow their well-worn pattern of over-reacting to both positive and negative news.

Distinguishing between cheap stocks and value traps

When looking for value investments, the biggest pitfall investors face is the danger of mistaking a value trap for cheapness. Sometimes companies can look cheap compared to both their fundamentals and historic multiples but face risks and are contending with problems not yet highlighted by management or analysts.

If these issues, which market participants have recognised despite their lack of public coverage, are not taken account of in guidance, forecasts or most third-party analysis, less experienced investors can see value. The reality is the current price is a value trap and has been discounted by the market for good reason.

There are a number of common ways to distinguish a value trap from value when assessing a stock for true ‘cheapness’ when its p/e ratio jumps out as attractive. You should always ask the following questions:

Is the company underperforming its sector?

It always make sense to judge an individual stock in the context of its broader sector. If it has seen lower growth than peers look for the reasons why that is the case. Are they transient in nature or deep lying issues?

Is the company’s market share declining?

Companies can remain profitable for some time despite declining market share, especially if they are a high margin business. But if market share is locked into a long term downward trajectory there is probably a good reason why it is no longer competitive with rivals. You want to avoid buying in at the point the stock’s fundamentals still look superficially solid but are heading in a direction that will eventually mean that is no longer the case.

Is capital allocation efficient?

Assessing the efficiency of capital allocation can be tricky as it involves a level of understanding of the sector. However, if a company has been investing significant amounts of its free cash flow in a way that has not been delivering growth, it’s a warning sign that things may not be heading in a promising direction.

Sometimes it’s difficult to tell if capital is being allocated efficiently or not. An example would be Facebook owner Meta Platform’s heavy investment in the metaverse or a traditional car maker investing heavily in EV technology.

These investments could pay off spectacularly if they come off. If they don’t, they could potentially undermine the long term viability of the company if too much is riding on them.

In other cases, it’s far easier to judge. For example, if a company has recently allocated significant capital to acquiring assets that are not performing or have already seen their value written down significantly.

Does management have a history of over-promising and under-delivering?

One strong indicator of a potential value trap is a company with a record of missing publically announced targets and forecasts. This indicates a disconnect between management and operations which rarely ends well.

How much debt is the company carrying?

A common mistake less experienced investors make is failing to take a company’s level of debt into account when assessing its current performance and potential. Always look at the Debt to Equity ratio and compare it to peers.

Is the company overly reliant on a particular product or market cycle?

Sometimes companies make a lot of money from a single product or temporary surge in demand. A good example of this would be stocks that saw their revenues surge during the Covid-19 pandemic. Several vaccines and biotech companies saw their valuations shoot up as a result of the roll-out of coronavirus vaccines they produced or licensed their technology to.

However, those whose revenues were most heavily influenced by the vaccine roll-out quickly saw their valuations deflate again when the initial rush of demand started to ebb. The same can be said of other companies such as the upmarket exercise bike company Peleton, which saw its valuation go into orbit on the back of sales during lockdown periods before plunging again when they started to return towards historical norms.

Has the stock’s value dropped sharply over a short period?

On the one hand, buying into a stock that has dropped in value sharply and then goes on to have a V-shaped recovery is every investor’s dream. Unfortunately, the reality is that stocks that plunge by 30% or more over a short period almost always take a long time to recover, if they ever do.

Yes, you are looking for value which often means a stock is a long way off its peaks. But be very wary of companies that suddenly look cheap very quickly. There’s probably a good reason.

Has the stock traded at low multiples for a long time?

While you should be careful of stocks that quickly drop to trading at low multiples over a short period the same can be said of those that have done so for an extended period. That’s usually because the market sees little growth potential and a company treading water. Even if treading water takes up little energy, staying in one place for too long almost always ultimately ends in eventually sinking.

5 UK stocks that do look like they represent value, not a value trap

A recent Forbes article highlights 5 London-listed stocks that, according to a filter tool that looks for companies with strong 10-year revenue per share growth rates (at least 6%), and takes into account analysts’ future earnings projections and attractive p/e ratios, look undervalued. They are:

Ashtead Group

A construction and industrial equipment rental business, Ashtead Group may struggle during a recession and markets have priced that in with its share price falling by over 29% so far this year. At its current market cap of £18.82 billion, Ashtead now has a p/e ration of around 18 as well as a price-book ratio of 4.21 and price-sales ratio of 2.9.

Other positives are a positive return on capital invested and strong profitability despite a declining operating margin influenced by inflations. Return on equity, assets and capital are also all better than the majority of its peers.

Schroders

The filters used also pinpoint asset manager Schroders as looking undervalued at its current market cap of £7.24 billion. It has a p/e ratio of just 13.08, a price-book ratio of 1.77 and price-sales ratio of 2.5.

The company is almost 220 years old and shows good profitability and steady revenue and earnings growth. Operating margins are sliding but but returns are still in the top 50% for the sector.

Mondi

Paper and packaging company Mondi is not an exciting stock but has a strong history of reliable returns and currently trades at a p/e of just 6.43, a price-book ratio of 1.42 and a price-sales ratio of 0.91.

The company is still creating value for investors and has good profitability and returns that outperform competitors despite contracting operating margins.

JD Sports

With its strong growth, good market share, customer loyalty and relationships with premium brands, JD Sports was relatively recently a darling of investors. However, it’s had a tough year with its value down over 40% in a trend that has caught up a majority of retailers of consumer discretionary goods.

After its fall in value from recent highs, JD Sports trades at a p/e ratio of 17.78, a price-book ratio of 3.39 and a price-sales ratio of 0.75.

JD Sports is still highly profitable and its operating margin is actually improving while returns are among the best for its sector. This stock looks particularly undervalued at its current price.

DCC

Another stock that looks significantly undervalued is the Irish provider of sales, marketing and support services DCC. Its current p/e is 15.13, price-book ratio 1.62 and price-sales ratio 0.27.

Value is being created by its capital investments and profitability in a good place with returns outperforming over half of its sector competitors. The company also has a history of consistent earnings and revenue growth.

The post These UK stocks look even more undervalued after pound sterling’s fall first appeared on Trading and Investment News.
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