Brexit blues: Finding neglected UK domestic stocks

by Jack Brumby from Stockopedia |

Battered UK domestic shares might be one of the best contrarian plays around. Here's how to pick them.

Uncertainty kills business confidence - and it seems like there's a lot of uncertainty around these days.

More than a decade after the last big financial crash, and at a time of fairly weak global economic growth, you might think that Britain's exit from the European Union is perfectly poised to be the straw that broke the camel's back.

But being a contrarian is what a lot of successful investing is all about. With all this doom and gloom around Brexit, battered UK domestic stocks might actually be one of the most attractive contrarian plays around.

Overseas buyers certainly seem to think UK assets are good value right now if the recent spate of M&A activity is anything to go by. Asset-backed, UK-focused leisure stocks easyHotel (LSE:EZH) and Greene King (LSE:GNK), for example, are both getting snapped up by overseas buyers.

At a Mello event last year, guest speaker Lord Lee said that there had been two huge investing opportunities in his lifetime: the banking crisis in the 1970s and the 2008 financial crash. Brexit, he said, might be the third. Big returns usually require patience, bravery, or both. So, is Brexit an opportunity for brave investors willing to look at out-of-favour domestic stocks? 

A quick way of identifying UK-focused, cheap, high-quality consumer cyclicals is to simply look at this sector and sort it in descending order of Stockopedia's Quality-Value ('QV') Rank. 

What would Buffett do? Why it pays to combine Quality and Value

The QV Rank is an equally weighted combination of Stockopedia's QualityRank and ValueRank. It looks at a stock's quality measures, such as return on capital and operating margin, alongside its value attributes (how cheap the stock is according to metrics like price to book and earnings yield).

Screening in this manner is useful as the QV Rank is a composite measure, meaning it condenses a lot of financial information to do with a company into one comparable figure.

When we organise the Consumer Cyclicals sector according to QV Rank and get rid of smaller companies with a market cap of less than £50 million, we get the following top 10 candidates for further research:

Name QV Rank Quality Rank Value Rank Market cap (£m)
Halfords (LSE:HFD) 99 95 95 349.85
SCS (LSE:SCS) 99 97 90 93.22
Elegant Hotels (LSE:EHG) 98 93 92 62.17
XLMedia (LSE:XLM) 98 96 88 151.48
Character (LSE:CCT) 98 99 84 90.85
Walker Greenbank (LSE:WGB) 98 92 90 59.63
Sports Direct (LSE:SPD) 98 97 84 1,306.70
Headlam (LSE:HEAD) 97 97 83 360.76
Tremor International (LSE:TRMR) 97 97 81 210.1
Mission Marketing (LSE:TMMG) 97 98 81 63.1

Source: Stockopedia

Some familiar names populate the screen. Halfords (LSE:HFD) was a stock market star five years ago but has fallen on hard times. Its shares now pay out an impressive forecast dividend yield of 9.66%, although dividend cover hovers around one times earnings and the group's trading troubles arguably pre-date Brexit.

Elegant Hotels (LSE:EHG), which trades at just 0.62 times tangible book value, is UK-listed but it has cornered the hotel market in Barbados, enabling it to generate favourable returns on capital. 

Then you have the likes of Character Group (LSE:CCT), which has recently been marked down in the market following Hasbro's acquisition of Peppa Pig rights owner Entertainment One (LSE:ETO). The group is consistently profitable and cash-generative. With its shares hovering around multi-year lows, might now be a good time to take a closer look at this toy company?

Talking of snapping up undervalued assets, Mike Ashley - Sports Direct (LSE:SPD)' maverick chief executive - has been on a veritable spree and now has a sprawling empire of retail brands. With rumours of investor rebellions and hefty tax bills, however, Sports Direct is as risky an investment as it ever has been.

A far steadier candidate might be Headlam (LSE:HEAD), which positions itself as a distributor linking floor covering suppliers to vendors. With a distribution network across Europe, competitive barriers to entry, and solid returns on capital, this could be an intriguing candidate for further research at just 10.7 times forecast earnings.

Contrarian picks for the long-term investor

QV investors are bargain hunters at heart, always on the lookout for great companies selling at great prices. This blend of hunting down good quality value stocks has been a trait of reams of great investors - including Warren Buffett, Joseph Piotroski and Joel Greenblatt. But beware - they are not necessarily looking for a quick trade. 

QV investors don't try to predict when their undervalued, high-quality stocks will come good - they just know they are likely to at some point in the future. In the meantime, a strong conviction is required in order to handle periods of volatility and potentially years of waiting. 

As Benjamin Graham once said: 'in the short run, the market is like a voting machine -- tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine -- assessing the substance of a company'. Picking stocks with both strong profitability and value characteristics is a good way to increase your odds of finding long-term winners.

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