UK shares: tips on how to find bargains and avoid value traps

Whether you are buying shares or funds, Danielle Levy explains how to tap into the ‘cheap’ UK market.

Bargain hunters will be looking for investment opportunities across the UK market following the announcement of a viable Covid-19 vaccine.

Along with other global markets, UK shares rallied strongly yesterday (9 November) and it looks like further gains will be made today.

Yet, the FTSE All Share index’s former high of 4,242 points in May 2018 still feels like a distant memory. Today, the index is sitting just above 3,500, so around 17.5% lower.

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UK stocks have cheap price tags for a number of reasons – not least Brexit uncertainty and the ongoing Covid-19 crisis. What’s more, the UK has one of the lowest tech stock weightings across the largest 15 markets worldwide, according to Morgan Stanley. This makes it very difficult to keep pace with the likes of the US, which is home to tech giants such as Amazon (NASDAQ:AMZN) and Facebook (NASDAQ:FB), at a time when investors continue to flock to exciting growth stocks.

In spite of these challenges, some investors (speaking before yesterday’s news that a Covid-19 vaccine could be within reach) argue that cheap valuations across Blighty have become too difficult to ignore. They point out that the UK is home to a host of fantastic businesses, which will survive Brexit and the Covid-19 pandemic – and ultimately grow their market share over time. The good news is they are attractively valued to boot.

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Where do the best opportunities lie?

“The UK is cheap and small-caps are even cheaper,” says Gervais Williams, manager of the LF Miton UK Multi Cap fund.

“We would argue that if global growth doesn’t really return, investors will need to access small-caps to continue to participate in growing businesses on attractive valuations, rather than being forced to pay very high valuations for high-beta technology stocks,” he adds.

Williams points to AIM-listed Randall & Quilter Investment Holdings (LSE:RQIH) as a stock that looks undervalued. He recently added to the insurance services company because he felt the market hadn’t recognised its strong market position. For example, in the US the company offers a way for insurance agents to operate without having to apply for authorisation in each state.

“They have been very successful in bringing a large number of customers in. We think the cash payback on that over the next two or three years will be remarkable, and as that comes through we think the dividend yield will grow really well going forward,” he says.

Meanwhile, in the mid-cap space, the fund manager recently invested in AO.com (LSE:AO.). He expects the electrical retailer will grow its market share as shoppers continue to shift online.

Daniel Hanbury, manager of the ES River and Mercantile UK Equity Income fund, highlights car maintenance and cycling specialist Halfords as a stock to watch. Six months ago, he invested at a distressed valuation.

“The market was clouded to the fact that their services would remain in strong demand both throughout a pandemic and through a period when an economy is trying to decarbonise,” Hanbury explains.

Although the shares have almost quadrupled since then, he believes they still offer value because investors have wrongly assumed that the business is “ex-growth” and is unable to compete with online competitors.

“The lesson is that there are significant undervalued opportunities in the UK stock market today and they come in a range of forms. We do not have to choose between growth or value, but simply look for undervalued or unrecognised companies to enjoy significant returns,” he concludes.

How to spot a value trap

Nick Marshall, head of fund solutions at Peregrine & Black Investment Management, points to the divergence in performance between sectors across the UK market. For example, while healthcare companies have been fairly robust through the Covid-19 crisis, some energy stocks are down by around 40% (prior to yesterday’s stock-market rally). In his opinion, this divergence should allow active fund managers to add value.

However, they also face the challenge of avoiding so-called value traps, too. This term refers to an out-of-favour stock that looks cheap against its peers or even relative to history. However, a closer look at the investment case shows that it is cheap for a reason: namely, because the company or industry’s fundamentals are so poor that it is unlikely to recover.

Distinguishing between an undervalued stock (where the share price is suffering a temporary setback) and a value trap (when the share price is suffering a more permanent setback) is no easy feat, particularly at a time when many stocks look cheap. With this in mind, Williams advises investors to take a closer look at whether a company is still generating cash.

“If cash is coming in, a company can buy back shares, pay dividends or invest in a new business – and that will drive up the share price. As long as the cash arrives, you don’t get a value trap,” he explains.

Meanwhile, Hanbury describes digitisation as the “major industrial wave of our time” and notes that companies that fail to adapt to this new age are likely to disappoint. In this sense, they could ultimately turn out to be value traps.

He points to a previous innovation wave to illustrate this point. “After train stocks performed strongly for 20 years during the 19th century, any value investors at the time arguing there was book value in their underperforming canal stocks ended up missing out on decades of train stock outperformance – i.e. canal stocks turned out to be the value traps,” he explains.

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At a time when many parts of the UK market look cheap, those looking to select funds to access investment opportunities face another dilemma: should they buy an out-and-out value fund or is there simply no need?

Ian Brady, chief investment officer at Harpsden Wealth Management, says there is no need. He prefers to back funds that have a strong focus on valuation, as well as a bias towards “quality” business models and strong balance sheets.

“We also like the managers to identify catalysts rather than merely waiting for a return to the mean,” he adds.

For example, Brady is a fan of Franklin Templeton UK Equity Income owing to its fund manager Colin Morton’s approach to not take “extreme style or sector bets”. The company also holds Unicorn UK Income and Montanaro UK Income to provide exposure to smaller companies.

“Although both funds come under the income banner, they are much more focused on quality companies which exhibit above-average dividend growth over time, rather than concentrating on the highest-yielding stocks. These funds have performed well in both the near and long term,” Brady explains.

Marshall agrees that there is no need to hold a value fund at a time when fund managers can access opportunities across huge swathes of the UK market. Peregrine & Black Investment Management’s top fund picks include Liontrust Special Situations, Merian UK Alpha and Artemis Income.

Meanwhile, Gary Potter, who is co-head of the multi-team at BMO Global Asset Management, suggests it could be worth looking at dedicated value funds. However, he stresses that patience will be key. He remarks that a number of his favoured UK value managers are telling him that their portfolios have never looked so cheap. They include Henry Dixon, who runs the Man GLG Undervalued Assets fund, and Jupiter UK Special Situations, managed by Ben Whitmore.

Potter urges investors not to lose sight of one of the most important rules of investing. “The only thing that determines success in investment is the price you pay for the asset,” he says.

This is why it could pay off to back a fund manager with a solid track record who is temporarily out of favour.