Shunned, Hated, And Cheap: Why You Might Want To Buy UK Stocks Now

The UK stock market is one of the world’s most loathed. Investors are giving it the cold shoulder, fund managers are avoiding it, and the only ones throwing money in are the UK companies themselves. But when a group of assets is this despised, you know you’d be wise to check it out. So let’s take a look at what’s now the cheapest market in the world.

So why is everyone snubbing UK stocks?

The UK's been caught in a gnarly storm of stagnant growth and relentless inflation. The Bank of England (BoE) has been hiking interest rates, sending them to near-dizzying heights, to try to cool the price hikes that hit a 40-year high in late 2022. And those higher rates have been putting a major squeeze on growth and business profits.

And that was just the economy. Peek under the hood of the UK's main stock indexes and you’ll find commodities producers (like Shell, BP, and Rio Tinto), defensive consumer staples (like Unilever, Diageo, and, British American Tobacco), banks (like HSBC), and pharma (like AstraZeneca and GSK), with very few tech and growth stocks. And that big bias toward defensive and value stocks has been challenging at a time when investors have been gunning for growth and cyclical stocks.

UK stocks lean heavily toward “old economy” sectors like energy and financials, defensive consumer staples, and healthcare, and are extremely light on tech. Sources: Bloomberg, Finimize.

Why even go near UK stocks, then?

Fair question. If you're playing the long game, you want to focus on what drives those juicy long-term returns: cheap starting valuations, attractive dividends, and improving company fundamentals (think: rising earnings growth and profit margins).

The short-term forecast for UK shares might be foggy, but these elements hint at brighter days ahead for those who are patient:

1. Valuations: UK stocks are the cheapest ones going.

Morgan Stanley crunched the numbers and found that UK shares are currently the cheapest in the world. They're not just cheap when stacked against their pricier US counterparts, but also when measured against their European mates (light blue line) and global mates (dark blue line), trading at discounts of 20% and 40%, respectively.

UK stocks are trading at a 20% discount to European stocks and a 40% discount to global ones. Source: Morgan Stanley.

And it's not just down to the UK's strong ties with the kinds of sectors that typically bag lower valuations: even after adjusting for these sectors, UK stocks still trade at a drool-worthy 30% discount to their global peers. Perhaps even more importantly, UK stocks aren’t just cheap relative to other regions, but also relative to their own history, making the opportunity even more tempting.

Even after adjusting for differences in sectors, UK stocks trade at a 30% discount to global ones. Source: Morgan Stanley.

Sure, a cheap asset isn’t always a smart buy. But usually, nabbing assets on the cheap will tip the scales slightly in your favor, especially over the long haul. Investors often overemphasize a bleak recent past and fail to see potential bright futures. So on average, when everything looks doomy and gloomy, sentiment tends to shove valuations below their fair value. If you’re brave enough to buy low, you’re more likely to reap benefits from the less grim fundamentals and the boost from rising valuations. In fact, research has shown that valuation is one of the most important drivers of returns over a long horizon.

2. Dividends: among the world’s most tempting yields.

Even if UK shares don't skyrocket, their high dividend yield of 4.3% (double that of US stocks) means you’ll still see some handsome returns. Pair that with a robust return on equity (on par with US firms) and a potential uptick in valuations, and suddenly UK stocks look less drab compared to other high-yield assets like cash or bonds. And, sure, UK shares might not be the Nvidia-like rocket ships that some investors dream of. But remember, it's often the tortoise, not the hare, that crosses the finish line first.

UK shares deliver a juicy 4.3% yield and an attractive return on equity. Sources: Bloomberg, Finimize.

3. Fundamentals: room for improvement.

Current prices have already factored into the rocky macroeconomic landscape. So any improvement on that front could bring a boost to share prices as investors reassess their outlook. Things are already looking up: inflation data brought a pleasant surprise last week, and the UK bagged the largest 2023 GDP forecast upgrade so far this year. Even in the medium term, the risk-to-reward ratio is looking pretty tasty.

Looking over a much longer horizon, some of the UK market's current weaknesses might just morph into strengths. We could be at a major macro turning point, with inflation and interest rates staying higher than in recent decades. Plus, governments might shift focus from financial assets to economic growth, using fiscal stimulus to kickstart progress. In such an environment, cash-rich value stocks, commodity producers, and "old-economy" sectors like banks and house-builders could outpace the high-flying growth stocks of yesteryear.

What’s the opportunity then?

Look, there's no sugarcoating it: UK stocks probably have a bumpy road ahead, and if you're chasing those Nvidia-level gains right now, you might want to scroll on. But, if you're playing the long game, it could be a savvy move to carve out a slice of your stock portfolio for these underdogs. They can add a layer of diversification to your US-centric portfolio, and might even inject a bit of zip into your long-term returns. It’s the wisdom of putting your eggs in different baskets – some baskets will have flashier eggs, but it's often the unassuming ones that turn out to be golden.

The easiest way to invest in UK stocks is through a diversified ETF, like the iShares MSCI United Kingdom ETF (ticker: EWU; expense ratio: 0.5%) for US investors, and the iShares Core FTSE 100 UCITS ETF (ISF; 0.07%) for European ones.

If you’re looking for a higher octane investment, you might want to consider backing domestic, smaller players, which could benefit most from an improvement in the macroeconomic environment. The iShares MSCI United Kingdom Small-Cap ETF (EWUS in the US, SXRD in Europe; 0.59%) is a solid bet.

Of course, such extreme pessimism also provides a good environment for stock pickers, who might be able to snap up good companies at bargain prices. An excellent starting point is Morgan Stanley’s top picks of companies with the biggest gap between their bull and bear price targets: BAE Systems, Ashtead, 3i, BP, Smith & Nephew, Haleon, Prudential Financial, Rio Tinto, AstraZeneca, Indivior, Segro, and SSE.

For another interesting roster of investing ideas, the investment bank also went through its analysts’ list of overweight-rated UK stocks and found the ones trading at their lowest valuations compared to the past ten years. They are: British American Tobacco, British Land, Derwent London, DCC, Unite, Breedon Group, Landsec, St James Place, and Hays.