Take Advantage of U.K. Budget to Bag Some Bargains

 | Mar 07, 2017 | 8:00 AM EST
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The latest data out of the U.K., released just a day before Chancellor of the Exchequer Philip Hammond presents his spring budget, do not paint a cheerful picture for investors.

Immediately after the Brexit vote last year, retail sales jumped, prompting some people in the Leave camp to say consumers are confident the U.K. would be better off outside the European Union. But more evidence has emerged that retail sales are beginning to cool down, which could indicate that last year's consumer spree had more to do with people buying ahead of rising inflation rather than great hopes for the future underpinning spending. Indeed, U.K. consumers' inflation expectations have jumped in the wake of the pound falling by around 18% against the dollar after the June 23, 2016, referendum vote to leave the EU.

Spending on non-food items fell by 0.2% in the December-to-February period versus the same period a year ago, data from the British Retail Consortium (BRC) show. It was the first non-food quarterly decline since November 2011.

Helen Dickinson, chief executive at BRC, said that "the persistent weak sales performance of several non-food categories points to an undeniable trend of cautious spending on non-essential items."

"Tougher times are expected ahead," Dickinson said. "The impact of inflation on consumer spending will add further intensity to an already-fiercely competitive environment in which the ability to adapt and innovate will be key to survival."

This news comes after Office for National Statistics data last month showed retail sales in January falling for the second month running, with higher food and fuel prices to blame.

Tomorrow's budget is unlikely to bring good news in the form of large fiscal stimulus for consumers. Hammond already has said he wants to build a war chest to be able to fight the potentially negative effects of the Brexit vote.

What can investors do? They would do well to steer clear of U.K. government bonds, for two reasons: First, borrowing could increase because the government will need more funds if the economy slows down due to Brexit-related uncertainty. It's true that tax receipts have been better than forecast as GDP growth beat gloomy expectations, but the government still is expected to borrow more over the next five years than it would have if the Brexit vote didn't happen.

Second, the Bank of England's quantitative easing program is nearing its end. The central bank plans to purchase a total of £435 billion ($531.6 billion) of government bonds, also known as gilts. As of March 1, it had bought £431.9 billion. With a big buyer out of the market and potentially more supply coming this asset class doesn't look good, unless the Bank decides on another round of buying.

But this doesn't mean investors cannot find buying opportunities elsewhere in the British economy. The pound is likely to remain weak due to uncertainty, so foreign investors, especially U.S. ones, could find they have more money to buy undervalued stocks.

In an inflationary environment, the sectors that usually do well are those where companies have pricing power either because they are quasi-monopolies or because people still must buy their products or services regardless of how squeezed their disposable income is.

Another important thing to look for is the debt these companies carry. While it is true that rising prices inflate away debt, increasing interest rates could make it more difficult for them to pay it back.

Utilities, telecommunications and health care are the usual shelters from inflation. A quick look at these sectors, screening FactSet for companies with debt to equity of less than 60% and with net sales increasing at more than 10%, shows some potential bargains investors could use to start their research.

Of course, when something is cheap, it is usually cheap for a reason, so investors should do deep research into each of these companies. For example, telecommunications giant BT Group (BT) meets these criteria and appears very cheap, with a price/earnings (P/E) multiple a little above 11 in its primary listing on the London Stock Exchange.

However, last November the former British state telecom company earned the dubious reputation of running the second worst-funded pension scheme in the world after that of DuPont (DD) , according to research by MSCI.

Small-cap Manx Telecom (LON:MANX), which offers fixed-line, broadband, mobile and data center services to businesses and consumers on the Isle of Man, seems a better bargain in the sector, currently trading at a P/E of around 15.

In the utilities field, the FactSet screen shows United Utilities Group (UUGRY) trading at a P/E of 17 on the London Stock Exchange, around the same as rival Severn Trent (STRNY) , while National Grid (NGG) trades at a P/E of around 18. Power solutions provider Aggreko (ARGKF)  sports a P/E of a little more than 18.

Centrica (CPYYY)  has a meager P/E of just 7, but that's only for die-hard believers in its restructuring plan, which has seen it cut almost 3,000 jobs last year. Another really cheap one is Drax Group (DRXGY) , an electricity and biomass supplier. Its profits were hit hard by changes in government taxation policy and it currently trades at a P/E of 7.33 -- an enticing mulitple for brave investors who believe it can recover.

In the health care sector, Smith & Nephew (SNN) , which sells medical devices and services, trades at a P/E of 17, CareTech Holdings (LON:CTH) at 10.5, Alliance Pharma (LON:APH) at 9.9 and small-cap Quantum Pharma (LON:QP) at 14.7.

Tomorrow's U.K. budget will reveal a bit more about the government's preparations for rising uncertainty before leaving the EU. Investors should be prepared to take advantage.

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