UBS flags opportunities in cheap UK stocks as market shrinks

UBS has identified potential investment opportunities in UK stocks, calling them the most attractively priced among G10 nations. This follows a decline in market size due to takeovers and delistings, UBS noted in a research note. The UK now holds a smaller share of Europe's total market value, down from 25% in 2002 to around 10% in 2021.

The broker highlighted several challenges, including reduced capital deployment since Brexit, higher inflation expectations compared to other G10 economies, and a scarcity of AI-exposed stocks. However, UBS argues that debt isn't the primary reason for the discount. While nominal 10-year rates are elevated in the UK, real yields remain lower than in the US, France, and Italy, suggesting higher inflation expectations rather than a debt credibility issue.

UK financial stocks, comprising 29% of the market's total aggregate CFROI (Cash Flow Return on Investment), are particularly cheap, trading at a 30-year discount to European counterparts. Technology's contribution to UK aggregate CFROI is less than 1%, providing a potential hedge against tech market fluctuations for those concerned about global exposure.

Historically, the UK market has outperformed when tech lags and shows a low correlation with global tech, delivering a positive median monthly excess return during prolonged tech underperformance periods. Strong UK businesses with higher asset efficiency have shown resilience, with their median CFROI surpassing European peers across most sectors, except healthcare and utilities, attributed to better asset efficiency.

Among the 23 large European stocks meeting quality criteria at reasonable prices, nine are UK-based, including Unilever, RELX, and Haleon. Additionally, 33 large UK exporters rank in the top two quintiles of UBS's HOLT Scorecard, trading at historically low valuations with positive consensus revisions. UBS identified a pattern of cheap British stocks with strong momentum, including lenders NatWest and Vodafone.

Smaller UK-focused stocks also trade at substantial discounts, though consensus revisions to their CFROI remain negative. UBS attributes the positive outlook to improving economic indicators, which tend to be pro-cyclical for aggregate UK valuations.