Is This the World's Most Undervalued Market?

Value investors may find plenty of opportunities in the UK

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Mar 14, 2018
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According to a recent survey from Bank of America Merrill Lynch, which quizzed investors managing a total of $510 billion, U.K. equities are currently the most disliked in the world, with managers more underweight the asset class than at any point since 2008.

From a value investing perspective, this makes the region look highly attractive. At a time when most developed equity markets are trading at all-time highs and record valuations, U.K. stocks look cheap, offering a fertile hunting ground for those searching for value.

Indeed, the region has already attracted the attention of none other than Seth Klarman (Trades, Portfolio), who, according to the Financial Times, last year took a position in Dixons Carphone (LSE:DC., Financial), Britain's most extensive electrical retail chain. As a result of concerns surroundng the health of U.K. consumers, shares of this retailer have dived over the past 12 months, falling 40%. At the end of last year, the stock had lost nearly 60% of its value.

Regardless, the underlying business continues to report strong results and is expecting to deliver profit before tax between 360 million pounds ($502.8 million) and 400 million pounds for its current fiscal year, leaving the shares trading at a forward price-earnings ratio of 7.1 and an EV/EBITDA ratio of just 4. The stock also supports a 6.2% dividend yield.

Dixons is just one of many stocks with healthy financials that are currently being shunned by the market due to general concerns surrounding the future of the U.K. Many of these companies operate in highly defensive sectors, such as the country's leading telecommunications provider, BT Group (BT, Financial).

BT's share price has more than halved over the past two years. The stock is currently trading at a forward price-earnings ratio of 8.1, supports a dividend yield of 7.1% and trades at an EV/EBITDA ratio of 5.2.

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Lloyds Banking Group (LYG, Financial) is another leading British company trading at a dirt cheap valuation. One of the four main banks in the U.K., the stock currently supports a dividend yield of 6% and trades at a forward price-earnings ratio of 8.7.

The reason why these companies trade at such deeply discounted valuations has a lot to do with the uncertainty surrounding the economic outlook of the U.K. With Brexit on the horizon and the possibility of a Labor government ( who are looking to nationalize specific industries), investors are worried companies may never live up to their full potential. But the general pessimism surrounding the country is the perfect opportunity for value investors. Economic forecasts show that despite the Brexit headwinds, the U.K.'s economy is still growing. With net debt to GDP set to begin falling next year, the country has one of the most fiscally responsible governments in the world.

Compared to other regions that have offered value over the past decade, such as Greece, Russia, Japan and South America, the U.K. is an investor's paradise. Companies prioritize dividends, and the country has some of the best corporate governance in the world.

What's more, many British businesses operate internationally as well, so even if the U.K. does fall into a recession, international growth should provide a tailwind.

Put simply, many companies in the U.K. currently look cheap based on earnings estimates and historical growth profiles. This valuation does not make sense considering the country's economic outlook and projected earnings growth for many businesses. The low valuations leave some room to maneuver if the worst-case scenario should occur and plenty of room if the outlook improves.

Just to give some perspective on how cheap the market is, the average price-earnings ratio of the three stocks above is only eight, compared to the S&P 500's average of 25.7, indicating these companies are almost 70% cheaper than the U.S. market as a whole. That could be too cheap to pass up.

Disclosure: The author owns no stocks mentioned.