Why it's time to buy Lloyds Bank, Shell and Vodafone

With such an increasingly uncertain macro backdrop - rising inflation, stagnant wages, political uncertainty and Brexit - the UK market has fallen out of favour with asset allocators at the big investment management firms.

The UK has been dismissed as a basket case and, true, recent data has hardly impressed. Corporate earnings momentum has also just turned negative for the first time in a year, as benefits of a weak pound and higher oil prices fade. We're now seeing more downgrades than upgrades.

"The relative risks do not appear to be fully priced in," argue strategists at broker UBS.

Elsewhere, with US markets expensive and earnings forecasts overly optimistic, investors are being nudged toward Europe and emerging markets.

But, while DIY investors should diversify through exposure to overseas markets via investment funds and trusts, a home bias is understandable, as UK stockmarkets are easily accessible.

The good news, then, is that plenty of UK-focused fund managers still see pockets of value. And, in a note to clients this week, UBS trumpeted that it has 94 'buy' ratings on the 213 UK companies it covers. Take that with a pinch of salt, of course, but it suggests selective stockpicking can still pay off.

According to UBS analysts, the FTSE 100's 12-month forward price/earnings (PE) ratio is roughly in line with its long-run average - 14.2 times versus 14.7 - and trades at a modest 4% discount relative to history compared to Europe. "It's a similar story on the dividend yield and price/book value measures," they add. 

"Whilst we see the bulk of sterling weakness as behind us, given the sharp deterioration in the domestic economy, we would have a preference for international exposure."

The broker's top FTSE 100 picks list is headlined by a couple of heavyweights, although they're at opposite ends of the scale regarding their level of domestic exposure.

Five most favoured stocks

The expected slowdown in the UK economy should not put investors off backing popular high-street lender Lloyds Banking Group, says analyst Jason Napier. "In four of the last five UK recessions it paid to buy banks early."

He reckons Lloyds is "well positioned for a downturn", due in part to good capital levels, good forecast capital generation, its defensive loan portfolio and high levels of liquidity.

"Lloyds targets 200 basis points of capital generation in 2017, worth 6p of potential payout power. Compounded by the completion of the government sell-down, we believe Lloyds offers strong income returns."

Forecast earnings per share (EPS) and dividends per share (DPS) of 7.4p and 5.5p respectively put the stock on a forward PE of 8.8 times and yielding over 8%. At a discount to the European bank average, a re-rating is expected, so UBS tips Lloyds up to 85p, implying 30% upside.

Royal Dutch Shell ended 2016 on fire and began 2017 at a one-year high of 2,354p. That was a peak, though, and it's been downwards ever since, as the oil price struggles. In early May, first-quarter profits beat forecasts, but the downtrend resumed. Year-to-date Shell shares are down 11%.

However, UBS analyst Jon Rigby says results reinforce the investment case, which is predicated on its cashflow and capital investment programme generating enough free cashflow to both fund the dividend and reduce debt. "Shell printed an impressive cashflow figure, which implies the company is able to cover capex and dividend at less than $50bbl."

Its divestment activity is on track, net debt is coming down and gearing of 20% is within sight. Performing in line with targets, it's now up to management to deliver the value potential. A target price of 2,550p gives potential upside of 22%.

Analyst Helen Brand says luxury clothing brand Burberry is a "core pick", and believes "there is more upside to productivity and cost savings than the market is currently willing to attribute credit for". UBS sticks a price target of £20 on the stock.

And there's progress already, with first quarter results, announced Wednesday, ahead of low expectations. A 4% increase in like-for-like retail sales was double UBS estimates.

Telecoms giant Vodafone has managed to arrest eight years of decline in European revenue and the numbers have stabilised. Now, analyst Polo Tang thinks Voda can deliver top-line growth on the continent over the next few years.

"We think the shares imply no growth going forward," he says. "We also see M&A upside potential from a broader deal scenario with Liberty Global." He values the shares at 270p.

While an earnings slowdown at advertiser WPP is expected, industry-specific structural threats look overplayed, says Richard Eary. It's number one in the space, with market share of a third, and has a strong geographical mix. On a PE of 12 times and with a 9% free equity cash flow yield, the valuation looks attractive. His target for the stock is 2,050p.

Five least favoured stocks

Growth targets at equipment rental company Ashtead look ambitious, according to Rory McKenzie. Further, the current valuation implies return on invested capital (ROIC) of 16%; McKenzie has 2018 ROIC falling to 12.5%.

Up 32% since the US election, "a good outcome for both market stimulus and competitive dynamic is already well priced in".

Intercontinental Hotels is currently running just shy of all-time highs achieved in early June. However, Jarrod Castle thinks its ability to keep making special returns to shareholders is reducing.

Concerns around where we are in the cycle persist and IHG shares should be trading around three points lower at 10 times enterprise value/cash profits. It's why UBS thinks the shares are worth just 3,150p compared with 4,265p currently.

On the other end of the scale in terms of year-to-date performance is chemicals and catalytic convertors giant Johnson Matthey, down 13%. "With consumers shifting away from diesel and a weak process catalysts market, we see few positive catalysts ahead," says Andrew Stott.

A 6% dividend yield at insurer Legal & General is under threat, argues Colm Kelly, but the valuation at 260p does not reflect this. Underlying cash generation growth is at risk and, as a result, dividend expectations are increasingly reliant on management actions. "The risks are skewed to the downside."

Transitioning to the cloud means software firm Sage is experiencing uncertain times, as such a shift creates a risk of discontinuity. It should navigate the change successfully, but expectations could be re-based as the shift to the cloud has its impact. "We do not think this risk is adequately reflected within the shares," says Michael Briest.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.