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'Breathtakingly cheap' UK stocks could rally 30% on Brexit deal

'Breathtakingly cheap' UK stocks could rally 30% on Brexit deal

Fund managers are eyeing a recovery in 'breathtakingly cheap' UK stocks focused on the domestic economy should prime minister Theresa May convince the cabinet, then parliament, to back her Brexit deal.

May will today try to convince the cabinet to back a draft Brexit deal agreed with the European Union, before bringing the deal to a parliamentary vote.

Speculation over a Brexit deal has been a big driver of the UK stock market and the pound this month. Having fallen to $1.27 against the dollar at the end of October, the pound rallied to over $1.31 at the start of this month as a Brexit deal appeared to near. 

Optimism over a deal then faded, before last night's confirmation of agreement on a draft deal with the EU sent the pound surging.

On the UK stock market, companies reliant on the UK domestic economy for the bulk of their earnings have jumped with each sign a deal was nearing. Since the lows following October's sell-off, the more domestic-focused FTSE 250 has outperformed the more international FTSE 100.

Steve Davies (pictured), manager of the Jupiter UK Growth fund and the Jupiter UK Growth (JUKG) investment trust, said the tentative rally ‘gives an indication of how cheap UK domestics are and how quickly they would react’ to a deal.

The cheap valuations seen in UK-facing stocks means they have some way to climb in the event of a favourable deal, or any deal at all that would ensure certainty.

Davies said investors did not have to buy ‘distressed or junk domestics’ to gain access to cheap valuations, pointing to Lloyds (LLOY) and house builder Taylor Wimpey (TW) as undervalued examples.

‘[They] have proper management teams and are businesses that will be around 10 years from now with good balance sheets,’ he said.

He predicted Taylor Wimpey, which currently trades at 165p, would pay an 18p dividend in the next 12 months.

‘The yield will be in double digits, which we believe is sustainable – it trades on a cheap valuation,’ he said.

‘Lloyds can pay out 6p next year and that is on a 58p share price. These really are breathtakingly cheap.’

Davies said most investors were underweight UK stocks and could miss out on any jump on positive Brexit news.

‘Some of those stocks could jump 20% to 30% quite quickly but we cannot predict when that will happen,’ he said.

Martin Walker (pictured), who runs the Invesco UK Growth (UK) and UK Focus (UK) funds, said the broader stock market bounce on a deal could be in the region of 5% to 10% over a month, although 'probably more towards the bottom' of that range, as the likely jump in the pound would weigh on overseas earners.

‘Sterling would rally [in the event of a deal] and that would result in downgrades and upgrades and how they net each other out,’ he said. 

He added that sectors ‘primed for a rebound’ include financials, banks, retail and leisure.

Davies is equally enthused about these areas, particularly domestic banks, which he said looked ‘very cheap relative to how well they are doing’.

‘If Lloyds was a French bank it would be on a 20% to 30% higher rating,’ he said.

In retail he is backing WH Smith (SMWH), which has just completed a US travel retail deal, and furniture company DFS (DFSD), arguing  it becomes ‘stronger when the competition goes bust’.

In leisure, Davies singled out JD Wetherspoons (JDW). Despite the pub chain being hit by higher wage costs, he said overall rising income was a good indicator for consumer spending and the leisure industry.

But while UK domestic earners could enjoy a bounce on a deal, the other side of the coin is they will look even more vulnerable should it fall through.

But Davies said any sell-off was unlikely to be as sever as that seen in the immediate aftermath of the UK's vote to leave the EU in the summer of 2016.

‘We had a real life example in June 2016 and a lot of stocks fell 30%,’ he said. ‘The difference back then was people were positive about the UK. I do not think all the negativity is priced in but I would hesitate to say they would fall as much as they did.’

Davies remembers those falls all too well. His Jupiter UK Growth fund fell the furthest of any on the date of the EU referendum result, tumbling 11%, with his heavy backing of Lloyds, Barclays (BARC) and Royal Bank of Scotland (RBS) weighing.

The portfolio's Brexit woes have driven the fund to a three-year loss of 6% to the end of October, the worst return of any in Citywire's UK All Companies sector. Davies had enjoyed Citywire's top AAA rating throughout the bulk of 2015 thanks to his strong returns before the referendum.

Likewise, Walker was Citywire AAA-rated for the bulk of 2013, and throughout both 2014 and 2015, but hasn't been rated since the summer of 2016. The UK Growth and UK Focus funds have delivered a mid-ranking return over the last three years, up 16% and 18.4% respectively.

Davies added that while Brexit uncertainties surrounded the UK stock market, overseas markets were now presenting their own share of worries.

‘If you are a sterling investor, most people have been underweight domestic UK since 2016 and have chosen to own US, Europe, and emerging markets equities, and they have done well with them,’ he said.

‘Now people are more nervous about the rest of the world - trade wars, elections, and a slowdown - UK domestic assets are not as unattractive. People will think, what do I do if there’s a deal and sterling could run up 10% to 15%, overseas assets will get knocked, and you have nothing going up on the other side.’

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