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3 UK share ideas – companies that could benefit from an economic rebound

With Brexit talks coming to a close, we look at which companies on the stock market depend most on the economy.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

It’s not been a good year for the UK economy or the UK stock market. Recent studies have found the UK was one of the worst performing major economies in 2020. Meanwhile the London stock market has delivered one of the weaker performances among international peers.

However, several analysts think a positive end to Brexit talks could mean the UK is on course for a bumper 2021.

That result is far from guaranteed though as trade talks go down to the wire with just days to go. Even if the UK manages a smooth exit from the EU, the government has the largest national debt pile to deal with in peacetime. Forecasting a UK economic recovery might be high reward, but is also high risk.

We look at some of the stocks and sectors that could reap the rewards from any potential economic rebound.

Investing in an individual company is higher-risk and isn’t right for everyone. Your investment is dependent on the fate of that company. If it fails, you risk losing your whole investment. Investors should only buy and hold individual shares as part of a well-balanced, diversified portfolio.

This isn’t personal advice. If you’re unsure what’s best for your situation seek personal advice.

Banks – a complex balancing act

For those willing to back the UK economy despite the high risks, it could pay to consider a bank.

Banks are classic economic bellwethers. When the economy is booming, borrowing increases and loans are usually paid back. However, when times are hard, companies and consumers tend to tighten the purse strings and those in tough positions might fail to repay their loans.

When it comes to UK exposure, Lloyds and NatWest (formerly RBS) are two names that jump to mind. Both make the bulk of revenues from the UK, with sizeable high street and commercial banking businesses. Rivals like Barclays, HSBC or Santander all have large overseas businesses which, while attractive in their own right, reduce the “pure UK” exposure.

Now it should be said that, even putting economic recovery to one side, these are far from ideal times to be a bank.

To make money, banks rely on being able to borrow cheaply and lend money out at a higher rate of interest. The difference between what a bank pays for funding and what it charges on loans is known as the net interest margin or ‘NIM’.

As interest rates fall, NIMs also tend to shrink – loans make less profit. Interest rate cuts are passed on to borrowers quickly, thanks to a mix of base rate tracking loans, competition and regulatory action.

However, with interest rates already at rock bottom, it’s much harder to pass lower interest rates on to savers (who account for most of banks’ funding). After a certain point, rates are so low savers simply move their money elsewhere.

Banks face a complex balancing act. They have to offer interest rates to borrowers low enough to compete with rivals, while paying enough interest on savings to keep money from walking out the door. They have to get the mix right to support a NIM high enough to deliver shareholders a healthy return. With interest rates set to stay low, this’ll keep pressure on NIMs for some time.

Share in the spotlight – Lloyds Banking Group

We prefer Lloyds out of the two large UK centric banks. Lloyds makes a higher proportion of total revenue from non-interest sources. Things like overdraft fees, insurance sales and (crucially) wealth management. The group has big plans to build out its wealth business through a partnership with Schroder’s. Revenues like these aren’t as exposed to interest rate pressures.

The bank also has a lower cost-to-income ratio, which means a higher proportion of income turns into profit.

Finally, we think Lloyds’ balance sheet is better placed to weather a storm should things take a turn for the worse. Mortgages account for 65.5% of the bank’s loan-book, compared to 49.8% at NatWest. Mortgages are generally deemed safer loans than those to commercial customers, or unsecured consumer lending like credit cards.

With a price-to-book ratio of 0.57 for Lloyds versus 0.46 for NatWest those strengths aren’t costing investors a fortune either.

However, it’s worth noting Lloyds’ current strengths are potential areas for improvement for NatWest. Major steps forward, particularly in costs, could see NatWest’s profits rise steeply in years to come. That could see a share price move overshadow Lloyds if all goes well.

Once you’ve come to terms with the risk of investing in a UK bank, choosing between the two is all about how much risk you’re willing to take. Like the banks themselves, it’s a balancing act for investors – weighing up risk and potential rewards.

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Supermarkets – the future of feeding a nation

As essential retailers, supermarkets have been better placed than their high street counterparts. However, they’ve not escaped the pandemic unscathed – with extra costs ranging from thousands of new hires to personal protective equipment. With big names like Sainsbury’s and Tesco handing back hundreds of millions in business rate relief, those costs are expected to hit margins and profits this year.

Traditionally grocers have been seen as fairly defensive – food is essential. However, with Covid costs set to subside next year, and the pandemic driving a boom in online grocery shopping, the sector could do well in a rebounding UK economy.

Share in the spotlight – Tesco

We think Tesco’s 3,800 stores in the UK and Ireland puts it in a strong position to capitalise on the long-term digital shift. 25 UK urban fulfilment centres are expected to open in the next three years, and online capacity is set to double to 3 million delivery slots a week.

Operationally, an improved pricing proposition is helping Tesco poach customers back from Aldi. But pricing pressure remains an industry-wide issue. Consumers always want more for less, and Asda’s return to British ownership raises the possibility of another margin-diluting price war.

We’re reassured by the fact Tesco’s been streamlining its offering to focus on the core UK & Ireland business. The sale of the Thai and Malaysian business equates to a cool £8.2bn of cash. About £5bn of that will come back to shareholders as a capital return via special dividend, while the rest should strengthen the balance sheet.

That brings us to Tesco’s yield, a market beating 4.0%. That’s higher than it has been for most of the last 5 years – although as ever no dividend is guaranteed.

All of these changes bring execution risk, especially as a new CEO was welcomed in October 2020. We’d like Ken Murphy to set out his strategy sooner rather than later, but we suspect he’ll be focused on continuity rather than radical reforms.

Ultimately we think Tesco’s primed to make the most of the shift to online, while a strong UK recovery would keep the store businesses simmering away. Reliability is rare in today’s stock markets, and a price-to-earnings ratio of 13.5 makes Tesco stand out.

Tesco charts, price and how to trade

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Logistics – delivering online

The rapid rise of online shoppers over the course of the pandemic has brought to light the importance of the humble warehouse.

In a digital world, retailers can no-longer rely on customers travelling miles to small town centre distribution points – otherwise known as the high street. Now retailers have to bring their product to the customer. In the past, stock could’ve been delivered by the box load to maybe 300 store locations nationwide. Deliveries now need to be made on an item-by-item basis to thousands of locations. It’s a logistical nightmare.

Operating in the new world requires far more sophisticated systems in retailers’ warehouses. Retailers also rely on a network of delivery companies to take the parcel the ‘last mile’ to customers’ doors. As more products are delivered direct to customers, demand for the ‘big box’ warehouses and last mile ‘urban warehouses’ is only going to increase.

That’s good news for the companies that own and rent out those warehouses.

Share in the spotlight – SEGRO

SEGRO owns a mixture of both types of warehouse (65% urban and 32% big box) in the UK and Europe. Last year those warehouses were worth £10.3bn, and generated net rental income of £281.3m from tenants ranging from Amazon to IKEA.

Many property companies, particularly those focused on retail property, have struggled to collect rent during the pandemic. However, SEGRO has been able to collect well over 90% of what was due. It’s a testament to how crucial logistics assets have become.

The group has also been able to increase rents on properties that come up for review, and leased 80% of the new space completed during 2020.

The group raised £650m from the sale of new shares back in June to take advantage of the extra demand and fund expansion. That’s good news for long-term growth, but also means the balance sheet is in excellent nick – with an overall loan-to-value of 24%. That bodes well for the future of the dividend, which with a prospective yield of 2.6%, needs to grow to be really attractive. Remember yields are variable and not guaranteed.

However, the recent share sale highlighted one of the drawbacks to SEGRO’s Real Estate Investment Trust (REIT) structure. As a REIT, the vast majority of the group’s profits have to be paid out to shareholders as a dividend.

That makes funding organic growth difficult and means shareholders are regularly asked to put their hands in their pockets to fund expansion. Recent cash calls have delivered good results – but when the shares are highly valued, as they are at present, they become more risky.

SEGRO charts, price and how to trade

The author holds shares in Lloyds Banking Group.

HL’s non-executive Chair is also a non-executive director at Tesco.

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income they produce can rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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