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The British economy contracted by 0.5 percent in the three months through September, ending a string of 16 years without a negative quarter and almost certainly indicating that an economic losing streak has begun.
Mervyn King, the governor of the Bank of England, said as much, and even if he had kept his own counsel, the same message is clear from the plunge in stocks and the pound.
From their peaks earlier this year, the FTSE-100 index lost as much as 40 percent of its value, leaving it close to a 12-year low, and the pound was down more than 20 percent at a five-year low. That double-whammy meant that dollar-based investors could pick up British stocks for well under half of what they cost a very short time ago, and history suggests that they should.
King's statement late last month - “it seems likely that the U.K. economy is entering a recession” - ignited a fresh wave of selling in stocks and sterling, but investors might have been better off taking it as a buy signal. A rule of thumb during bear markets is that by the time a recession is acknowledged by a country's leaders or in news headlines, the worst of the selling is over and a reversal is due.
That is how several veterans of the British markets see things; they contend that the twin sell-offs have provided a solid opportunity to buy shares of excellent companies at bargain prices. Valuations account for just about any negative developments, but nothing positive, that the economy is likely to encounter, they say.
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“Everyone is expecting this recession to be unusually long and deep, and that's almost certainly right,” said Alan Brown, group chief investment officer for Schroder Investment Management. But even if the downturn runs twice as long as the postwar average of one year, and corporate earnings fall 50 percent from their peak instead of the usual 25 percent or so, he added, British stocks would trade at a “hardly demanding” price-earnings multiple of 13. As for the pound, Brown thinks it has gone from “very overvalued to cheap.”
That leaves foreign (in this context, non-sterling-based) investors with two chances to win. If the pound recovers, they can profit even if stocks go nowhere. If the pound remains depressed, it could underpin the stock market.
Max King, a strategist at Investec Asset Management, pointed out that a cheaper currency is often very good for business, especially for exporters or companies with extensive overseas operations.
“The market has largely ignored the benefit to U.K. companies of the fall in sterling,” King said. He highlighted research at the London Business School showing that stock markets in countries with devalued currencies tend to outperform other markets by more than the amounts by which their currencies fall.
To make the most of the weakness in sterling, he would focus on exporters that have the bulk of their production in Britain or multinationals with heavy foreign earnings. He declined to recommend individual stocks, but he offered the jet engine manufacturer Rolls-Royce and the drug maker GlaxoSmithKline as respective examples of the two types of companies.
Tony Dalwood, head of public equity at SVG Investment Managers, is a fan of Glaxo and another large pharmaceutical company, AstraZeneca. He finds both “very cheap.”
Another favorite of his is Vodafone, the mobile phone service provider, which owns nearly half of Verizon Wireless in the United States.
Dalwood said he was “beginning to allocate resources to companies with more U.S. exposure” as a currency and macroeconomic play. He expects that “the U.S. will lead the globe out of recession” and that investors will take a circuitous but low-cost route into the market by buying shares of British companies with strong American activities.
There is no guarantee that buying British stocks will be profitable in the short run, he acknowledged. Just because they are cheap does not mean they won't get cheaper. But while many shareholders raise the prospect of a prolonged recession to justify selling, Dalwood says he thinks that the decision is more emotional than rational and that investors who can make a three-to-five-year commitment will be glad they bought now.
“Greed has driven bubbles on the way up,” he said, “and fear is driving one the other way.”
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