Should investors be shunning UK retail?

Cash-Wallet-Consumer-Retail-Shopping-700x450.jpgThese are low times for the UK high street. Even before the uncertainty caused by the general election result, British retailers were out of favour with investors. As Brexit negotiations begin, retailers face rising costs from sterling’s weakness and potentially reduced supply chain labour. Add in rising inflation and concerns that consumer spending will fall and it is easy to see why investors are shunning the sector in favour of exporters that benefit from a weak pound.

Quite apart from the political and economic uncertainties, UK retailers have had to contend with rapid structural change. The rising popularity of e-commerce is putting margins under pressure and many retailers are finding that a proportion of their floor space is becoming redundant. Many traditional high-street stalwarts are also coming under fire from the discount chains. We should not be surprised, then, that most investors prefer to look elsewhere.

However, this is something that we’re disinclined to do at The Scottish Investment trust. In the hunt for superior returns, we think that UK retail offers some very interesting investment opportunities. We are contrarian to our core and believe that the best opportunities can arise when the market overreacts. It is then that the ‘wisdom of the crowd’, or herd instinct, can push stocks into either over or under appreciated territory.

So why do we detect an overreaction in the market’s reluctance to invest in retail? To start with, we think that investors are overlooking the potential for the Bank of England and the Government to relieve some of the pressure from consumers. A considered policy response could create jobs, boost investment and offset any volatility that the Brexit process may cause. In light of the surge in populist sentiment around the globe, steps may be taken to help those who feel left behind. As domestic consumption accounts for around two-thirds of UK GDP, its maintenance should be a policy priority and such policies would provide a boost British retailers.

It is also possible that Brexit negotiations will be smoother than expected. Despite all the noise, a pragmatic approach may prevail once the process is in full swing. If so, both the UK market and the pound could benefit, providing a lift to growth. We should also remember that the robustness of the UK economy was underestimated after the Brexit vote, with forecasts being revised up since.

Similarly, we think that concerns about the UK consumer may be overcooked. Although consumer spending could be curbed by some potential Brexit outcomes, so far, consumers have been carrying on as normal. Following the Bank of England’s interest-rate cut last summer, cheaper mortgages and loans have encouraged consumers to borrow and spend. With interest rates likely to remain low, the combination of low unemployment and higher wages would help to keep the retail sector on a steady footing.

Some retailers are already meeting those challenges with far-sighted businesses exploiting technological advances to create multi-channel offerings including mobile apps and click and collect. There are also some innovative approaches to the use of excess floor space as some retailers are adding other leisure services to their sites, thus increasing footfall and encouraging spending. Good leadership is required for such initiatives, but forward-thinking managers can create propositions that meet their customers’ needs while taking market share from their rivals.

We define most of the opportunities in UK retail as ugly ducklings – unloved shares that the majority of investors shun. Because their operating performance has been poor for some time, their shares are very much out of favour. But we see potential for them to defy the market’s expectations and turn their circumstances and share prices around. While we wait for our ugly ducklings to become swans, there are often higher-than-average dividend yields on offer.

At present, we see Marks & Spencer as a classic ugly duckling. Its clothing division has been struggling for some time. But under Steve Rowe – a veteran retailer who started on the shop floor – we believe it has begun to turn around, initially benefitting from a more value orientated pricing strategy. Meanwhile, the company’s food division is among the best, and investments in IT and infrastructure are creating a multi-channel offering that looks positioned to succeed in today’s digital environment. While we wait for the shares to reflect this, they offer a dividend yield of 5.5 per cent (7 per cent with this year’s special dividend).

Another example of an ugly duckling is Tesco. With Dave Lewis taking the reins, it’s also under new leadership. Lewis is aiming to rebuild profitability, restore market share and regain the trust of consumers and investors. We are positive about the progress he is making by focusing on growth in the core UK business and selling off peripheral assets at home and abroad. He recently announced the acquisition of food wholesaler Booker, a deal designed to secure Tesco’s position as the UK’s largest food business. Better pricing and an enhanced customer offering have led to improved same-store sales. Meanwhile, a £1.5bn cost-cutting programme should support margins, which are currently the lowest among UK supermarkets.

These are not the only retail opportunities out there, but to find them, you need to stand apart from the crowd. Taking this sort of contrarian stance is often uncomfortable and you have to be patient as the investment case unfolds. But for those who are prepared to shop around, the UK high street offers some real bargains.

Alasdair McKinnon is lead fund manager for the Scottish Investment trust