Domestic cyclical stocks to buy and sell

The outlook for the UK economy is rather cloudy, with inflation far outpacing wage growth. This means consumers have less spending money in their wallets, while Brexit also throws a massive spanner in the works.

As a result, companies are feeling the heat, leading to a number of high-profile profit warnings. It’s been noted that while warnings in the second quarter of 2017 fell, there were more from retailers and business-to-business firms.

But are things beginning to turn? Discretionary retail – companies selling non-essential products – was the best-performing FTSE All-Share (ASX) sector in September, returning more than 8%.

Meanwhile, it looks quite likely the Bank of England will raise interest rates in November. That had led to a rally in the pound, although sterling is currently giving up ground at a rate of knots. ‘Value’ stocks outperformed significantly in September and global yields trended higher.

These factors have combined to re-ignite domestic cyclicals and mid-caps outperformed the FTSE 100 (UKX) in September, according to broker Liberum. “Talk of the ‘bottom’ in the UK economy has become more prevalent,” writes analyst Chris Ellis Thomas.

That chimes with the broker’s house view that there is an inherent strength in the economy, though further weakness in consumer cash flow is expected.

Liberum’s domestic cyclicals stockscreen pinpoints companies most exposed to the UK economy, finds those that have de-rated most since the January low in domestic valuation,s and separates into ‘buy’ and ‘sell’ lists.

In the 10 months since inception, the buys have returned 2.2% in absolute terms, while the sells have lost 2.8% – pretty much what you’d hope for.

This month, they’ve made two changes, both to the ‘buy’ list. Out is strong performer Safestore (SAFE) – up 26% year-to-date – and Ferguson (FERG), which is facing a moderation in dollar earnings. That said, Liberum is bullish on the US-focused plumber.

The ‘buy’ list

The two new entrants are challenger bank Aldermore (ALD) and student accommodation provider Unite (UTG).

Aldermore has traded sideways so far this year, just above its March 2015 IPO price in a range between 210p and 245p, with a very brief break out in May. But Liberum’s Portia Patel is convinced the shares are mispriced. She reckons they’re worth 275p.

Liberum likes UK banks and Patel reckons Aldermore’s forward earnings multiple of 8.4 times is pricing in a year-on-year doubling of impairments in 2018 flat net loan book growth. “This scenario is too pessimistic,” she argues.

Unite’s performed well year-to-date and is up 15%. Still, Kieran Lee sees plenty more upside. His target price of 720p is supported by an above-average yield of 3.7% that’s set to grow at around 15% per year.

“A sizeable development pipeline and predictable like-for-like rental growth prospects provide high visibility over a three-year earnings per share compound annual growth rate of 12% and total returns of 12% per annum,” Lee adds.

Other ‘buys’ include Neil Woodford-backed breakdown specialist AA (AA.), which has an attractive free cash flow yield of 13% despite recent troubles; and equipment rental firm Ashtead (AHT) and outsourcer Balfour Beatty (BBY), which are both well placed to benefit from positive conditions in their US markets.

Drugmaker Glaxo (GSK); media firm ITV (ITV); forecast-busting food travel experts SSP (SSPG); financial TP ICAP (TCAP); and Zoopla owner ZPG (ZPG) round up the list.

The ‘sell’ list

Unsurprisingly, there’s a pair of basket cases here. “The pain is not over” for Provident Financial (PFG) and a recent uptick in Pearson (PSON) shares will prove a false dawn, we’re told. Target prices for both imply 40%-plus downside.

Elsewhere, further falls in iron ore prices are set to weigh on miner Anglo American (AAL), while Halma (HLMA) is “high quality but overpriced”. Online stockbroker Hargreaves Lansdown (HL.) is expected to “de-rate over time” as structural pressures build and SIG's (SHI) risk/reward balance is unattractive.

Others attracting negative sentiment include takeaway chain Domino's Pizza (DOM), Lakeside shopping centre owner Intu Properties (INTU), pub chain Mitchells & Butlers (MAB) and retailer Pets at Home (PETS).

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.