Exclusive: Top fund manager on the UK retail shares worth buying right now Exclusive: Top fund manager on the UK retail shares worth buying right now

Alasdair McKinnon, lead manager at The Scottish Investment Trust, writes exclusively for What Investment on the opportunities he is finding in the much-maligned UK retail sector right now.

 Exclusive: Top fund manager on the UK retail shares worth buying right now

UK retail sales have been under pressure

Investors currently appear to hold the UK high street in low regard.  The uncertainty thrown up by the general election has not helped, but the retail sector had already fallen from favour. As the Brexit process gets underway, retailers are facing rising costs from a weakened sterling and the possibility of a reduced pool of supply chain labour. With clouded near-term prospects, rising inflation and fears that consumer spending will fall, it’s easy to see why investors are instead favouring UK export-oriented companies that benefit from the pound’s weakness.

In addition to the economic and political uncertainties, UK retailers are struggling with structural change. The growing trend for online shopping is putting margins under pressure, and a proportion of floor space is now proving to be surplus. At the same time, many high-street names are feeling the heat from lower-priced rivals, so it is no surprise that many investors are staying away.

We have a different take on things at The Scottish and think that UK retail offers some of the most interesting investment opportunities out there. As contrarian investors, we believe that the best opportunities arise when the market overreacts. It is at those points that it pays to swim against the tide, avoiding the ‘wisdom of the crowd’ in the search for superior returns.

Read more: Invesco Perpetual: The best UK retail shares to buy right now 

Why do we see the retail sector’s current weakness as an overreaction? For one thing, the market is ignoring the possibility that the Bank of England and the British government will alleviate pressure on consumers. Policy action could bolster the jobs market, encourage investment and offset the volatility arising from the Brexit negotiations. Given the populist sentiment experienced worldwide after the financial crisis, the authorities may seek to help those who feel ‘left behind’. As some two-thirds of UK GDP comes from domestic consumption, its maintenance should be a policy priority, something that could provide welcome support for British retailers.

Meanwhile, Brexit negotiations might proceed more smoothly than most expect. Despite all the posturing in the run-up, once negotiations are in full swing, a more pragmatic approach may prevail. This could support both the UK market and the pound.  For all the doom and gloom, we should remember that economists and the Bank of England underestimated the resilience of the UK economy and have had to revise their numbers up since the Brexit vote. Whatever twists and turns the coming weeks bring, we also know that accurate economic forecasting is very hard.

In that regard, we think that fears about the health of the UK consumer may prove somewhat unfounded. Yes, there’s uncertainty ahead, and yes, that could constrain consumer spending. But so far, consumers have simply been keeping calm and carrying on. After the Bank of England cut interest rates in response to the Brexit vote, cheaper mortgages and money have encouraged consumers to continue to borrow and spend. Low interest rates, low unemployment and higher wages would help to keep the retail sector on a steady footing.

Also, crucially, many retailers are already meeting those challenges. Some businesses are taking full advantage of technological advances: optimising their mobile online presence; investing in ‘click and collect’; and creating joined-up, multi-channel offerings. We are also seeing some innovative approaches to excess space, with retailers making room for other leisure services on their premises, to increase footfall and encourage spending. These initiatives require strong leadership, but innovative executives can create winning propositions that meet their customers’ needs and allow their businesses to take market share.

We categorise most of the current opportunities in UK retail as ‘ugly ducklings’ – unloved shares that most investors shun. After sustained periods of poor operating performance, these companies are very much out of favour, but we can foresee circumstances in which they can turn their operations around to confound the market’s expectations. This also provides the potential for outsized share price upside as a result.  While we wait for our ugly ducklings to turn into swans, we would also look for attractive income return as most of them offer higher-than-average dividend yields.

We see Marks & Spencer as a classic ugly duckling. Its clothing division has been a perennial problem, with sales under relentless pressure. However, we believe the company has begun to turn around under Steve Rowe – an experienced retailer who began his career on the shop floor. Rowe has already implemented a more appealing pricing strategy. Meanwhile, the company’s food department is still top-notch, and significant investments in IT and logistics infrastructure have created a multi-channel offering that looks well placed to succeed in a digitally driven environment. While we wait for the shares to reflect this progress, they offer a dividend yield of 5.5% (7% with this year’s special dividend).

Tesco is another good example of an ‘ugly duckling’. It’s also under new leadership, now that Dave Lewis has taken the reins. His challenge is to rebuild profitability, restore market share and regain the trust of consumers and investors alike. Recent data suggests that he is beginning to succeed. He is focusing on core UK growth and has sold off non-strategic businesses at home and abroad. He recently announced the acquisition of Booker, a major UK food wholesaler. The deal is designed to cement Tesco’s position as the UK’s largest food business. Healthier pricing and efforts to enhance the customer offering have led to improvements in same-store sales. Meanwhile, a £1.5 billion cost-cutting programme should help to support margins, which are currently the lowest among its UK peers.

There are plenty of other opportunities for those who are prepared to stand apart from the crowd. It can be uncomfortable to take a contrarian stance, but doing so reveals a wealth of opportunities – hiding in plain view on the high street.

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