We’re being too gloomy about UK stocks

The story has become family legend. When I was very young, I knocked over a valuable China ornament on a shelf at home and watched in horror as it fell to the floor and broke.

I was determined it would never happen again, and I had a cunning plan to ensure it wouldn’t. I went round the house, gluing anything that was breakable to the surface it was sitting on.

I am still not sure if my parents claimed on the insurance, but I know I was in a heck of a lot of trouble the next day when they found out.

Psychologists have a term for our tendency to let the recent past dominate our thinking: recency bias. They also point to the fact that it is human instinct to feel the negative impact of our failures more acutely than our successes. They call that loss aversion.

For me, these two combine in a tendency to let mistakes or bad economic news weigh on me and to overreact — to do the portfolio equivalent of gluing down the ornaments. After nearly 40 years as a professional investor, I think I have become much more self-aware and have managed to tame this instinct, but I still hear its growls.

And I see other investors succumb to the same temptations. The economy has been subdued, so stocks in sectors such as retail and property, which tend to rise and fall with the economic cycle,have been sold as though growth will never pick up again.

The desire for liquidity has meant smaller companies, regardless of prospects, do not have the investor audience they deserve. International markets are thought to be a better place to be invested than the home one. There is an obsession to avoid yesterday’s problems.

The general view about recent past experiences is obscuring today’s realities. The UK economy is growing, and interest rates are likely to fall further over the next 18 months. When the current drivers of inflation, Budget-inspired labour cost increases and food prices roll out of the numbers, a lower inflation number is likely to be posted.

Professor AlanTaylor, an economist who is an external member of the Bank of England’s Monetary Policy Committee, says this “neutral” rate of interest in the UK today is 2.25 to 3.25 per cent. This is the rate at which the economy should operate at full capacity — neither too hot nor too cold.A recent article by a Goldman Sachs economist argued it is 3 per cent.

It does not matter much which is right. Both are substantially below the current 3.8 per cent.

If investors moved on from having their behaviour determined by yesterday’s problems and factored in the lower rates at a time when the economy continues to grow modestly, the valuation of UK equities would move materially higher. I believe at some point they will — and this presents opportunities.

I think it would lead to a change in leadership in the stocks that are moving up, such as those in utilities and healthcare that consistently make profits regardless of the economiccycle. It would bring a smile to the contrarians and howls from momentum players positioned around avoiding yesterday’s mistakes.

The fall in short-term rates would filter down the yield curve. The 30-year gilt, currently yielding 5.5 per cent, would have a substantial way to fall as a lower neutral rate became accepted.

This would inspire a rally in the much-maligned property stocks, such as British Land and LandSec. The former is down 16 per cent over a year, against a FTSE All-Share up around 13 per cent. It has a handsome dividend yield of 6.5 per cent and trades at a discount of about 60 per cent of NAV. The latter, down nearly 5 per cent in a year, offers a 5.5 per cent yield and is on a discount of around 35 per cent.

Their assets could also show an upward movement as confidence returns. This would be a very benign background. On the other side, the favoured sector of this year has been the banks, which have benefited from higher than expected interest rates earned on deposit.

We have gained from their move to more usual valuations and taken the decision to take some profits to fund the purchase of some of those property companies.

It is not just high-yielding stocks that benefit from lower rates. So do early-stage growth stocks. These, too, have suffered in recent years, as during a period of high rates investors are not willing to pay for “blue sky”.

IP Group offers a ready-made portfolio of these next-generation companies. It is trading at a substantial discount to the value of its holdings. A better economic background should enable some of its companies to emerge as real growth champions.

Investors extrapolate too much from the recent past and don’t put enough weight on long-term factors. Having at least some of your portfolio in these gloomy “recovery” areas could prove beneficial. Maybe not tomorrow — or while we are all moping about what the Budget will throw at us — but one day not too far away. In short, ditch the glue and at least some of the gloom — and think ahead.

James Henderson is co-manager of the Lowland and Law Debenture investment trusts, which owns shares in British Land, LandSec and IP Group