3 Undervalued UK Stocks

Nick Kirrage: Hello, Emma.

Wall: So, what's your first stock?

Kirrage: My first stock is AstraZeneca (AZN) a slightly tried and tested value stock, but a stock that's gone nowhere in quite a strong pharmaceutical rally over a period of time. I think it suffers from all the stigma that pharmaceutical companies attract today that they don't invent new drugs. There is a lot of pricing pressure, Obamacare, so and so forth. It's very much the glass half-empty story again and again, and people missed the glass half-full story, which first and foremost is the extremely cheap valuation of these companies, nice dividend yields, good balance sheets, but also these are businesses with long-term growth.

Do we think we'll need more medical pills demand in 50 years in both emerging and developed markets? Of course, we will. There are very high barriers to entry in this industry. They're good companies making good returns. You get them at very cheap prices, so we like them.

Wall: So the patent cliff is just a myth then?

Kirrage: No, it's very much there, but I think it's very much priced in. And I think, the thing you see about patent cliffs is that they're very cyclical. Like many industries what happens is there is a bust of investment. That investment takes five, six, seven years to yield new drugs. The drugs come through and investment drops off as people milk those existing drugs and then we have dearth for a long period. We have gone through quite a lot of investment over the last five, six, seven years. So we don't think the patent cliff is something that is a perpetuity structural factor in the industry.

Wall: And the second stock?

Kirrage: The second stock is Royal Bank of Scotland (RBS), very much still the bête noire of the banking sector. I think you've seen a bit of improvement in the Lloyds (LLOY) share price, but Barclays (BARC) and Royal Bank both, I could’ve chosen either, are both still very depressed.

I think it's interesting with banking because people always focus on the things you can't know, the nebulous uncertainty around regulation and potentially things that are hiding in the balance sheet whatever it might be. People don't focus on the things you do. You do know that these are extremely blue chip, well known franchise in the U.K. with great brands, high barriers to entry in banking, a pseudo-oligopoly in lending in the U.K. and a much better competitive structure than we saw 10 years ago when everyone was fighting desperately to lend money.

The recovery of that sector, the reduction of the risks, and in fact, the Royal Bank of Scotland trades at 70% of its tangible book value suggest to us that that is somewhere investing on a five-year view, you’re going to make good returns.

Wall: There are risks with that stock though. I mean, every time it has announcements there is always the caveat of PPI insurance claims and other sort of outgoings. How do you factor that in?

Kirrage: I suppose the banking sector has really done a great job of snatching defeat from the jaws of victory several times over the last three or four years. That's for sure. I suppose what we would say is all of these things are newsworthy, if you like. But when you look at the direct impact on the financials of these companies, they're reducing over time.

So, yes PPI had a big impact, but I would kind of look at it the other way round. Other companies not more robust than most people would think. If you had said to someone, this will be the total hit from PPI to that business five years ago; they would have said it's going bust. But it hasn't. They have actually been resilient. They have been able to weather those storms. I am sure there will be other storms going forward. But I think they're better businesses than people perceive.

Wall: And your third stock?

Kirrage: My third stock is an overseas stock. We can own overseas stocks in our portfolio as I am going to pick Hewlett-Packard (HPQ). It's a good example of why we invest overseas in portions of our portfolios where we're able to because you can't give exposure to stocks like Hewlett-Packard in the U.K. It's a software and technology stock, but the old technology.

There is a huge irony today that everyone wants to go and do the tech bubble again for stocks like Facebook (FB) or Twitter (TWTR), social media 100 times P/E type stocks. But the old tech, the businesses that we're on 100 times P/Es 10 years ago like the Microsofts, the Hewlett-Packards, the Intels, today trade on P/Es of 10 or less, and in Hewlett-Packard's case, the P/E of more like 7 or 6.

You have a business with a reasonable balance sheet, incredible blue-chip franchises, number one in the world in PCs and printers, good in software and enterprise solutions, a very broad business, and yet tagged with the headline of PCs in structural decline because of tablets, therefore, Hewlett-Packard is sell. There are many things to like about that business and whilst I understand it's dangerous to be the other side of the trade from one of the world's great short investors in Jim Chanos. Actually that is an investment we would make every day.

Wall: Has the stock diversified enough though because you mentioned PCs and printers there. I don't own a PC or a printer and I think I reflect the majority of the U.K’s households. What else is it doing?

Kirrage: You probably do reflect the majority of many companies, but certainly Schroders where I work are not getting rid of their PCs anytime soon. I think, if you looked broadly across business, across the wider economy, people are not going to be getting rid of their PCs.

On the other side of this, of course, is that Hewlett-Packard make tablets. They don't own the operating system in the way the Android or an Apple do, but there is money to be made there. Money could be made from doing that.

Printing is a great example of business where we will over time reduce our printing requirements, but they'll still be selling printing supplies and extras and toner cartridges for a very, very long period of time. And as I say, businesses don't stand still. They evolve. They see these trends coming as everyone else does, and they're investing huge amounts in R&D on the other side of the coin. You see that across the technology space, business is understanding that things change. Technology is a great example, it never stands still. They need to evolve and I think today, the stock market gives no value or in fact, a negative value to that evolution.

Wall: Nick, thank you very much.

Kirrage: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.