5 Undervalued UK Stocks for 2016

Below are a selection of UK stocks with a four or five star rating for investors’ consideration and summaries of our analysts’ views on the outlook for these companies.

Pearson PLC (PSON)

Pearson is a global publisher that focuses mainly on the education sector. It recently sold The Financial Times newspaper and business magazines to Nikkei Group. According to Morningstar research, about 60% of the company sales are generated in U.S. dollars, so sales and earnings are sensitive to currency rate fluctuations between pounds sterling and US dollars

Morningstar analyst Philip Gorham thinks Pearson’s Uncertainty Rating is high because of the transition in the educational publishing industry from print to digital which creates above-average uncertainty, as well as the volatility around medium-term cash flows.

If education institutions began to adopt low-cost sources of materials, pricing could be put under pressure and this could upend the business models of the traditional publishers like Pearson, says Gorham.

But Pearson is also undergoing the shift to digital. Morningstar analysts believe that scale benefits from the growth of digital-subscriptions will likely occur, but only after a multiyear investment period that is likely to weigh on profitability.

Tesco PLC (TSCO)

Tesco is the largest food retailer in the UK with more than 6,500 retail stores in the UK, Europe and Asia, according to Morningstar Research. The majority of Tesco's revenues come from the sale of food products, although the firm also sells gasoline and a variety of general merchandise products in multiple channels, including large-store formats, online, and convenience stores.  More than 65% of its revenue is generated within the UK, and the remainder is generated from Asia, Europe and Tesco Bank.

Morningstar Analyst Ken Perkins expects Tesco to remain a market leader in the UK, but he has low confidence in Tesco’s ability to sustain excess returns on capital over the long term. Perkins thinks that Tesco's size advantage may currently give it an edge over rivals operating similar formats, and its convenient locations and loyalty program should continue to drive traffic.

However, he does not see clear evidence that Tesco has an enduring cost advantage, as most of Tesco's competitors have sufficient scale to remain competitive on price while touting points of differentiation.

Perkins added that the firm remains well positioned in Korea, Malaysia, and Thailand, but results in other regions have been more challenging. China and India remain areas of opportunity, but achieving results comparable to those in the U.K. will be no small feat given regional market dynamics.

BP PLC (BP.)

BP is an integrated oil and gas firm with operations across six continents. BP's upstream operations, excluding Russia, produce roughly 2.1 million barrels of oil per day. Downstream operations include refining, chemicals, lubricants, and service stations. 

With oil prices continued to be under pressure, Morningstar analyst Stephen Simko says that oil majors like BP will find replacing reserves increasingly difficult. There is a lot of oil left in the world, but finding large amounts of new low-cost reserves remains a daunting task, in no small part because many governments now don't allow Western companies access to their resources.

Not many barrels of cheap conventional oil and gas reserves are annually accessible to BP. This has forced the majors to increasingly focus on higher-cost resources. Simko expects BP’s future returns to be lower, and it’s likely to continue for the foreseeable future, despite its plans to lower capital sending and delay higher-cost project. Investors should be discriminating in their stock picking and prepared to weather additional volatility, Simko concludes, due to the existing uncertainty.

Lloyds Banking Group PLC (LLOY)

London-based Lloyds Banking Group is a financial services firm that operates primarily in the United Kingdom through its retail bank, insurance group, and wholesale and international banking unit. The Group is the UK’s largest mortgage lender, with controls of 20% of the U.K. mortgage market and 25% of its savings market, according to Morningstar Research.

Morningstar analyst Erin Davis is disappointed with Lloyds’ slow revenue growth and continued misconduct expenses in the third quarter of 2015. Revenue was down 4% for the three months to the end of September compared with year-ago quarter, and it was large enough to damp full-year results.

While the U.K. government has begun selling its stake in Lloyds, the government remains the firm's biggest shareholder and could further pressure Lloyds to increase lending to risky sectors, possibly increasing long-term losses. However Davis thinks that long-term view of the bank remain bright with its good underlying performance.

Rolls-Royce Holdings PLC (RR.)

Rolls-Royce is one of the world's leading suppliers of gas turbines and reciprocating engines and services to the aerospace, marine, and industrial power system markets. About 65% of revenue comes from civil and defence aerospace equipment sales and services. The land and sea division, which features Rolls-Royce's marine, nuclear, and powers system businesses, generates the remaining 40% of sales.

Morningstar Analyst Jeffrey Vonk thinks that Rolls-Royce holds a strong competitive position in civil and defence aerospace sector with its large investments in research and development. It results in returns on invested capital exceeding the costs of capital over our five-year forecast period and our analysts expect this to continue for years to come. However weakness in Rolls-Royce's civil aerospace business and its marine division will put pressure on revenue growth and profitably for the second half of 2015 and 2016, says Vonk. Vonk expects short-term share price volatility of the company, as management will update investors on operational midterm guidance, strategic review and shareholder payments policy in which he expects a change.