Best stocks to play a thriving U.K. economy

By Sara Sjolin, MarketWatch

The U.K. is the picture of health: Economic growth at pre-crisis levels, a stronger-than-expected labor market, consumer confidence at a six-year high and housing prices surging.

This is good news not only for the Brits, but also for investors worldwide who want to ride the U.K. recovery by buying stocks. Think restaurant chains, mortgage providers, retailers and home builders. These are companies well-positioned to benefit from the stronger domestic economy and they are less exposed to global jitters, analysts and fund managers say.

“This will last for maybe three or four years, and we are just at the foothills of the U.K. recovery, not at the top of the hill yet. There is still good upside left,” said Tim Steer, U.K. equity fund manager at Artemis.

Economic data out of the U.K. has kept delivering positive surprises in the past year, painting a picture of a country firmly leaving its financial crisis behind and ready to beat other developed nations in the race for growth. With GDP estimates pegged at around 3% for 2014, the U.K. is already poised to surpass most Western nations this year.

Read on for the best stock picks to ride the U.K. recovery.

-- Sara Sjolin @sarasjolin

Skip the FTSE 100

To catch the wave of U.K. optimism, don’t make the mistake of piling into the FTSE 100 index /zigman2/quotes/210598409/delayed UK:UKX -2.63% , analysts say. With its heavy representation of mining firms, oil companies, drug makers and international banks, the London benchmark depends much more on the well-being of the global economy rather than of its home. Instead, some of the best investing opportunities lie in the midcap FTSE 250 index /zigman2/quotes/210598417/delayed UK:MCX -3.64% , which consists of companies that generate most of their revenue in the U.K. Over the past 12 months, the FTSE 100 has gained 3.1%, while the FTSE 250 index has rallied 16.9%.

When picking stocks for the Artemis U.K. growth fund, Steer looks at about 40 different variables, such as price-earnings ratio, share-price momentum, cash flow and earnings revisions.

“In the past, the stocks that had the best scores would be the overseas earners. But now the companies that are the best for these metrics are the domestic ones,” he said.

Home builders

House-construction firms have a lot going in their favor at the moment: low interest rates, government-supported home-purchase schemes and a solid rise in U.K. house prices. All help push up demand for new homes, and several builders are poised to benefit, say analysts. These include Barratt Developments PLC /zigman2/quotes/209812640/delayed UK:BDEV -8.90% , Crest Nicholson Holdings PLC /zigman2/quotes/207992108/delayed UK:CRST -5.58% , Berkeley Group Holdings PLC /zigman2/quotes/202576163/delayed UK:BKG -6.41% and Taylor Wimpey PLC

In London alone, house prices have climbed 17.7% in the last year, and across the U.K., the rise is 9.1%, official figures for February show. The government’s Help to Buy scheme has bolstered mortgages, and supply isn’t keeping up with demand, even though Markit data shows a surge in homebuilding.

Two things to note, though: First, interest rates may rise as the U.K. economy strengthens. Second, there was significant volatility in shares of house builders after the Bank of England withdrew its Funding for Lending Scheme in November. However, Jonathan Ingram, fund manager of the JPM UK Dynamic Fund at J.P. Morgan Asset Management said this shouldn’t affect the appetite for housing and mortgages.

“The development could almost be seen as a positive, because it suggests [the] Bank of England views the lending recovery as self-sustaining,” the fund manager said.

Lloyds Banking Group

Banks likewise could get a lift from the housing upturn, and two lenders are favorite investments among analysts: Lloyds Banking Group PLC /zigman2/quotes/202285510/delayed UK:LLOY -4.79%   /zigman2/quotes/200709414/composite LYG -2.92% and Barclays PLC /zigman2/quotes/208409333/delayed UK:BARC -4.46%   /zigman2/quotes/208409333/delayed UK:BARC -4.46%

Here’s the scenario: As more people look to buy homes, the demand for credit picks up. More mortgages are sold, bumping up revenue for lenders. Plus, the amount of bad loans should drop as house prices rise and the broader economy improves.

Lloyds has increased its lending to home buyers, and it looks set to keep benefiting from the rising mortgage demand, J.P. Morgan’s Ingram said. In its 2013 earnings report, Lloyds pledged to pay out big dividends on the back of that demand.

Lloyds showed improved profitability last year as its net interest margin, the difference between its cost of borrowing and the interest it rakes in from borrowers, rose. Also, the government cut its stake in the part-state-owned bank to 25% in March and is preparing to sell off a bigger chunk .

As for Barclays, Ingram believes the bank is well-placed to profit from higher credit demand. He cautioned, however, that people should be careful about holding globally exposed HSBC Holdings PLC /zigman2/quotes/203901799/delayed UK:HSBA -2.62%   /zigman2/quotes/208272822/composite HSBC -1.00%   /zigman2/quotes/202687335/delayed HK:5 -2.72%  and Standard Chartered PLC /zigman2/quotes/200125072/delayed UK:STAN -4.56% .

Countrywide

The housing wave looks set to lift real-estate agents, too. In this space, consider Countrywide PLC , the U.K.’s largest, which has seen its stock rise almost 80% since its IPO in March 2013, benefiting from increased activity in the housing market.

“We fully expect the U.K. housing recovery to continue and anticipate that we can deliver the highest ever levels of group profitability in 2014,” interim Chairman David Watson said in the company’s full-year earnings report .

Last year, the company earned 16 pence a share, but if the housing market continues to recover, earnings could rise to 42 pence a share this year, Ingram from J.P. Morgan Asset Management said.

Retailers

The recent boom in the U.K.’s economy has largely been driven by a pickup in consumer spending and confidence. Consumer confidence in March, for example, jumped to a more-than six-year high, while February retail sales surprised most people with a 3.7% rise on the year.

Several retailers are worth buying into in this context, each generating most of their revenue from domestic spending: fashion retailer Next PLC /zigman2/quotes/200704121/delayed UK:NXT -2.99% , home-furnishing retailer Dunelm Group PLC /zigman2/quotes/200625778/delayed UK:DNLM -3.02% , newsagent WH Smith PLC /zigman2/quotes/201823422/delayed UK:SMWH -3.26% , Sports Direct International PLC  and Howden Joinery Group PLC /zigman2/quotes/201332803/delayed UK:HWDN -2.89%

The retail sector is also home to some of the companies that fund manager Tim Steer calls the U.K. “survivors” — businesses that have come out of the economic crisis in better shape than before.

“Embracing U.K. survivors has been the right thing to do over the past years. They are in a stronger position than before Lehman,” said Steer, who runs the U.K. growth fund at Artemis Fund Managers. “They have been suited for the new economic environment and come out stronger with less competition and more efficient working practices.”

Restaurant Group

As the economy picks up, Brits also hit the pubs and restaurants more frequently, setting the stage for solid returns in that space. Derek Mitchell from Royal London Asset Management points to Restaurant Group PLC /zigman2/quotes/207518837/delayed UK:RTN -8.40%  as the sound choice here, as although it’s not cheap, it’s a “quality operator.”

The brands under Restaurant Group include Frankie & Benny’s, Garfunkel and Chiquito — typically found in shopping malls, cinemas and amusement parks, which are seen as ripe to profit from the upturn.

Restaurant Group has in recent years seen a steady improvement in earnings, with the company making £56 million last year — a 17% rise year-on-year.

EasyJet

The no-frills airline EasyJet PLC /zigman2/quotes/202825892/delayed UK:EZJ -5.32% is another example of Tim Steer’s survivors, having emerged from the economic crisis stronger than before. Passenger traffic increased 2.9% in February, and since January 2012, the carrier has not seen a decline in monthly passenger numbers year-on-year.

And the good news is likely to keep on coming for EasyJet. It has successfully scooped up more business travelers, which bodes well for future earnings, Steer explained. In September, rival Ryanair Holdings PLC said it was introducing measures to attract more corporate passengers, a tacit admission EasyJet has dominated that space in Europe.

What’s more, Steer pointed out that EasyJet can focus on flying only to places people want to go (think Paris, Barcelona) as it’s not required to cover smaller, more-regional destinations, something part state-owned carriers such as Scandinavian Airlines have to do.

In early April, analysts at Barclays reiterated their overweight call on EasyJet and said it remains their preferred low-cost carrier because of its “superior business model.”

ITV

The media business was hit hard by a sharp fall in advertising revenue during the worst of the crisis, but now there’s good news. Revenue rose in the third quarter 2013 at the fastest clip since 2010, and this year is looking robust, the Advertising Association said.

Basically, as companies grow more confident about the economy, they’re willing to spend more on marketing — and that should benefit commercial TV stations and the like.

“Ad spend is more than a bellwether — it has been shown to drive GDP growth, not just follow it,” Tim Lefroy, the AA’s chief executive, noted earlier this year.

Broadcaster ITV /zigman2/quotes/205378065/delayed UK:ITV -5.42% , a top pick among fund managers, could see ad money send its stock near its all-time high. While investors once were worried about competition from the Internet, those concerns seem outdated now, Artemis’s Steer noted — not because online content is any less of a possibility, but simply because ITV is producing programs good enough to keep viewers coming back for more. Its popular shows include “X Factor”, “Mr. Selfridge” and “the Only Way is Essex”.

IPO winners

A boost in confidence, driven by the U.K.’s impressive economic recovery, has fueled IPO optimism in 2013. So much, that the final quarter last year was the third most-active in the last decade for IPOs. Noteworthy recent listings include real-estate agent Foxtons Group PLC /zigman2/quotes/205446863/delayed UK:FOXT -10.73% , low-cost retailer Poundland Group PLC and AO World PLC , according to fund managers from the JPM UK Dynamic Fund.

The fund managers said they look at three key characteristics when choosing newly-listed companies to put in their portfolio: value, momentum and quality.

“Stronger investor sentiment, supported by increasing valuations and relatively low volatility, has contributed to a ripe environment for issuers across Europe,” they said.

They cautioned, however, that even successful IPOs can be tricky as the “potential for significant gains also carries a large potential for downside.”

ETFs exposed to the U.K. recovery

Instead of focusing on individual stocks, there’s a great opportunity in investing broadly in the U.K. recovery. One way to do this is through Exchange Traded Funds, or ETFs, which are tracking an underlying index, said Adam Laird, head of passive investments at Hargreaves Lansdown.

He suggested finding ETFs that track the FTSE 250 index /zigman2/quotes/210598417/delayed UK:MCX -3.64% , which covers U.K. midcap stocks that are often local firms, poised to benefit from the upturn and recommended the HSBC FTSE 250 ETF /zigman2/quotes/204617271/delayed UK:HMCX -3.72% .

“The index has performed well, but the growth has been justified — the index is only slightly above long-term valuations. If earnings improve, we could see further rises. I would caveat that, though the FTSE250 has a higher beta than the FTSE All Share and FTSE 100, it is likely to suffer more if we see a general U.K. correction,” he said.