R emember the glory days of British business when our industrial cities were the pride of the nation and we exported cars across the world? Not so long ago the UK was a manufacturing superpower, leading the way in technology and innovation.
The perception may be that those days are long gone thanks to ferocious competition from emerging economies, but investors can still make handsome returns from "buying British" as this island is home to more than enough global giants and fast-growing younger companies.
The question is how to get exposure. Is it best to opt for a broad-based investment fund tracking a major index or buying into a handful of individual stocks instead? In addition, should investors opting for the latter choose well-established names or those with smaller market capitalisations?
According to Geoff Penrice, an independent financial adviser with Honister Partners, it all depends on whether an individual wants pure exposure to the domestic economy, because many of the UK's largest stocks earn the majority of their revenue from overseas markets.
"Britain still boasts many world- class companies in fields such as aerospace, drugs, technology, oil and banking," he says. "Just think of names such as Rolls Royce, Vodafone, BP, HSBC, Rio Tinto, British American Tobacco and GlaxoSmithKline, but they do a lot of business in other countries."
It is a fair point. These household names may officially be UK companies – or at least listed on the Stock Exchange – but they are also multi-billion pound giants in their respective sectors with diversified income streams stretching around the globe. Very few derive much revenue from the UK.
One such interesting name is supermarket chain Tesco, according to Tineke Frikkee, manager of the Newton Higher Income fund. "It's still very much perceived and rated as a domestic business, yet the ex-UK part of its business is growing nicely," she says. "People tend to ignore the millions of pounds it has invested outside the UK with all the stores in the likes of Poland."
Another example of a supposedly domestic company with a more global reach is FirstGroup, the bus and rail company. "It is also perceived as a business that transports commuters and leisure customers around the UK but it does have about 40 per cent of its business in the US," she adds.
Pros and cons of domestic UK stocks
Therefore, anyone wanting more focused domestic exposure will have to either move further down the market capitalisation scale or concentrate on finding companies which deal in products and services that are an essential part of life for UK consumers but not readily exported.
There are pros and cons with this approach because smaller companies often focus exclusively on the UK market because they are not big enough to expand or sell their products overseas, points out Patrick Connolly, head of communications at AWD Chase de Vere. "This means they will be significantly impacted by the UK economy," he says. "If it makes steady progress then these companies have the potential to do well. However, if the economy stutters, or even falls back into recession, then smaller companies are more likely to perform badly."
They are also at the behest of interest rate movements. "If rates rise then this is generally bad news for companies that derive their income from the UK because their cost of borrowing will go up and their prospective clients may cut back spending," he adds. "With interest rates at historically low levels, at some point they will rise and this will be bad news for domestically orientated companies."
One advantage of UK-listed stocks is that they are denominated in sterling, which means there is less currency risk. However, as many derive at least some of their revenue from overseas, currency movements are still likely to indirectly impact on an investor's overall return.
What sectors to consider?
Whether it makes sense to buy a domestically oriented company depends largely on the outlook for the home market, and it is fair to say there is a degree of uncertainty in this respect as far as the UK is concerned, according to Simon James, founding partner of Gore Browne Investment Management
"We're going to have pretty low growth for years to come, which is a function of UK indebtedness," he says. "There will be constraint upon domestic consumption so we should expect economic growth to progress at a slower rate than to which we have become accustomed to over the last 20 years. That causes us to be pretty wary of domestic consumption companies."
Of course, there will be some exceptions to this rule and a number of niche areas could flourish over the coming months. For example, Frikkee likes utilities – particularly the water companies which are protected from inflation due to the revenue from charges to their customers being indexed to the retail price index.
"They have already done well but in these uncertain times there's a case to be made for companies with stable end demand that are operating within a helpful regulatory framework," she says. "We're in an inflationary environment and need to consider whether companies can pass that on – and the prospects of doing so appear to be pretty good within UK utilities." Other broad areas which are worth a look include transport, housebuilding and general construction, suggests Geoff Penrice.
"The Government has 'ring fenced' government spending on the NHS but they are looking for greater efficiency, which could open up demand for private companies in the health sector," he says. "Clearly the long-term demographics would also suggest that demand in this sector will continue to grow for the long term."
What to look for in a domestic stock?
Well-known brand names, solid management teams, strong demand and decent cash flow generation are all important qualities, but arguably the most important one is a strong balance sheet because this gives the company some much-needed independence and flexibility.
"This will continue to be important because the prevailing Sovereign debt risks mean companies need to be able to finance themselves," says Tineke Frikkee. "Ideally it really helps if a company has so much cash that it can buy some of its own shares back as well."
Nick Raynor, investment adviser at The Share Centre, suggests there are a number of companies that have the necessary qualities to do well in the current environment, including Rightmove, Restaurant Group, Marston's, Northumbrian Water and Cupid, which owns online dating agencies. "Northumbrian Water is a steady water company with the added attraction of a potential takeover situation," he says. "If inflation is set to remain high in the UK, Northumbrian Water's pledge to grow its dividend above inflation will provide an inflation hedge."
The pub group Marston's, meanwhile, he classes as a higher-risk recovery stock, which has been swimming against the tide of economic and sector concerns. He also highlights the fact its management remains cautious on the outlook so investors may need to be patient.
"Food sales have provided a vital boost to the company and it is gearing its establishments towards families and increasing the importance of food," he says. "The share price has had a good run over the last two months, so new investors should drip feed into the stock for the time being."
Choosing a domestically focused fund
For those who lack the necessary skills and confidence to invest in individual stocks the answer is to opt for a fund instead.
In this way they will be getting exposure to a number of companies and can relax in the knowledge that a manager will be making all the big investment decisions, points out Connolly.
"UK listed companies should be an important part of nearly all investment portfolios. Funds we recommend include Aegon UK Equity and Schroder UK Alpha Plus," he says. "For those wanting to focus on stocks that generate most of their income from the UK, we would recommend BlackRock UK Smaller Companies and Old Mutual UK Select Smaller Companies. Investing in smaller companies is higher risk and so should usually represent only a minor proportion of portfolio, say five per cent."
The conclusion is that it is a sensible strategy to include UK companies as part of your investment portfolio but do not follow this to the exclusion of anything else because it will restrict your choice and increase the level of risk.
While it is sensible to include UK companies as part of your investment portfolio, restricting your investments to only those companies which derive all of their income in the UK will severely limit your choice and increase risk.
"The UK makes up only a small proportion of world stock markets and there are many fantastic companies such as Microsoft, Apple, Nestlé, Sony and Samsung, listed overseas, so it is important to diversify your investments into other countries as well," adds Connolly.