According to the analysts at Fidelity, UK shares have been getting cheaper and cheaper relative to rival markets in the US and Europe for several years.
A quick glance at some commonly used valuation measures backs up this statement emphatically. For example, analysis from Schroders shows that back in 2015, the price-to-earnings multiple for the UK stock market was less than 10% below that of both the US and Europe. That has now fallen to over 20% below Europe and more than 40% below the US.
The way I see it, there are two possible explanations. Either the attractive yields and current affordability of UK dividend shares represent a golden opportunity for investors seeking a reliable passive income stream, or British stocks are cheap for a reason because of doubts in relation to whether companies can deliver earnings and recover their valuations.
Let’s begin by exploring the possibility of the latter.
Not all cheap stocks are good investments
In the world of investing, a value trap occurs when a stock appears undervalued according to traditional financial metrics.
As a result, investors see these low prices and become convinced that they’ve found a great deal. However, the low share price may be due to fundamental issues within the company. These could include declining sales, high debt, management problems, or even an outdated business model.
Thinking about value traps serves as a useful reminder to me that not all cheap stocks are good investments. But what about cheap UK dividend stocks?
Well, for this to be true in the context of the British stock market, I think the relatively low valuations would have to be attributed to one or more of the following factors: underlying fundamental problems within the companies, economic factors such as a recession or economic instability, or negative market sentiment. In my view, only one of those applies in the case of the UK stock market.
Negative market sentiment creating opportunities
Across the FTSE 350, I see a wide range of high-quality companies with strong fundamentals and exciting growth prospects. And relative to other countries in Europe and North America, I don’t think the UK is battling with any more serious economic woes than its peers. That leaves me with just one explanation: market sentiment and perception.
Morgan Stanley analyst Graham Secker points out that UK equities have a long-standing reputation for being reasonably valued, but that persistent negative investor sentiment about the overall UK economic conditions over the last 5-10 years has arguably made them even more affordable than usual.
Even if companies are fundamentally strong, negative market sentiment about a particular country can keep share prices depressed. And that’s exactly what I believe we’re observing in the UK stock market.
Building a stable passive income stream
Consequently, I reckon investor sentiment towards British stocks is due an improvement. And if it comes, cheap dividend shares won’t stay cheap for long.
That’s why if I had any cash to spare, I’d load up on undervalued income stocks while I still had the opportunity. Doing so could position me well to benefit from a reliable and substantial passive income stream further down the line.
