UK stocks have surged in the last six months, but the improvement in share prices has not always reflected company fundamentals. During such general rallies it’s enough to be in the market, but now that stock prices are decoupling from the market as a whole, investors need to start picking stocks if they want to do well, explains Barclay’s analyst Alex Stewart. He recommends looking at EPS growth to find good deals.

UK recovery uneven

Correlation between prices rose during the last six months even though actual evidence of a sustained UK recovery is uneven, which is usually a good sign that prices are based more on sentiment than on fundamentals, since it is the only common factor between otherwise dissimilar stocks. “Positive sentiment towards the UK has seen significant buying of most cyclical stocks exposed to the recovery,” writes Stewart. “However, in the last week this correlation has started to weaken.”

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Correlation between share prices and EPS changes

There’s also a low correlation between share prices and consensus EPS changes, which usually means that corrections are coming down the pipeline. “Low correlation between domestic UK stocks and EPS revisions suggests the consensus trade so far has been to buy the market,” writes Stewart. “Differentiating between stocks which merely participated in the rally because of their cyclicality and those which our analysts believe are able to deliver decent EPS growth will, in our view, be key to picking winners.”

no uk correlation price eps

UK stocks trading

UK stocks as a whole are trading at 93 percent of their one-year maximum price-to-earnings ratio, and expecting the majority of companies to match those expectations in the coming months or quarters is unrealistic. “The key to picking winners, for us, is therefore to distinguish between companies that we believe can deliver earnings growth but look relatively cheap, and those whose P/E multiples may have got ahead of fundamentals,” writes Stewart. Barclay’s excluded financials and utilities from this analysis because P/E growth has been a poor way of predicting valuations for those sectors in the past.

EPS PE UK stock picks 0913

Comparing P/Es to the trend line shows a few standouts – Crest Nicholson Holdings PLC (LON:CRST), Dixons Retail PLC (LON:DXNS) (OTCMKTS:DSITY), and WH Smith Plc (LON:SMWH) – who look underpriced even in this market. Stewart thinks these companies can deliver 20.4 percent EPS growth compared to 10.5 percent for the larger UK market.