Time to invest in the best of British

I t is easy to be gloomy about the prospects for the UK economy. There are still 2.4 million unemployed, sterling is painfully low against rival currencies, and the residential property market remains mired in misery.

Even the recent stock market bounce back and GDP growth is being viewed suspiciously, with Mervyn King, the Bank of England Governor, branding the recovery "fragile" and warning the next few months may be volatile.

But that doesn't mean UK companies should be totally ignored by investors because there are plenty of stocks with the potential to deliver decent returns, according to Paul Marriage, manager of the Cazenove UK Smaller Companies fund.

"It isn't hard to be negative about the UK economy and there is a lot of uncertainty in the stock market, but there are also enough attractive companies to invest in which should hopefully be able to grow their earnings and see their share prices rise," he says.

So how should you get exposure to the UK?

The first point to remember is that many stocks listed on the bluechip FTSE 100 index earn vast revenues from overseas so are not truly UK-focused, explains Darius McDermott, of Chelsea Financial Services.

"Buying into this index will effectively give an investor 40 per cent exposure to the UK and 60 per cent to the rest of the world so it is certainly not the way to go if they want access to the UK itself," he explains.

The roll-call of companies listed in the UK includes names such as GlaxoSmithKline, HSBC and BP. All are multi-billion pound giants in their respective sectors with diversified income streams stretching around the globe.

"Even many mid-sized companies earn a chunk of their money abroad," he says. "The smaller companies will usually have the most exposure to UK plc but they come with greater risk and less liquidity as fewer shares will change hands on a daily basis."

According to Paul Spencer, manager of the Rensburg UK Mid Cap Growth Trust, the truly UK-centric sectors of the stock market include: house building, construction, building materials, general retailers, food producers, leisure (pubs, bookmakers, transport and restaurants), financials (wealth managers), real estate and utilities.

"Those performing well typically provide an essential service, a non-discretionary product or a value offering," he explains. "Alternatively they have exposure to a structural growth market unaffected by the general problems of the UK economy."

David Kuo, director at financial website The Motley Fool, points out that the correlation between the stock market and an uncertain UK economy is not always what it seems – and could actually be a positive.

"Britain in the doldrums and the subsequent devaluation of sterling could be good news for British manufacturers, particularly those that have resisted the temptation to shift their manufacturing base to cheaper shores as their products could be 25 per cent cheaper in dollar terms than they were two years ago," he says. "The fall in sterling should also act as a magnet to tourists which will help businesses involved in the hospitality supply chain."

One way of determining which companies might be worthy of investment is thinking about what you buy, where you get it from, and whether the supplier is in the UK, suggests Nick Raynor, adviser at The Share Centre.

"You can still make money if you look in the right areas," he says. "There are certainly opportunities available in a number of sectors as long as investors are prepared to carefully examine the prospects for individual companies."

In particular he likes property companies such as Land Securities and British Land.

"They are both very good yielders and the majority of their income is derived from London and the surrounding areas," he explains. "We have also started to see an upturn in rentals with some fighting over space in the capital which is a good sign."

He also suggests Dignity, the provider of funeral-related services, could be another interesting name. "It is the biggest player in the sector and has been buying up a lot of independent names, while retaining the personal touch. It's an extremely good business, very well run and goes from strength to strength."

Stobart Group, the transports and logistics business, is another UK business doing well, along with pub company Marston's and Booker – the wholesaler which supplies caterers, retailers and other businesses.

The goal is to find companies with market leading products whose management teams are investing in the future of its business, adds Paul Marriage at Cazenove.

"If they are putting in enough to keep growing its market share then it will be a much bigger company and worth more in five years' time," he says. "Investing in quality business through the cycle is the way to make the best returns. You might even be able to invest now at low valuations because people are worried about UK economic factors which might not be relevant to individual stocks."

The alternative for those who are reluctant to pick individual names is buying into a managed fund.

The IMA UK Smaller Companies sector has been a strong performer over the past year with its 54.97 per cent return being higher than the 46.70 per cent achieved by IMA Europe excluding UK or the 44.93 per cent of IMA UK All Companies, according to Morningstar figures to March 1, 2010.

The best performing fund among the 62 residing in the sector was Close Special Situations, which returned an impressive 166.3 per cent, but even those at the other end of the table were in positive territory.

However, even the smaller cap names can be heavily dependent on overseas markets so you will need to be careful what you buy, points out Mark Dampier at Hargreaves Lansdown. "UK small caps used to be very domestically oriented 20 years ago but that is no longer the case," he says. "Almost every fund manager is buying shares with overseas earnings because that is where they see the bigger opportunity."

It is a view with which he agrees.

"We think being in the UK economy will be a grind over the next three to five years with GDP unlikely to reach three per cent, so you don't want to be in construction, property, or consumer oriented retailers because these areas are going to struggle."

Darius McDermott, at Chelsea Financial Services, suggests that either the Marlborough Special Situations or the Old Mutual UK Select Smaller Companies funds could be worth a look for investors. "The managers have been running funds for a decent length of time and have got solid out performance records," he says.

Neil Mumford, of Milestone Wealth Management, has reservations about being too UK-focused, regardless of whether you opt for a managed fund or a selection of stocks.

"I'm just very wary of investing into companies that rely almost totally on UK earnings because I feel the economic outlook is very uncertain," he explains.

Investor: 'It's daft having it all in one area'

Experienced private investor David Stredder, has bought into a number of companies that earn most of their revenue from the UK and believes many can deliver top drawer returns regardless of the economic backdrop.

"There are always going to be companies whose management teams know what to do in a downturn," he says. Mr Stredder, 51, who lives in London, looks for undervalued companies that have a decent amount of cash on their balance sheets.

"I have been keeping my portfolio very balanced as it is daft having everything in one area," he adds. "Therefore I look at different countries and earnings streams so that I am not too adversely hit if something happens to keep earnings low in the UK."

The UK-focused stocks in which he has invested include MBL Group, the distributor of home entertainment products, which benefited from last year's disappearance of Woolworths. "It is very efficient and makes solid money from this business," he explains.