5% risk free? Why I’m still buying UK shares

Rising interest rates have created new choices for UK investors. It’s now possible to earn a 5% return on cash, risk free.

Recent data from the Hargreaves Lansdown (LON:HL.) website suggests to me that many of the firm’s investment clients are embracing this opportunity. Nearly 15% of the cash invested in individual securities (not funds) by HL clients last week was used to buy UK government bonds. From what I can see, these typically offer a yield-to-maturity of about 5%.

Hargreaves has a market share of about 40% in the UK, so I reckon this is probably a reasonable barometer of how private investors with share dealing accounts are allocating their cash.

In addition to this, there are plenty of cash savings accounts on offer at the moment offering 5% interest, backed by FSCS guarantees.

It’s not too hard to see why investors are happy to accept a capped upside in exchange for protection from losses.

Many of the small-cap and mid-cap stocks favoured by private investors have performed badly over the last couple of years, with the AIM market down nearly 40%:

With the economic outlook remaining uncertain, I can see the temptation to lock in a guaranteed return.

This approach probably makes sense for anyone who expects to withdraw cash from their investments in the near future. The short-term outlook for share prices is always uncertain.

But for investors like me with a focus on long-term returns, I think the cost of staying out of equities looks too high.

With valuations down almost across the board, I can see plenty of buying opportunities. I’m continuing to buy UK shares and have no intention of switching to cash.

Why buy UK shares?

There are several reasons for my continued focus on equities.

First of all, a 5% return isn’t enough to beat inflation, which remains over 7%. So saving in cash may still mean accepting an annual loss, in real terms.

More importantly, history tells me that it’s possible to do much better than 5% from shares.

Since 1900, UK shares have delivered an average annual return of 9.1% per year, according to the 2023 edition of the Credit Suisse Global Investment Returns Yearbook. That’s equivalent to a real return of 5.3%, after inflation.

Over the same period, bonds have delivered a nominal return of 5.1%, or just 1.4% after inflation.

These numbers tell me that UK equities have outperformed bonds by about 4% per year over the last 120 years. 

An extra 4% annual return over a 20 years is equivalent to an additional 120% gain. In other words, the extra return from equities would double your money, in addition to any other gains. Here's how £10k equity and bond portfolios would perform over 20 years, based on these historical rates of return:

These are long-term averages, of course. But I can share a couple of real-world examples of similar returns that have been generated in Stockopedia model portfolios over shorter periods.

• Ed’s systematic NAPS portfolio has delivered a 12% annualised return since its inception in 2015.

• My own rules-based SIF portfolio has delivered an annualised return of about 8% since its launch in April 2016.

These returns have not been delivered in a straight line. Both strategies have had good years and bad years. But I believe the portfolios’ consistent time in the market has paid off. When the good times have come round, we’ve benefited.

Although past performance is no guarantee of future returns, accepting some risk and uncertainty is a fundamental part of equity investing.

In return for this, we get the opportunity to invest in businesses that can create wealth for shareholders through long-term earnings growth. This has the potential to deliver returns far ahead of inflation – and much greater than 5%.

The market looks reasonably priced

Stock markets always attempt to look forward. While we’re worrying about the risk of a real-world recession, a fair amount of bad news has already been priced into many stocks.

While it’s certainly true that conditions could still get worse, my feeling is that there are plenty of good quality companies trading at reasonable prices, on a long-term view.

I think the valuation of UK stock indices also supports the view that the market is reasonably valued.

The FTSE 100 is trading on a forecast P/E of 14, which looks okay, but to my mind the real opportunities probably lie in the FTSE 250 and small-cap indices.

According to Stockopedia, the FTSE 250 is trading at a level first seen in 2017:

The valuations of some FTSE 250 firms are so depressed that the mid-cap index is now trading on a forward P/E of 12 with a dividend yield of around 4%, according to Stockopedia.

It’s a similar story for the FTSE SmallCap and AIM All-Share indices.

On balance, I don’t think this valuation is a fair reflection of the value of the companies in these indices.

If I wanted to buy a tracker fund today, I’d probably start with the FTSE 250. But as a stockpicker, I think there are better and more interesting opportunities on offer among individual shares and sectors.

Where are the opportunities today?

There’s no one single answer to this question. The best opportunities depend partly on what you’re looking for.

A good starting point for anyone seeking to clarify their investing strategy is our recent Strategy Map series. Ed’s opening piece includes a summary of investment styles and timeframes across the spectrum of quality, value and momentum.

In the final piece of the series, Ed pulled all the threads together and explained how the StockRanks use a balanced mix of quality, value and momentum – a combination that has outperformed since the system was launched in 2013.

For me personally, my interests lie across value, quality and income. I aim to hold shares for long periods. At the moment, I’m interested in taking advantage of any opportunities that have been created by the wider market weakness.

In recent months, I’ve covered a number of sectors and specific stocks where I think investors may be able to buy value and quality at attractive prices. In many of these examples, I think the short-term outlook remains uncertain, but the longer-term opportunity is very attractive.

REITs: last week I took a look at UK REITs and explained what I’m looking for in this sector and why I think there’s value on offer for selective investors.

Housebuilders: I covered this sector in May, but valuations have edged a little lower since then. In my view, recent news flow from the big housebuiders is no worse than expected. I continue to see medium-term value here and the potential for attractive income.

Containers & Packaging: another unloved sector right now. All the big names look good to me and score well with the StockRanks.

I took an in-depth look at Mondi in June and covered rival DS Smith a few months earlier.

Distribution: I think there are some good (and underrated) companies that operate as distribution specialists in various sectors.

I recently covered small-cap Kitwave in a Stock Pitch. This founder-led business continues to look attractive to me.

Among mid-sized and larger firms, I think DCC (LON:DCC) and increasingly Bunzl (LON:BNZL) are worth a closer look. I also think that automotive distributor Inchcape (LON:INCH) (which operates globally) is attractive at the moment.

Industrials: this may seem counterintuitive, given the risk of a recession. But I think there are some interesting opportunities in this part of the market. I explored the wider investment case in a recent piece.

In terms of specific stocks, I have previously reviewed Bodycote and also quite like Vesuvius (LON:VSVS) and (in an adjacent sector) construction group Morgan Sindall (LON:MGNS).

Mark Simpson recently covered small-cap steel specialist Severfield (LON:SFR) together with two other highly-ranked industrial firms that might be worth a look.

5% yield, low risk? Circling back to where I started this piece – the search for 5% returns – I’ve created a very quick stock screen to highlight shares with the following characteristics:

• 5% forecast dividend yield

• StockRank > 80

• Market cap over £50m

-> You can view this screen here

This is certainly not a list of stocks to buy. But I think the results of this screen include some interesting stocks that are worthy of further research. It could be a useful starting point for new ideas.

As always, please let me know what you think about the issues I’ve discussed in this piece. Are you tempted by 5% risk-free returns, or are you staying put in stocks?

Disclosure: Roland owns shares of DCC, Kitwave and Inchcape.