* UK retail index hits lowest level since Brexit aftermath
* Fund managers’ underweight on UK stocks at a record high
* Retail stocks have underperformed the market: reut.rs/2pxJgTN
* Struggling retailers' dividend yields eyewatering: tmsnrt.rs/2pt63Qg
* Valuations are near Brexit vote lows: tmsnrt.rs/2FWwRj3
By Helen Reid and Kit Rees
LONDON, March 21 (Reuters) - Britain’s retail sector has turned toxic in a climate of squeezed consumer spending laced with Brexit uncertainty, but low valuations are making some stocks a tempting prospect for the brave contrarian.
Moss Brothers and Kingfisher on Wednesday became the latest in the sector to suffer dramatic share price declines after reporting deteriorating trading.
The sector appears rife with “value traps” - stocks that appear cheap but turn out to undershoot even the most pessimistic expectations - partly because online rivals are peeling away the core customers of retail businesses that need reliable cashflows to service their debts.
Yet some investors are daring to dip in to consumer-facing stocks, from mid-caps to the smallest listed companies, saying valuations have been marked down in a blanket way and some now look like bargains.
“Despite there being all these headwinds, all these problems, there are still one or two interesting investments out there,” said Phil Harris, manager of the UK equity growth fund at EdenTree Investment Management.
“They’re just quite hard to find.”
Sentiment on UK equities as a whole reached a new all-time low in March, Bank of America Merrill Lynch’s fund manager survey showed on Tuesday.
That day, e-commerce giant Amazon.com, bane of the traditional bricks-and-mortar retailer, leapfrogged Google owner Alphabet to become the world’s second-biggest company by market value.
British retail stocks, the most exposed to domestic consumers, are the least preferred within an already unpopular asset class and have had an especially brutal start to the year.
Toys R Us UK and Maplin entered administration at the end of February, while early-years retailer Mothercare fell to an all-time low.
Carpetright, seen as a bellwether of consumers’ spending on home improvement, warned on profits for the third time in four months in March and is raising capital in a bid to turn things around.
Department store chain Debenhams kicked off the year with a profit warning and its shares are at their lowest since the financial crisis.
The retail sector index fell to its lowest level since the 2016 Brexit vote aftermath on Wednesday.
In such a climate, it’s lonely being an investor in UK retail stocks.
Paul Mumford, UK equities fund manager at Cavendish Asset Management, is one of these. He’s sticking with his holding in Moss Brothers despite the stock plummeting 20 percent, saying it has a decent online business and its balance sheet is “fine”.
BARGAIN-HUNTING IN HATED MARKET
Mumford may be joined by others looking for companies that could turn out to be a bargain if they can withstand the headwinds buffeting the industry.
“We are actually getting quite interested in the UK because it’s hated, it’s everyone’s biggest underweight,” said Rory McPherson, investment director at Psigma Investment Management.
While there are many more “land mines” than in the past, as Hawksmoor fund manager Daniel Lockyer put it, some are seeing opportunities.
Pessimism has driven valuations down so far that they’re attracting bargain hunters.
“Clients are asking about mid and small caps because they want to get those value areas where things have underperformed,” said Sharon Bell, European equity strategist at Goldman Sachs.
And a transition deal agreed with the EU on Monday has rekindled interest in the UK market.
Stocks across the retail sector have seen significant levels of short interest – bets against a company – in recent years, denting share prices.
One of these is Debenhams, a stock many have shunned for years as the shift to online shopping gathers pace. It’s another of Mumford’s holdings.
“At this level, the shares are saying the company is high risk, but the price might be considered artificially low having been dragged down by short selling,” said Mumford, adding it was a “double or nothing” situation.
Others are more cautious.
“I have steered clear because optically they can look very cheap, but particularly retail stocks are very operationally geared and it only takes a small downturn in trading to make a material impact on earnings,” said EdenTree’s Harris.
Hawksmoor’s Lockyer sees Debenhams, in particular, as a “value trap”.
Some are looking at stocks which could gain from consumers’ shrinking spending power as they opt for cheaper products.
Laura Foll, fund manager at Janus Henderson Investors, has a holding in Shoe Zone which has been able to maintain stable levels of sales thanks to its budget-friendly offering.
Disruptions to retail across the globe are also visible in Britain. Consumers are visiting stores less, enjoying price transparency thanks to the “infinite shelf” of the Internet and the dominance of Amazon, and favouring experiences over objects.
Leisure, accordingly, is one part of the UK market investors are willing to bet on. While Schroders’ income growth fund manager Sue Noffke backs Hollywood Bowl, Janus Henderson’s Foll invests in another bowling alley operator, Ten Entertainment.
Although inflation figures on Tuesday indicated slowing pressure on consumers’ purses, indicators of consumer confidence remain weak and much hangs upon how Britain will exit the EU.
Even those willing to risk exposure to UK retail advise others not to “try this at home” or to commit too much capital.
“Leave it to value players,” said Mumford.
Reporting by Helen Reid and Kit Rees editing by Tom Pfeiffer and Adrian Croft