Finding value in UK equities

27 May 2020

 

Key points:

  • Across the portfolio, all but one company are now operating in some way, which compares to a peak of 10% that were closed during the height of lockdown.
  • Economists are now looking at an annual contraction of UK GDP somewhere between 8% at the optimistic end of the scale and around 15% at the pessimistic end.
  • It’s very difficult to call the exact timing of the reversal of the value vs growth underperformance - but the extreme dispersion in valuations, negative headlines and the exodus out of value funds we are currently seeing are typical of prior ends of cycles.

As lockdown in the UK is beginning to ease, is there cause for optimism in markets?

It’s clear that the lockdown has had a significant impact on many UK businesses and the UK economy as a whole. Figures released in April show that the peak-to-trough GDP decline was close to 50% for the UK meaning that the economy halved during the height of the lockdown.

I do believe that we are through the lowest point of this highly unusual recession and we are rebuilding. Economists are now looking at an annual contraction of UK GDP somewhere between 8% at the optimistic end of the scale and around 15% at the pessimistic end. So, I think it’s safe to say that we are now in the recovery phase.

When I look at the portfolio, all but one company are now operating in some way from a peak of 10% that were closed. Re-opening is quite different across different businesses, and there have been some clear winners. For example, our position in Halfords has done very well through the lockdown, having closed around a third of its branches but keeping online and click-and-collect open. As a result, sales fell around 20% but, given that their costs decreased, their profitability has maintained.

Across other sectors, however, the picture is very different. Airlines and hospitality have been worst hit and when we talk to these companies about what re-opening looks like, for these businesses you may see losses accelerate in the beginning. This may seem counterintuitive but, for airlines, for example, if you’re operating at a lower level given social distancing measures, as you incur more costs but without the revenue growing, this becomes challenging. The question is: can these businesses manage that increase loss level once lockdown is eased further?

Whilst I do have some companies exposed to those more affected sectors, like Meggitt (who does aftermarket for airlines), C&C group (a drinks delivery business) and Hammerson (who own shopping malls), those are small positions and make up less than 5% of the portfolio. I think life will be hard for them in the near-term.

At a general level, the market is still very bifurcated and we don’t have to focus on one specific area to find value today. A large number of our holdings are in companies mostly unaffected by the virus such as Babcock and Imperial Brands, or beneficiaries such as Mylan. In total, around 42% of the portfolio consists of such stocks.

Given the news flow around the possibility of negative interest rates, what is your view on banks and what is the funds exposure to banks? 

Banks are an area that have performed poorly over a prolonged period of time, owing to the low interest rate environment. This is why I have dramatically reduced the funds’ exposure to banks over the last 18 months. We now only have around 4% of the funds invested in banks. Citigroup is by far the biggest holding at around 2%. We also have smaller positions in RBS, AIB and Barclays. Whilst the balance sheets are strong, the income line is an issue and if we did see negative interest rates that would be a further headwind.

Many companies have been reducing or stopping dividend payments to shareholders, have any of the fund holdings been directly impacted by this?

I think it’s worth putting the companies that have cancelled their dividends into different categories. Firstly, those who did so as a result of regulatory pressures, such as banks and non-life insurers, more as a cautionary step. On the other side, some cyclical stocks have also cancelled their dividends given that their balance sheets and profits are going to be severely affected and therefore it was a necessary step. We have also high-profile cases such as Shell owing to the  severe oil price weakness and associated uncertainty over how the future might look.

One of our biggest trades so far this year has been to reduce our exposure to oil which has been beneficial. We do still have around a 3% position and I view the sector in the same way as I view the banks - I do think the stocks are extremely cheap. The oil price is likely to rise on a 12-18-month view, but I have lower conviction in this area given deteriorating long-term industry dynamics.

What changes have you made to the portfolio in recent months?

Over the last month there haven’t been any substantial changes, and I am happy with the shape of the portfolio. We have added one new position in Origin Enterprises which is an agricultural stock, unaffected by the crisis. Any other additions since our last update have been relatively small positions.

Since March, the market has been trading on virus-related headlines; we saw a huge dip as the virus took hold and now as we move beyond containment of the virus and as the death toll decreases, markets are trading strongly. A big red flag for me as we move through this recession is the cost of the crisis - not only for the economy but also the fiscal and monetary stimulus that has been pumped into global economies.

As a result, the funds are more defensive than they were in February going into the crisis. The traditionally defensive companies whose activities were hit by virus containment measures form a far smaller proportion of the funds today. Given where we are to date, I think we will do reasonably well - even if things deteriorate on the virus front - because we have so much in areas that aren’t affected by the impact of the virus, unlike the first wave when we held larger positions in activity sensitive businesses. Valuations also play a big part; there was a lot of value across the market before the crisis and there’s even more now. There is no need to take disproportionate risk to get back some of the recent underperformance we have suffered.

What is your view on the value versus growth debate? 

Value stocks have had a tough time since around 2007, which is pretty much my entire career running money. As I commented last time, through this crisis the underperformance has accelerated and the valuation differential has gone parabolic - value has underperformed growth by around 25% since mid-2018, which is worse than we saw at the height of the tech bubble.

While it’s very difficult to call the exact timing of when this will reverse, the extreme dispersion in valuations, the negative headlines and the exodus out of value funds we are currently seeing are typical of prior ends of cycles.

Valuations can be partly justified in some areas such as online, where we are seeing a reshaping of some industries. But when you look at performance across the board in areas such as industrials from the most highly rated to the least, there is an unbelievable gap. There are a lot of opportunities out there for value investors. I don’t believe things are different this time around, and when people think so it is when they have been proven wrong in the past.

What would you consider to be your best and worst decision over this challenging period?

It’s difficult to pinpoint one decision - for better or worse - that would stand out. By virtue of the portfolio being constructed of over 100 stocks, I make sure that there are small, incremental decisions that power performance rather than just one decision.

I would say however that, although we were defensively positioned and we always model for a recession, we did not model for a situation where companies are seeing 50-100% of their revenues disappear virtually overnight. The exposure to such stocks did hurt us. Halford was one of the stocks we began to sell under these conditions. However, once the government stepped in to improve company liquidity through furlough schemes and tax breaks, we began to buy some of that stock back once we realised the outlook for the business was cushioned through that help.

On the other side, selling oil stocks early on was a good decision for us. The falling out of OPEC and the huge demand gap, coupled with a subsequent pause on dividend payments, I think combined that is probably the best story in terms of performance saved as a result of trading those stocks.

Does this period of volatility change your views on what a Brexit trade deal could look like and the impact on the portfolio?

I think it’s quite interesting because this period of lockdown has caused supply chains to be disrupted and gives us an idea of how robust those supply chains are. So, I think some of the incredibly negative things that people were expecting from a no-trade-deal Brexit would not be that dissimilar to the disruption we've seen from the virus.

While the economy has taken a significant hit, supply chains continue to work and clearly in some businesses the planning for a no-deal Brexit has been beneficial.

From a portfolio perspective, we maintain our diversification and we are overweight UK-domestic businesses, but as I have mentioned before that part of the index is quite small, so we still only have around 30% of the funds in UK-facing stocks.

I think the impact of a no-trade-deal Brexit won’t be as large as some people were thinking. So, to be honest, it's not something that I spend much time thinking about at the moment. I think my time is better spent ensuring that the portfolio is diversified and that we own attractively valued stocks in which we have conviction across sectors and geographies (from a revenue perspective) in order to put us in the best position to weather whatever the future may hold.

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