The real value in UK equities

While aggregate valuations in the UK look attractive, this picture masks some significant stylistic and sectoral differences. As investors continue to seek comfort in steady growth stocks, contrarian investor Alex Wright outlines some of the out of favour areas which he believes offer overlooked upside potential.

Key points

  • An uncertain economic and political backdrop means that UK equities remain attractively valued relative to both its history and other markets.
  • The Fidelity Special Situations Fund and Fidelity Special Values PLC trade at a discount to an already cheap market - making a good starting point for investments.
  • There are notable valuation differences between different sectors and we see particular potential among a number of defensive areas - both classic and hidden.

Ongoing political chaos, US-China trade tensions and weakening fundamentals have created a challenging environment for UK equities. A cautious approach is needed, but attractive valuation opportunities are out there.

These sizeable risks and uncertain outlook mean that the UK remains very much out of favour with both global and domestic investors. For example, in July alone, investors withdrew £1.2bn from UK equity funds. The valuation of the UK market reflects this with a P/E multiple that is low both relative to history and other equity markets globally. The Fidelity Special Situations Fund trades at a further 12% discount to an already cheap market (Fidelity Special Values PLC is at a 13% discount), making for a good valuation starting point for investments.

But market averages don’t tell the full story and hide a significant divergence in relative valuations between value and growth stocks. Despite value stocks having underperformed for a number of years, they have suffered further significant underperformance this year as globally interest rate expectations have fallen further from already low levels. This has left long duration, steady growth stocks trading at high valuations, whilst stocks with uncertainty or without growth characteristics are very cheap. It’s not clear what will trigger a reversal in this growth over value trade but it is clear that investors in growth equities are taking on much more risk that they have done in the past given the valuations they are paying.

This increased dispersion in valuations together with a weak pound has driven increased M&A in the UK and the portfolios have been a beneficiary of this. There have been six takeover bids of companies held in the portfolios so far this year. The majority of these have been relatively small positions with the exception of Millennium and Copthorne Hotels. The company had received an initial bid from its majority Malaysian holder over a year ago which was turned down. Following extensive engagement with the parent bidder, they subsequently came back with a more attractive offer, increasing the share price 50%.

Opportunities in defensives, both classic and hidden

Although I see a broad spread of value across the market, worsening fundamentals mean I am increasingly finding value in defensive stocks which I have increased to their highest overweight in history in the portfolios. The UK market is a good source of defensive companies, both classically defensive and others with more hidden defensive qualities.

Amongst the “classic” defensives I have added to Imperial Brands. Tobacco companies have de-rated significantly with Imperial now trading at an attractive 7.2x P/E multiple and offering a well-supported 9.1% dividend yield. I hold it in preference to BAT due to its stronger balance sheet and its promising new vapour innovations which are underappreciated by the market. Contour Global is another new classical defensive position in the utility space.

Amongst the “hidden” defensives I have added to Pearson which continues its transformation from print to digital and is countercyclical; it performs well in a US economic downturn as education enrolment picks up.

Source: Fidelity International, 30 June 2019. Sector/stock categorisation is at Fidelity’s discretion

I’ve also been further trimming exposure to cyclicals, particularly banks, where fundamentals have deteriorated markedly. The significant move down in global bond yields will put major pressures on the net interest margin for banks. For most banks there are few avenues left to offset this margin pressure. Most have little room left to cut costs and provisions are already at record lows. Unlike in 2009, all banks are well capitalised, encouraging competition. It’s therefore not an option to simply raise borrowing rates to compensate.

I have now sold out of Lloyds. In line with our original thesis, the company was successful in cutting costs and driving efficiencies, but I saw limited upside. The bank has now become a bellwether for the UK economy with its future performance tightly linked to the performance of the UK mortgage market and interest rates. I look to own companies in control of their own fate, able to drive positive change from the inside. For Lloyds, it will be predominantly external, macroeconomic factors that will take centre stage from here. By contrast, I continue to hold RBS which is at an earlier stage of its recovery and still has room to go in its evolution towards becoming a high return bank with excess capital. I have also sold out of Bank of Ireland and Discover and trimmed my Citigroup position.

Despite this overall reduction in cyclical exposure I am still finding selective opportunities. One such recent addition is Hammerson. The UK focused retail landlord faces challenging fundamentals but its current 70% discount to NAV more than compensates for this. This extremely low starting point offers limited downside and we expect management to pursue further asset sales and bring down leverage.

Given the rally in markets this year, deteriorating fundamentals and a fall in the number of stocks in stage one of my three-stage investment process, neither Special Situations nor Special Values are currently geared with a net exposure of 99% (excluding the Millennium & Copthorne cash bid which has been accepted and will close imminently).

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Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. The Fidelity Special Situations Fund and Fidelity Special Values PLC use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. They also invest more than other funds in smaller companies, which can carry a higher risk because the share prices may be more volatile than those of larger companies. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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