The deeply unloved status of the UK equity market has created an exceptionally fertile period for contrarian stockpicking. In aggregate, the Fidelity Special Situations portfolio is as cheap today as it has been in the five years of my tenure or at any time since the 2008 financial crisis - I am struck by the sheer number of stocks across different sectors whose valuations suggest significant asymmetry of risk and reward over the next 2-3 years.
I believe my investment style is well-suited to this environment and I have backed this belief by making a significant personal investment into my funds at the end of 2018.
Opportunities can be found across the market, among international as well as domestic businesses. Following the further deterioration in sentiment towards the UK in the fourth quarter of last year, I increased exposure to domestic UK stocks, recycling capital primarily from US-facing businesses. We now have a 7% overweight to sterling revenues relative to the FTSE All Share.
I don’t have a differentiated view on the UK political or macroeconomic outlook. I acknowledge the risks here but am interested in investing in UK domestic businesses if they can satisfy these criteria:
A low valuation which reflects a worst-case outlook. It is not difficult to find stocks meeting this criteria!
A strong balance sheet that can support the business through a period of earnings volatility. This will be key to limiting downside if we do enter a slowdown. Some businesses saw the ‘lower for longer’ environment as an opportunity to increase gearing at low cost. I am avoiding stocks I feel to be carrying unsuitable amounts of debt, particularly if they are cyclical or UK-facing.
Structurally sound markets. It can sometimes be difficult to distinguish a short-term cyclical downturn from a long-term structural weakness. A low valuation will not provide much of a margin of safety to shareholders if cashflows are being gradually lost to new competitors.
A self-help story independent of the UK macro picture. A permanent feature of my investment process is to look for companies that can ‘help themselves’ without relying on a rising macroeconomic tide. I will typically avoid companies where margins are at historic highs.
I now own three UK life insurers - Phoenix Group, Aviva and L&G - where the average dividend yield for 2019 is well over 7%. This is well above historic averages, reflecting the market’s concerns around asset quality and the effect of widening credit spreads on life insurer balance sheets.
The work done by Fidelity’s insurance specialist suggests that the assets held by UK life insurers are significantly higher quality and more internationally diversified than the market is discounting. The dividends should be payable even in a downturn, and the long-term growth opportunities for the life insurance sector remain attractive, both in terms of organic growth and consolidation.
I continue to hold positions in the UK banks. However, position sizes reflect the fact that while trading at attractive valuations, banks are cyclical and have been in a relatively benign environment for loan loss provisions. With a lower loan to deposit ratio of 85%, I now believe RBS has the most attractive balance of risk and reward in the sector. It holds significant excess capital which would provide a buffer in the event of any future losses. I don’t hold any challenger banks, where balance sheets are weaker and risk appetite seems to have been higher.
I continue to avoid UK housebuilders. I prefer the two Irish builders Cairn and Glenveagh, which enjoy significantly better industry fundamentals, rising returns, and lower valuations. An Irish recession caused by Brexit remains a risk, although given most of Ireland’s trade with the UK is in agricultural products, the Irish economy may prove more resilient in the face of Brexit than many seem to think.
Elsewhere, I continue to tread cautiously among the retailers, where low valuations give no comfort if we feel the business is structurally compromised. Currently only around 2% of the portfolio is invested across a number of small positions in companies which are relatively insulated, or benefit from, the shift online. Protection from disruption could be provided by a cost advantage, or the provision of an ‘in person’ service in the shops.
Some clients seem to expect me, as a contrarian, to have a higher weighting to this sector. However, with such a wealth of valuation opportunity across the market, there is no need to buy structurally compromised businesses - there are much more attractive opportunities elsewhere.
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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. 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. 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.