The value in UK value

Alex Wright, portfolio manager of Fidelity Special Values PLC, shares his outlook for UK equities in 2024. He highlights the unloved areas of the domestic market where he sees potential for recovery and discusses why we could be at the start of a sustained period of outperformance from UK value stocks and sectors.

What is your investment outlook for 2024 given the prevailing macro environment?

The global backdrop remains very unsettled. Geopolitical risks have affected energy prices and global trade, as well as contributing to an increasingly fractious global environment. In the UK, we have had a new Prime Minister, seven months of double-digit CPI inflation and eight consecutive base rate increases.

UK equities are currently pricing in extreme pessimism and, as a result, trade at a significant discount to other markets. While the outlook is uncertain and corporate earnings could disappoint in the near-term, this is also true of other markets such as the US, where valuations are meaningfully more expensive.

Value stocks have outperformed growth stocks over the last three years, but they still have significant ground to catch-up. The current market environment of stickier inflation, higher interest rates and economic volatility is more aligned to the long-term pattern seen over the last 100 years. History suggests that over the long-term value tends to outperform, given generally higher discount rates and a reversion to the mean.

We, therefore, believe that we are in the very early stages of a long-term rally in value stocks. With its high dividends and low valuations, the UK market offers better prospective returns than many other asset classes, including global equities.

What do you think could surprise markets in 2024?

The biggest risk is a recession and its impact on corporate earnings. While there is increasing talk of a soft landing, there is considerable historical evidence on the impact of monetary tightening to keep us cautious on company prospects in the near-term. In this uncertain environment, we favour companies with lower levels of debt. We are  wary of stocks where fundamentals and margins have been strong and where a potential deterioration is not priced in.

Given the nature of the post-pandemic environment, there are companies that have already exhibited fundamental weakness resembling a recessionary scenario. Many of these companies, especially in the small and mid-cap space, have seen their earnings rebased and trade on low valuations, with limited downside and significant upside once the environment normalises. This is starting to present us with some interesting opportunities, and we have begun to build some positions in selected stocks.

What has worked well in your portfolios over 2023?

Overall, we have been pleased by the earnings resilience of the holdings in our portfolios. Last year, we materially reduced our consumer exposure, selling our holdings in domestic housebuilders and cutting exposure to areas more susceptible to a demand slowdown, such as big-ticket items and advertising. These decisions contributed positively to this year’s performance given profit warnings in those industries and housing experiencing a particularly marked slowdown. However, profit warnings have not been as widespread as feared and, in general, the consumer has proved relatively resilient, helping Marks & Spencer, travel companies and airlines to beat earnings expectations.

Elsewhere, some of our overseas facing financial holdings such as AIB (leading bank/mortgage provider in Ireland) and Kaspi (dominant consumer finance/e-commerce/payments platform in Kazakhstan) have performed particularly strongly. Support services groups Babcock and Mitie have also performed well - both are much improved businesses, with stable growth profiles that remain generally underappreciated by the broader markets.

Where are the key areas of opportunity in 2024?

The combination of higher rates and a weaker economic environment is likely to remain challenging in the near term for corporates and consumers who need to refinance their debts. As a result, we remain selective with a preference for companies with lower levels of debt.

Higher interest rates have benefited sectors such as banks and life insurers, which had been shunned since the global financial crisis. While they continue to be well represented in our portfolios, we have taken some profits following strong returns. For instance, we have reduced our exposure to UK-facing banks such as Barclays and NatWest on concerns that meaningfully higher rates would incentivise customers to seek higher returns on their cash and hurt profits, which was subsequently born out in recent results. We have also scaled back our exposure to life insurers, primarily by exiting Legal & General on near-term concerns over its fund management business and exposure to real estate. We recycled some of the proceeds into areas such as industrials, where some stocks have de-rated particularly sharply and factored in overly pessimistic scenarios.

Overall, our portfolios are balanced sector-wise, somewhat more defensive with modest levels of gearing. While valuations are attractive and we are finding new ideas, we are conscious of the near-term uncertainty and want to retain some dry powder to take advantage of any forced sellers. Prior periods of uncertainty have in retrospect turned out to be great buying opportunities.