Portfolio manager Alex Wright provides an update on Fidelity Special Values PLC investment trust and reviews the current landscape for UK equity investors. Amid increasing market volatility and worries over inflation, he outlines why he remains confident on delivering attractive returns by identifying unloved stocks with overlooked investment potential.
- UK equities remain attractively valued versus other developed markets and this has been reflected in the market’s resilience through recent volatility.
- Rising inflation and interest rates tend to favour value managers due to the increased focus on shorter-term earnings and valuations. This supports the outlook for our strategy.
- Looking ahead, investors will need to be more discerning as it is unlikely that the next 10 years are going to bring the same kind of synchronised strong returns as seen in the last decade.
How has Fidelity Special Values PLC performed amid the recent market volatility?
Interestingly, the UK market has materially outperformed the US and is mainly flat year to date - which is also largely how the investment trust has performed over the same period. Looking at where the broad market sell-off has come from, it has been among highly-rated US growth stocks and unprofitable tech names. I believe this is quite a healthy sign for markets because for a long time, I have argued how certain markets, particularly the US, are overvalued and how that poses a big risk.
On the other hand, when you look at the UK market, it has a very low valuation versus international markets and is roughly in line with where it has been historically. So, I do think the UK is a more compelling place to invest than other developed markets right now and that has been reflected in the resilient performance of UK equities.
Do you expect inflationary pressures to be transitory or persistent and how do you expect the investment trust to perform in different scenarios?
US and UK inflation rates are probably going to peak around 7% in the near-term, which is the highest we've seen for more than 20 years. Some of the factors which are leading to these extreme inflation readings are likely to be transitory, such as the huge spike in the oil and gas prices, particularly in the UK. However, some of those pressures - such as wage rises - are much less transitory and are likely to be stickier.
This is now reflected in central bank rhetoric, particularly around the likelihood of some larger than initially expected increases in interest rates. This in turn has led the market to believe that this period of ultra-loose monetary policy and stimulus - that lowered discount rates and rewarded very long duration stocks, particularly in areas like tech - is being challenged by this stickier inflation.*
When interest rates rise, there tends to be more focus on short-term earnings and valuations, and this is a much better environment for the trust given its contrarian value approach. This has been reflected in the better relative performance of both the UK market and Fidelity Special Values in the last six to 18 months.
*Fundamental methods of valuation generally value a stock on the basis of its future cashflows discounted to a current value. The discount reflects the fact that investors prefer to have cash now, rather than in the future. Long duration stocks are companies that rely on continued earnings in the future to justify their valuations. Investors can be enticed to wait with the promise of extra returns in future, but they expect more when inflation is a concern. This has led to a recent rotation into more cheaply valued companies with attractive/improving shorter-term cashflows.
Given the pressure on consumers and the rising cost of living, have you made any changes to your consumer exposure?
The trust remains overweight in UK consumer stocks (relative to its benchmark) because of low valuations and a number of very good stock-specific turnarounds. That said, we have been reducing some of our exposure at the margin due to this top-down inflationary view and its effect on consumer purchasing power. For example, we’ve sold out one of our two holdings in UK housebuilders, as well as a building materials company and a real estate company. But there continues to be a lot of very good turnaround stories such as at Marks & Spencer and Kingfisher.
Also, in terms of rising energy costs, this has to be seen in the perspective of a consumer coming off a period of high savings from the pandemic. You are going to see an income squeeze, but consumers’ balance sheets are in good shape because of those high savings and low levels of debt. We have also seen strong house price increases, which is a key driver of spending. Those wealth effects are very strong and we think consumer-facing companies - as long as there is evidence of positive internal/external change taking place - still provide interesting investment opportunities compared to other areas of the market.
What is your overall outlook for UK equities?
It has been a great decade for equity market investors, despite the Covid-19 market decline. Going forward, investors will need to be more discerning as it is unlikely that the next 10 years are going to bring the same kind of synchronised strong returns across asset classes. Moreover, it does look like the regime of incredibly low interest rates and central bank easing is drawing to a close.
That being said, as a UK equity manager, I feel extremely lucky in this environment because the UK market is one of the few areas globally which still offers decent value and a broad range of stock picking opportunities. So, there is still potential for decent returns, but it is going to be harder than we've seen in the past.
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