We are living in extraordinary times. Alex Wright, portfolio manager of the Fidelity Special Situations Fund and Fidelity Special Values PLC discusses his new view on the world, through his old contrarian lens. He explains some of the changes he has made to the portfolios in light of the recent market moves, dissects some of the challenges UK equity investors face in the months ahead and answers: are value investors in for an even rougher ride?
- It is consensus that we will have a deep recession, although it is not clear whether market participants are yet correctly assessing how long this may go on for.
- Levels of government support and bank forbearance will be important for companies in order to try and maintain balance sheets.
- Markets are currently presenting long-term investors with the opportunity to buy companies at exceptional prices, without having to take big cyclical risks.
The UK, along with many other countries across the world, is now in lockdown. The number of recognised COVID-19 cases, and tragically deaths, has substantially increased. Markets have continued to prove very volatile, and individual company share prices have experienced sizeable up and down daily moves, not always explained by fundamentals or developments affecting their business.
What’s been happening?
The bull market that had characterised recent years did little for the fortunes of value stocks, but in the last year and a half, the environment has deteriorated further still. Approaching the end of February, the portfolio was behind the benchmark on allocation to value stocks. This was not the result of any stock-picking disasters, but simply because growth rather than value stocks have been so firmly in vogue. The subsequent sell-off caused value stocks to underperform further.What is now clear, is that beyond just the initial lockdowns, there will also now be a global recession at least as bad as seen in the 2008/2009 period and quite possibly worse. Indeed, investment banks and our own internal economists are predicting a Q2 economic contraction in the -10 to -25% range, much larger than the worst quarter in the global financial crisis of -8%. Additionally, the government support measures will result in significantly higher government debt-to-GDP levels for Western countries which have had to lock down. This is at a time when debt-to-GDP levels are already high.
A challenging time for value investors
Re-evaluating and taking stock in a new world
As COVID-19 struck, I recognised the risks to the most impacted sectors such as airlines, and quickly sold my small Dart position (at a significant profit) and my small Wizz Air position. However, it is fair to say that I underestimated the degree to which Western governments would need to curtail economic activity and thus the huge knock-on effects.
Over the past weeks I have been conducting dozens of company meetings - and our analysts literally hundreds of meetings - to hear what’s happening on the ground. Our fixed income colleagues have also been feeding in to our daily and weekly meetings as to what’s been happening in debt markets. Alongside this, our healthcare team very ably lead by Dr Judith Finegold, has been making sure that we have the best possible view of what medical implications the virus has.
A series of global investment team meetings have been put in place and we are communicating regularly with teams, despite almost universally working from home. While these are deeply unsettling times, Fidelity has the best possible resources to deal with this situation.
What does the road ahead look like?
What is now clear, is that beyond just the initial lockdowns, there will also now be a global recession at least as bad as seen in the 2008/9 period and quite possibly worse.
Indeed, investment banks and our own internal economists are predicting a Q2 economic contraction in the -10% to -30% range, much larger than the worst quarter in the global financial crisis of -8%. Additionally, the government support measures will result in significantly higher government debt-to-GDP levels for Western countries which have had to lock down. This is at a time when debt-to-GDP levels are already high.
I think it is consensus that we will have a deep recession, although it is not clear to me whether market participants are yet correctly assessing how long this may go on for. It seems inevitable that there will be significant and wide-ranging dividend cuts in this environment.
Against this backdrop, our contrarian funds have suffered from recent market dynamics. At the time of writing, the Fidelity Special Situations Fund was down 34% year to date, which is around 8% lower than the broader FTSE All Share benchmark (as at 31st March 2020, using mid-day pricing for both the fund and index). The Net Asset Value of Fidelity Special Values PLC has performed similarly. This is clearly very disappointing.
Going into this crisis, the portfolios had what I believed were their highest ever defensive weighting. Unfortunately, it emerged that we had a number of large positions in what I considered, and still consider, economically unsensitive names which are, however, activity sensitive. For instance, C&C - a drinks distributor - and Photo-Me who produce ID photos and laundry machines are normally defensive stocks but have proved not to be in this environment. Meggitt is a defence and aerospace supplier. Irrespective of airline profitability, if planes fly, they get after-market business. Never have we seen a period where planes don’t fly to this degree.
The funds are also tilted away from Asia given the high valuations of consumer staples companies and my discomfort with the quality of the business models of the Asia-facing financials. Given China has currently been seen to deal with the disease better than the West, these stocks have done better than more domestically focused companies and as a result have hurt fund performance.
Positioning the funds for a new world order
In the first instance I have been working through the portfolios to assess where a deep recession will likely cause balance sheet problems. I have then looked to sell names where I think there is a real bankruptcy risk. This is something of a moving feast, as in some sectors revenue falls are so severe that even companies with net cash balance sheets may go bankrupt as they cannot cover costs and burn through cash. Levels of government support and bank forbearance will also be important, and these are changing on a daily basis.
The largest addition to the fund is a telecom operator, an unloved stock but a clear winner of the current crisis where revenues are going up and costs are falling, but where the stock has fallen 20% year-to-date, only slightly outperforming the market.
I have also increased the position in communication equipment firm Ericsson, which I bought initially in the early part of Q1 to take advantage of a significant expected increase in telecom-related capex spending.
I have trimmed back the portfolios’ oil exposure selling around 2% across BP and Shell. I have also added to positions in utilities, life insurance and healthcare, as well as some selectively cyclical areas where balance sheets are strong. Given the large recession we are about to go through, I think it is right not to be too aggressive at this point.
Investing for the long-term
While the coming months are likely to prove very challenging, markets are currently presenting patient, long-term investors with the opportunity to buy companies at exceptional prices, without having to take big cyclical risks. The funds remain diversified across stocks, sectors and market capitalisations. While they are geared to the market given the cheapness of value stocks, the portfolios are well balanced with a defensive tilt.
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