UK: a fertile hunting ground for contrarian investors

The unpopularity of the UK market in recent years has made it an attractive hunting ground for contrarian value investors. While investors continue to be seduced by the charms of the US technology sector, we believe the UK market has an underappreciated richness of opportunity, combining strong earnings growth, high dividend yields and low valuations. 

The post-financial crisis period of lower interest rates was difficult to value strategies, and for the UK market, which has a natural value tilt. However, this has significantly changed over the last 4 years and the UK has delivered healthy absolute returns and performed in-line with global markets. Value has also resumed its long-term pattern of outperformance in the UK market. 

This has been a fertile environment for the Fidelity Special Values trust. Over the last 4 fiscal years¹, the trust has done well versus the UK market, but also – perhaps more surprisingly – it has also beaten the US technology heavy Nasdaq. 

This is not a result of any meaningful rerating in the UK stock market. Instead, it has been a product of strong earnings growth from UK companies in the portfolios. Last year, these companies have delivered an earnings growth premium of around 20% to the wider market, supported by a record number of companies buying back their own shares at low multiples, which is accretive to their earnings growth. M&A activity has also been beneficial for the strategy as overseas investors continue to remain the largest bidders and take advantage of the attractive valuations the UK offers. 

While valuations have increased slightly, the UK market remains cheap by historic standards. Adjusting for sectoral differences, the UK historically traded at roughly 85-90% of global markets, but this has dropped to around 75% in recent years². While other markets contend with excessive valuations and the risk of a de-rating, the UK benefits from a meaningful margin of safety, offering protection if exogenous events impact markets. 

We are finding attractive opportunities in smaller cap equities, which are trading at an aggregate price to earnings ratio of under 10x. The trust always has a strategic bias to small and mid-cap companies, which make up around 50% of its holdings, but this is a particularly productive hunting ground today. 

The financials sector is the largest absolute weight in the portfolio, though retains a high degree of diversification among holdings across a range of sub sectors, geographies and business models. We hold a number of the large UK banks – including NatWest and Barclays - but also some emerging market exposure through Standard Chartered. We also hold a number of the insurance companies including Aviva and Just Group. Tobacco companies also feature with Imperial and BAT both large positions. We look across the UK market and balance heavyweights such as Reckitt Benckiser and AstraZeneca, with smaller companies operating in more niche markets. 

Our only significant underweight position is in resources. This has been a consistent underweight through the life of the trust. We struggle to find value there, in contrast to the abundance of attractive investment opportunities elsewhere in the UK market. 

We continue to believe that market conditions favour our value contrarian style. The vulnerability with growth companies is that they tend to be priced for good news, and share prices fall significantly if that good news does not materialise. The opposite is true for value companies. If the consensus is negative, an investor doesn’t lose much if it turns out to be correct. In contrast, if it’s wrong, the share price can move significantly higher. 

At a time when the global economic outlook is uncertain, our focus on downside risk is vital. We always look at how much we could lose first, before considering a company’s share price potential. Our investment process incorporates earnings risk, financial risk and valuation risk. Importantly, if an investor pays the wrong price for a great business, it can still lose money. Developing a strong asymmetric returns profile is a key consideration for the strategy.  

We also think hard about what might improve a company’s fortunes. This helps us avoid value traps, where a company’s weakness will persist. In identifying these positive catalysts, we will meet companies regularly, but also talk to companies across their ecosystem - customers, suppliers, and competitors to gain a holistic view of their market landscape - this is where Fidelity’s global research platform helps build and support the investment case. 

The large divergence in performance between different international markets this year may be the signal of a new turning point. Despite popular belief last year that the US would continue its dominance, the exact opposite has occurred so far this year, highlighting the benefits of a contrarian investment style. We believe that the UK’s low valuations, strong earnings growth and high dividends makes it an attractive environment for contrarian stock pickers. 

Sources: 

¹Fidelity International, LSEG DataStream. Time period is based on fiscal years of Fidelity Special Values occurring from the 1 September to 31 August each year. Returns denominated in GBP.  

²JP Morgan Equity Strategy, DataStream, February 2025. Valuation is based on 12m forward P/E of the MSCI UK Index vs MSCI World Index (both are sector neutral indices).