Alex Wright and Jonathan Winton, Co-Portfolio Managers at Fidelity Special Values Plc (LON:FSV) explore why this is a new era for investors and we’re only at the start of the turnaround.
The investment landscape has seen a profound shift over the past 12 months. Investors must now reckon with higher interest rates, persistent inflation and deglobalisation after a decade when market forces were pushing in the opposite direction. In navigating this new landscape, investors will need to shift their thinking on the type of assets that stand to benefit.
The past decade has been a bumper one for growth companies. Capital was freely available, and at low cost. Mistakes weren’t punished: companies could disappoint the market on earnings and still raise money if they had an exciting enough growth story.
This reversed in 2022. There was a correction in the significant over-valuation seen in certain high growth assets, which was painful for those who had made technology stocks the bedrock of their portfolios. It was a far better year to be a value manager, and particularly a UK value manager. It was the first year in six that the UK outperformed major global indices and value companies reversed a long period of weakness.
This sudden reversal has been a shock, but in reality it just brought the world back to a more normal environment, with interest rates closer to historic averages. There are shifts in the global economy – particularly around deglobalisation and supply chain re-organisation – that mean inflation, and therefore interest rates, are likely to be structurally higher. The past decade has been an anomaly. Investors need to invest for the market environment of the next ten years rather than the past.
The value conundrum
Investors may be unprepared for this shift. The market has leaned towards growth companies in the face of strong performance. Just as global investors have gravitated to US technology stocks, UK managers have drifted towards growth stocks as well. The share of the investable universe occupied by true value portfolios such as Fidelity Special Values which I manage was always small, but over the past decade it has fallen to below 1%. The perception is that the UK market is all value – and that investing in the UK is enough to give you value exposure – is not quite true.
It has always been contrarian to be a value manager (it is part of our job description) but it has become even more so. This is no bad thing, extending the opportunity set available. Unlike the latest hot technology stock, we’re not competing with thousands of other investors to try and get an edge.
In spite of a stronger performance for value over the past year, the valuation gap between value and growth companies is still in place. It is only the start of the turnaround. Earnings in a lot of traditional value sectors, such as financials, have been so strong that value is still some way below its 10-year average valuation. As such, even though the environment is tough, investors are well-compensated in this part of the market for any risks they are taking.
The nature of ‘value’ investing
Value should not be synonymous with stodgy ‘old economy’ companies and certainly not with bad companies. My investment approach focuses on those companies that benefit when current trends don’t work out as expected. We assess the risk and reward of every name, look back at history to understand their performance in different economic environments.
A catalyst for change is vital for any company currently unloved by the market. We are not investing in unfashionable companies that will remain unfashionable indefinitely. Our due diligence looks at where a company is trying to change and whether they are achieving it. We meet with customers, suppliers and competitors as well as the company itself to assess its progress against its milestones.
The result is a portfolio that will look very different to the FTSE All Share, with a mix of companies at different stages – some that will be at an early stage of their change; a second group will be seeing earnings start to improve, while some will have seen change come through and now look appropriately valued. These companies we would sell and recycle the proceeds into new ideas.
Where we are finding opportunities
Financials are the biggest part of the portfolio at around one-third of assets, primarily banks and insurers. Higher interest rates have allowed banks to improve their return on equity, yet many investors continue to avoid them because they are scarred from the financial crisis. They have become far higher quality businesses since the changes to the regulatory environment over the past decade. Life insurance companies are also benefiting from higher interest rates and are a meaningful overweight position in the trust.
However, many of our holdings will have idiosyncratic factors driving their growth as well. For example, Allied Irish Banks plc is not only an interest rate story, but is also the beneficiary of an improvement in Ireland’s banking market, where the number of competing groups has recently shrunk from five to three. Banking regulation there has also eased somewhat, which has improved areas such as mortgage lending. In a mark of the ongoing growth bias of many of our competitors, the three largest UK funds don’t own a single bank.
We also see ongoing value in defensive areas. These are not the crowded trades of Dollar earning companies, or consumer staples, but areas such as tobacco or hidden defensives such as government outsourcer Serco Group plc. We are also seeing a pickup in merger and acquisition activity. Where value is not being appreciated by investors, it is being appreciated by trade buyers.
Ultimately, we see this as a good moment for a value approach, with the cost of capital rising and relative valuations still low. Many investors remain structurally underweight in this part of the market after a decade where growth stocks have been strong. It is a new era and investors will need to adjust.
Fidelity Special Values PLC (LON:FSV) aims to seek out underappreciated companies primarily listed in the UK and is an actively managed contrarian Investment Trust that thrives on volatility and uncertainty.
Serco Group PLC is a FTSE 250 company managing over 500 contracts worldwide. Serco is a British multinational defence, justice & immigration, transport, health, and citizen services company.
Allied Irish Banks PLC is one of the so-called Big Four commercial banks in Ireland.
Important information
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. Overseas investments are subject to currency fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. The trust invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. This trust uses financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference in this article to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. Investors should note that the views expressed may no longer be current and may have already been acted upon. 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.
The latest annual reports, key information document (KID) and factsheets can be obtained from our website at www.fidelity.co.uk/its or by calling 0800 41 41 10. The full prospectus may also be obtained from Fidelity. The Alternative Investment Fund Manager (AIFM) of Fidelity Investment Trusts is FIL Investment Services (UK) Limited. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0322/381308/ ISSCSO00115/NA
