Fund Spotlight: a value play for the unloved UK market

The UK enters the winter with renewed signs of stress in the near term, weighing on the future of UK-based assets. Higher for longer interest rates, continued uncertainty over a potential recession in 2024, and sticky inflation, means that it is no surprise some investors are steering clear of the UK market.

However, for those still confident in investing on home soil this creates opportunity to capitalise on undervalued companies that are in strong positions to recover.

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Fidelity Special Values (LSE:FSV), managed by Alex Wright since September 2012, and in February 2020 joined by co-manager Jonathon Winton, seeks unloved companies across various sectors which the team believe to be undervalued or where the potential has not been recognised by the market.

The portfolio has a flexible mandate, enabling the managers to buy into these situations at an early stage. The outcome of this mandate tends to result in the portfolio having a value bias and heavy tilt towards smaller and mid-cap companies versus the FTSE All-Share Index, where Wright believes there is more scope for mispricing.

Management has a long and successful track record of implementing this strategy with the support of the extensive Fidelity analyst team. The in-depth, bottom-up, contrarian approach seeks to invest in companies across all sectors before any wider recognition of changes in fortune, whether in operational results or sentiment.

An example of this is AIB Group (LSE:AIBG) (the trust’s top holding), which benefited from improving its position in Ireland’s banking market. A fall in the number of competing groups in the market (from five to three) along with rising interest rates has driven growth. The stock has returned 17% year to date and 74% over one year.

What does the trust invest in?

The portfolio comprises predominantly of UK-listed equities (currently 116 companies), although up to 20% of total net assets can be held in non-UK listed stocks. These are bought in instances where Wright has a strong understanding of the sector, and the company is well covered and typically focuses mostly in Europe, including 10% in Ireland.

Key to the bottom-up process is Wright’s focus on undervalued names. Broadly, FSV seeks companies trading at lower multiples (generally a price/earnings ratio of well under 15x) where the market is yet to realise the future value. This bias leads Wright to typically look outside the FTSE 100 index for opportunities.

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The current split is 28% in larger companies, 22% in mid-caps, and 47% in small-caps, which is an outcome of bottom-up stock selection. While the larger-cap holdings in the portfolio derive revenue from abroad, a good portion of the smaller companies in the portfolio are beholden to domestic demand, meaning that nearly 50% of the portfolio derives revenue in sterling.

At the sector level there is often an overweight to industrials (21%) and an underweight to consumer staples (12.5%) versus the benchmark (FTSE All-Share Index). These biases can impact relative returns at times, but over the longer term returns have been strong. A notable current overweight position is financials (27%), with Wright predicting this sector to be a strong source of returns in the coming years as bank profits inflate off the back of higher interest rates.

Wright invests on the basis of revenue exposure and has created a portfolio of companies with varied revenue sources, reducing the typical sterling exposure that investors in the UK small/mid-cap space are often exposed to. Proceeds from some recent profit-taking in financials have been redeployed into the non-life insurance sector due to an improving pricing environment and falling cost of insurance claims. The trust has also increased its exposure to industrials as weakness in the sector has created opportunities.

How has the trust performed?

Investing in small and mid-cap companies can lead to elevated volatility of returns and periods of underperformance where investor sentiment is weak. Accordingly, the year-to-date period has been tough for UK smaller companies, and FSV’s inclination towards the lower echelons of the market-cap spectrum has been a headwind for returns where compared with its large-cap heavy benchmark (the FTSE All-Share). Since the start of 2023, the trust has returned -1%, versus a 4.5% rise in its benchmark FTSE All-Share. A widening of the trust’s discount, from roughly -2% at 2022 year end to nearer -8% (30/09/2023) further dampened returns.

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Over the past three years, Wright’s keen focus on valuations proved positive in an environment which rotated away from growth in favour of value companies. Over three years, the trust has returned near 19%, versus 12% for the benchmark 11.8% and peers 9.5%. Exposure in the Industrials, Energy and Financials sectors were key contributors to performance, with particularly successful stock selection coming from Wright’s holdings in MITIE Group (LSE:MTO) and Meggitt, which was taken out of the market in 2021.

It is clear that over the longer term, in spite of a more volatile return profile and a painful 2022 period, UK smaller caps have succeeded in providing superior capital growth opportunities.

Furthermore, Wright’s expertise in the small/mid-cap area and successes in stock selection, has delivered investors in FSV stand-out excess returns versus the benchmark over the long term, returning an annualised 7.5% over 10 years, versus the FTSE All-Share’s 5.6%, albeit with a higher level of volatility.

Source: Morningstar Return GBP to 30/09/2023.

Why do we recommend this trust?

FSV’s bottom-up process is differentiated first by its contrarian approach to finding value opportunities. Wright’s willingness to invest in companies where valuations are reflective of a lack of investor confidence, makes for stock and sector divergence from its benchmark index.

Second, FSV’s all-cap approach allows investors to access the opportunities arising from smaller and mid-size companies, in tandem with larger, household names. While prices of smaller companies can exhibit greater volatility on account of lesser research coverage and heightened sensitivity of valuations of small-caps to macro factors, Wright possesses a great wealth of knowledge of the UK SMID-cap area, and leverages a large team of more than 170 Fidelity analysts behind each stock-selection call.

The portfolio frequently trades at a marginal discount to its NAV and over the past year has traded at roughly -7% discount. The current discount of circa -8% represents a slightly cheaper entry point for investors with a three- to five-year view.

For investors seeking a stock-picking approach to the UK market, with a keen focus on valuations, Wright’s flexibility and expertise in managing a portfolio that can invest across companies of all sizes may provide a suitable vehicle for investors. The trust has a place on our Super 60 investment ideas' list under the “Adventurous” category.

Please find the live factsheet here.