Among global stock markets the UK stands out as cheap and unloved for reasons that have been discussed at length by many commentators over the past three years. However, looking forward, the tail risk of a ‘no deal’ scenario now appears to have reduced meaningfully since Boris Johnson secured a deal in Brussels and the subsequent general election.
While I am not banking on a ‘parting of the clouds’ moment in which the way forward suddenly becomes clear, I do think it seems likely that the worst-case ‘no deal’ outcome now seems significantly less likely.
It is true that fundamentals are not great in the UK, but neither are they in many other parts of the world. Importantly, what the UK has which others markets do not is a low starting valuation and potential for a positive catalyst. However, I do not want to claim that I have some insight into when this valuation gap could close. I will continue to focus on what has driven performance of Fidelity Special Values PLC since its launch 25 years ago - contrarian stock-picking.
A value comeback?
The value investment style has experienced a difficult 10 years since the financial crisis. Falling interest rates have favoured stocks with more certainty and bond-like characteristics, whereas value stocks by their nature often have some uncertainty around their future. Given that the performance of the value style is tightly linked to unpredictable macroeconomic events, it is very difficult to make predictions as to when value might stage a recovery, although it would seem that this would require growth and interest rate expectations to rise from current levels.
Following years of outperformance, many of the market’s most popular funds today have a distinct ‘growth’ bias. However, an investor who wants to be properly diversified should own a mixture of value and growth stocks in their portfolio, so must be prepared for a range of future economic scenarios. One of the reasons that value tends to outperform over the very long-term is that when things change in the market, it often happens in unexpected ways that surprises the consensus.
As a value investor, recent market trends have created a challenging backdrop for relative performance. However, our approach does not rely exclusively on the value style to drive returns, instead looking for stock selection to be the primary driver of performance.
UK domestics - cheap but risky
While undoubtedly an area of increasing interest, it remains prudent to tread cautiously among UK domestic stocks as the structural issues facing some of these businesses mean they could be ‘value traps’. In order to navigate this risky environment, I look for businesses with strong balance sheets, a self-help story, and a relevant offering that should withstand structural challenge from disruptive market entrants.
It is hard to ignore the effects of politics and economics on this part of the market, with UK retailers particularly exposed to sterling weakness as they buy their goods overseas and sell it in the UK. However, taking all this into account, I do see selective opportunities in UK domestics and own positions in financials and consumer businesses.
Defensive areas offer potential
Over recent months, stock markets have continued to rise despite a weak macro picture on expectations of central bank policy easing. On a bottom-up basis, higher valuations and weaker fundamentals have meant that I have been able to identify more attractive opportunities in defensive stocks in comparison to previous years. In fact, the portfolio today has a more defensive tilt than at any time over my tenure.
The defensive stocks I own are not the ‘quality’ defensives seen by many as a safe-haven in the UK equity market (and as such trade at high valuations). The portfolio has exposure to cheaper hidden defensives, which may not be part of a traditional defensive sector, or alternatively more obvious defensive businesses in which the market has lost confidence.
One such stock is DCC which as a logistics business sitting in the capital goods sector has resulted in investors overlooking its defensive characteristics. The company has an excellent track record in capital allocation, very little debt, and an appealing valuation.
Elsewhere, a company which three years ago was regarded as a consensus high-quality stock - but today is seen as structurally compromised - is tobacco company Imperial Brands. The stock has a double-digit dividend yield, clearly indicating the market expects a dividend cut. However, our work suggests this view could be wrong. The dividend is comfortably covered by free cash flow and the management appear committed to the dividend policy.
These are examples of some of the overlooked and unloved opportunities currently on offer in the UK. They are not overly reliant on the external environment - a cheap starting valuation provides an element of downside protection, while stock-specific drivers also offer the potential for positive change and a significant re-rating going forward.
As we head into 2020, it will be important to tread carefully but the unloved status of the UK market provides a plentiful opportunity set for contrarian stock-picking. We are confident that our focus on businesses with strong balance sheets, a self-help story and a relevant offering that should withstand structural change will serve investors well.
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. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Overseas investments are subject to currency fluctuations. Fidelity Special Values PLC can use 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. This 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. 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. 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.