The recent record high from the FTSE 100 seems to be at odds with the uncertain outlook for the UK economy. What’s more, this strong performance from blue-chip stocks has not been reflected across the market cap spectrum, with valuations particularly attractive among smaller companies. Alex Wright, portfolio manager of Fidelity Special Values PLC (LON: FSV), reviews this complex backdrop and outlines where he sees overlooked investment potential in the current environment.
The FTSE 100 reached an all-time high back in February, breaching its previous May 2018 record. However, this appears to be at odds with the current economic environment, where the latest GDP reading indicated that the UK economy avoided a recession but did not grow in the final quarter of 2022.
The UK’s blue-chip index reaching a new all-time high comes on the back of a resilient 2022 relative to other global indices. Recent returns have been largely driven by sectors such as energy, mining and banks which have benefited from the macroeconomic backdrop of rising energy prices and higher inflation. However, dig a little deeper, and you’ll notice a huge discrepancy in returns, with mid and small-cap companies in particular lagging significantly. In fact, 2022 saw only a very small proportion of the FTSE 350 constituents outperform (c. 20%) the index – the lowest number on record since 1990, according to research by Berenberg.
So, despite an uncertain economic outlook, the large divergence in performance between different parts of the market create good investment opportunities with attractive upside potential on a three to five year view. The UK market as a whole traditionally pays higher dividends compared to most markets and should continue to do so going forward, with the portfolio well positioned to benefit. Within this, we believe the prospects for value stocks and sectors are particularly strong given that these areas tend to perform well in a higher rate environment.
Financials look exciting
If we look at how this is translating into the current positioning of Fidelity Special Values PLC, we continue to favour financials, especially banks, where profits have been boosted by rate rises. While banks have struggled to make a return on the costs of running current accounts as rates remained low over the last decade, the reversal in rate levels in the last 12 months has led to strong performance as banks are beginning to earn decent returns on equity again. NatWest, for instance, is now forecasting a return on equity for 2023 of around 15%, but yet it is trading on about 6x those earnings. So, while it is now higher quality than the average company within the market, it is still trading on a significant discount and offers strong upside potential, in our view.
Banks should also be more resilient to a downturn as a result of these higher profits and, while they may experience some defaults on loans, it provides them with a strong buffer. Aside from NatWest, we also have holdings in the likes of Barclays, whose capital position has improved over the years now allowing for increasingly attractive distributions, as well as Irish market leader AIB Group, which is well placed to take advantage of the consolidation in the Irish banking industry.
The outlook is also positive for life insurers, whose earnings have proved resilient during the pandemic and should continue to benefit from an acceleration in the pace of pension fund re-risking. Further resilience can be found in the likes of Serco, the government outsourcer and another large holding in the portfolios, which has been able to weather the recent macro environment given it benefits from a degree of inflation protection in its contracts.
Overlooked small-cap opportunities
The smaller end of the market cap spectrum is rich in investment opportunities given the lack of research coverage. This has always been a big structural overweight for us, and the portfolios currently have around 60% exposure to mid and small-caps. Smaller companies have suffered particularly sharp deratings over the past year as they are seen as more cyclical and therefore more vulnerable to an economic slowdown or recession. But in our view, some of the share price declines have been excessive.
For instance, TT Electronics, a stock we bought in the second and third quarter last year, generates around half of its revenues from the healthcare sector, which is a-cyclical, and the aerospace/defence industry, which is going through a recovery post-Covid. The market underappreciates its transformation and increased focus towards higher quality end-markets which command higher margins.
A note should also be made on M&A, following the unprecedented activity we have seen in the UK over the past couple of years. Acquirers have typically involved private equity players and US-based corporates willing to pay prices based on US valuations. While rising rates have dulled the ability of private equity groups to borrow, most private equity funds have still got cash to invest and need to put it to work. We also expect to see further takeover bids from North American corporates over the coming months given the valuation differential.
While the economic environment remains uncertain, the UK is a large and diverse market, and we see a number of overlooked companies across the market cap spectrum with good upside potential. Within the portfolio, we are confident that our holdings, which have significantly lower levels of debt, possess the resilience to navigate a tough macro environment.
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.
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. UKM0322/381276/ ISSCSO00114/NA
