Where Fidelity sees value in UK equity investing (LON: FSV)

UK equities continue to offer comparatively attractive valuations at a time when artificial intelligence is changing assumptions about business models, competitive advantages and long-term earnings visibility. Alex Wright, Portfolio Manager of Fidelity Special Values plc (LON:FSV), believes this backdrop is reinforcing the importance of disciplined stock selection and a clear understanding of where market expectations may have become too pessimistic.

The UK market recovered during the second quarter as risk appetite improved and corporate earnings remained resilient. More domestically focused and cyclical areas also participated in the rebound, including mid and small-cap companies that had previously experienced an extended period of weaker performance.

Despite continuing geopolitical uncertainty, Wright continues to see opportunities across the UK market, where valuations remain at a significant discount to other developed markets. That creates scope to identify businesses where expectations appear particularly low and where operational, financial or strategic improvements may not yet be reflected in share prices.

The investment approach behind Fidelity Special Values is not simply based on buying companies because they appear cheap. Wright focuses on understanding why a business has fallen out of favour, whether the challenges are temporary or structural, and what catalysts could support a recovery over time.

Artificial intelligence is becoming an increasingly important part of that assessment. Relatively few UK companies currently benefit directly from the expansion of AI infrastructure, although some businesses have exposure to associated investment. Keller, for example, continues to benefit from demand connected with data centre construction in the US.

The wider impact of AI may be more significant through the uncertainty it introduces into established competitive positions. Companies including RELX, Experian and Sage have historically commanded premium valuations because of strong market positions, attractive margins and high returns on capital. Wright’s view is that AI has made their long-term competitive positions less certain, creating a need for greater caution when assessing whether current valuations adequately reflect that risk.

This does not mean those businesses cannot remain successful. Instead, the emergence of AI changes the level of confidence that can be attached to longer-term assumptions. Where valuations remain elevated, greater technological uncertainty can reduce the margin for error if competitive conditions develop differently from expectations.

Wright expects AI to support productivity improvements over time, but he also sees the potential for greater disruption across industries. That reinforces the case for distinguishing between companies where valuations already reflect substantial concern and those where prices still assume a high degree of competitive predictability.

Financial companies remain one of the highest-conviction areas within the portfolio. Banks account for almost 20% of Fidelity Special Values, with modest additions made to large domestic banks as valuations became more attractive. Within an interest rate range regarded as normal at around 2% to 6%, Wright believes banks are capable of generating returns on capital in the high teens, while many continue to trade at seven or eight times earnings.

Holdings including Lloyds, NatWest, Standard Chartered and AIB illustrate the opportunity being identified across the sector. The central argument is that current valuations may not fully reflect the underlying quality and earnings potential of these businesses.

Similar valuation gaps can be found elsewhere. Smith & Nephew provides one example of a company where market attention has been concentrated on a weaker part of the business. Its orthopaedics division has faced prolonged challenges, but the other two divisions now account for around 70% of group profits and continue to perform well. Stronger cash generation has also allowed the company to undertake share buybacks while operational improvements continue.

Recruitment companies offer another example of the distinction between cyclical weakness and structural change. Hays, PageGroup, SThree and FDM have experienced an extended downturn in hiring activity, while concerns about AI have added another layer of uncertainty. Wright has yet to see evidence that AI has structurally impaired the staffing industry and considers the current challenges to be largely cyclical rather than permanent. With valuations already reflecting a high degree of pessimism, that creates potential for expectations to improve if hiring conditions recover.

Corporate activity is providing an additional indication of how UK valuations are being assessed. DCC received a takeover approach during the quarter, highlighting continued interest from strategic and private equity buyers in UK-listed companies available at attractive prices. Individual transactions cannot determine the outlook for the wider market, but they can draw attention to the gap between public market valuations and the prices potential acquirers may be prepared to consider.

Near-term risks remain important. Higher energy prices, geopolitical developments and broader economic uncertainty could affect individual companies differently. However, Wright’s approach remains firmly focused on company-specific fundamentals, with periods of uncertainty potentially creating greater divergence between businesses and more opportunities to identify situations where valuations do not fully reflect the scope for improvement.

The overall strategy remains centred on building a diversified portfolio of companies at different stages of recovery. Wright continues to look for businesses where positive change has yet to be recognised by the market, combining valuation discipline with an assessment of company-specific catalysts and longer-term competitive risks.

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.