Why a shifting market is creating opportunity in UK value smaller and medium‑sized companies

Amid heightened volatility, UK equities have come under pressure, in line with other major markets, as rising energy prices weigh on growth and inflation expectations. However, the UK’s valuation discount, both relative to other regions and its own history, provides a margin of safety. Alex Wright, portfolio manager of Fidelity Special Values plc (LON:FSV), explains why smaller and medium‑sized companies continue to trade at a meaningful discount, creating selective opportunities in undervalued companies.

UK equities have come under pressure recently as the Iran conflict has pushed energy prices higher, weighing on growth expectations and increasing uncertainty. This has driven weakness in more economically sensitive parts of the market, particularly smaller and medium‑sized companies, which have underperformed in the current environment. 

This near-term weakness has been compounded by a longer-standing trend. Persistent outflows have left parts of the market increasingly overlooked, most notably divergent from larger sized companies where capital remains focused. This has created pockets of inefficiency, with valuations becoming more depressed and for contrarian investors, this presents opportunities to identify companies where recovery potential is not yet reflected in share prices.

Positioning through a more complex cycle

This creates a more challenging backdrop. The opportunity set is characterised by a tension between attractive valuations and weakening fundamentals. Many domestically exposed and cyclical sectors are trading at depressed levels, reflecting a prolonged period of economic weakness. At the same time, traditionally defensive areas have rerated significantly and now offer limited upside.

Portfolio positioning reflects this trade-off. There has been a selective increase in exposure to GDP-sensitive sectors, where valuations are most compelling. This includes areas such as industrials, recruitment and building materials, where stocks are pricing in a high degree of pessimism. At the same time, exposure to defensives has been reduced, following good performance and where valuations are no longer as attractive. 

Defensive companies generally performed well, and we have opportunistically taken profits in several positions. These included consumer goods company Reckitt Benckiser, tobacco companies Imperial Brands and British American Tobacco, regulated grid operator National Grid and defence-related businesses Babcock and Serco. Similarly, we have also reduced our gold mining positions after a good performance run and gold generally becoming an increasingly crowded trade.

Against this backdrop, the net equity exposure of the fund has reduced, and cash levels have increased to around 6%. 

Cyclical weakness and AI disruption driving valuation opportunities

Recruitment companies such as Hays and PageGroup have come under pressure, reflecting weak hiring activity and broader economic uncertainty. Investor concerns have also centred on the potential for disruption from artificial intelligence (AI) through disintermediation and reduction in white-collar workers. However, current evidence suggests that the challenges facing these businesses are primarily cyclical rather than structural. Early signs of stabilisation in certain markets, including the US, support this view. Against this backdrop, valuations have reached levels that offer an attractive risk reward profile, particularly if hiring activity begins to recover.

We maintain a positive view on banks and continue to see value across our holdings. These include emerging market-focused Standard Chartered, domestic lenders Lloyds Banking Group, NatWest Group and Close Brothers, Irish banks AIB Group and Permanent TSB Group Holdings, as well as a couple of smaller banking positions. While economic conditions have worsened, we don’t believe there will be a provision cycle, and the current environment of elevated interest rates is supportive for bank profitability. 

In digital media, companies such as Future have experienced significant share price declines due to concerns around reduced web traffic and changes in user behaviour from AI. While these pressures are real, this is affecting a quarter of its business, but its remaining operations, including its price comparison assets, provide a degree of underpinning value, supported by strong cash generation and ongoing share buybacks.

Cautious outlook amid rising uncertainty

While the long-term case for UK value and smaller and medium‑sized companies remains compelling, the near-term outlook is more cautious. Recent geopolitical developments have increased uncertainty, particularly through their impact on energy markets. The disruption linked to the Iran conflict has driven a sharp increase in energy prices, with expectations that UK household bills rise meaningfully later this year. 

This represents a headwind for consumers and, by extension, for domestically exposed sectors. It also complicates the path for monetary policy, with expectations for interest rate cuts being pushed back. Against this backdrop, economic growth is likely to remain subdued, and the risk of further earnings downgrades persists.

Positioning reflects this more cautious backdrop. The greater allocation to cash provides downside protection and flexibility, while exposure to cyclicals remains selective given weaker fundamentals. The emphasis remains on identifying companies where valuations already reflect a challenging environment, thereby limiting downside risk while preserving upside potential over a three-to-five-year horizon.

Overall, we believe the portfolio is well positioned to navigate a more challenging backdrop, while remaining exposed to a compelling opportunity set. Our holdings trade at a meaningful discount, particularly across smaller and medium‑sized companies, despite resilient business models and potential for robust earnings growth. This supports our confidence in the portfolio’s ability to deliver attractive returns over the long term.

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. Past performance is not a reliable indicator of future returns.  This trust can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. The shares in the investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Reference in this article to specific securities should not be interpreted as a recommendation to buy or sell these securities but is included for the purposes of illustration only. 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 FIL Investment Services (UK) Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0426/416492/ISSCSO00281/0427

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.