Fidelity Special Values — Benefiting from UK value stocks’ return to favour

The coronavirus crisis hit the UK economy harder than most advanced economies. The IMF forecasts that UK GDP will contract by 10.0% in 2020, compared to an average decline of 4.9% across the advanced economies. However, UK growth is projected to rebound more strongly, with GDP forecast to rise by 4.5% in 2021 and by a further 5.0% in 2022, compared to forecast growth of 4.3% among its Western peers in 2021 and 3.1% in 2022. Recovery is likely to be supported by ultra-low interest rates, several rounds of very generous fiscal stimulus and a surge in discretionary spending once consumers are free to resume social and leisure activities and to travel.

During 2020, UK equity markets made only a partial recovery from the precipitous market sell-off in Q120. They spent the summer and autumn trading well below their pre-pandemic highs – a disappointing performance compared to many other markets, which regained most or all of the ground lost in the Q1 market turmoil and, in some cases, reached all-time highs. This underperformance of UK equities exacerbated a long-term trend (Exhibit 2, LHS). UK equities, especially UK value stocks, have been out of favour with investors for many years, particularly since the EU referendum of June 2016, which marked the beginning of years of uncertainty for businesses and investors as negotiations between the EU and successive UK governments proved tortuous and slow.

However, towards the end of 2020, UK equity market sentiment improved as investors welcomed the arrival of several vaccines, which served to ease worries about the near-term economic outlook, despite the emergence of more contagious strains of the virus in parts of the country. Markets rose further into year-end and early 2021 following the conclusion of a trade agreement with the EU, just days before the UK was due to leave the Union, with or without a deal. This agreement, although much narrower than many hoped, at least ensures the tariff-free flow of goods between the UK and the EU, and eases much of the uncertainty that has plagued the UK since the EU referendum. However, while UK stocks have improved in recent weeks, they remain at long-term lows relative to world markets, which might suggest scope for further gains. A recent pick-up in UK M&A activity may be another sign that foreign corporates and private equity investors are also beginning to recognise the value on offer in this market.

FSV was launched in November 1994 and has been managed by Alex Wright since September 2012. Wright aims to deliver long-term capital growth from a diversified portfolio of primarily UK equities. He employs an actively managed, contrarian investment style, seeking undervalued companies with the potential for positive change, rather than businesses just trading on low valuation multiples. He invests across the market cap spectrum, usually with an overweight to medium-sized and smaller companies. FSV’s portfolio usually holds 80–120 companies, and up to 20% of the portfolio may be in overseas-listed firms. At the time of investment, no single stock will make up more than 10% of the portfolio, while up to 5% of gross assets may be held in unquoted securities. The trust’s investment performance is benchmarked against a broad index of UK companies.

In addition to equities, the manager may also invest in other transferable securities, collective investment schemes, money market instruments, cash and deposits. Derivatives are permitted for efficient portfolio management and investment purposes. The board believes that long-term returns can be enhanced by the prudent use of gearing. While gross gearing of up to 40% is allowed, the manager typically employs a working range of zero to 20% net gearing. Contracts for difference (CFDs) are used to gear long exposure.

In February 2020, Jonathan Winton was appointed as co-manager alongside Wright. Winton, who joined Fidelity in 2005, is lead portfolio manager of Fidelity UK Smaller Companies Fund and he has worked alongside Wright in Fidelity’s UK equities team since 2013. His appointment as co-manager of FSV is expected to strengthen its investment process by introducing greater challenge to decision-making and by increasing the team’s capacity to meet more companies. However, Winton shares Wright’s contrarian approach, so the investment philosophy and process will not change and Wright will retain responsibility for all investment management decisions.

Wright and Winton believe that in a world where most asset classes look expensive, UK equities, and especially value stocks, continue to look particularly attractive, even after some recent gains. ‘There has been a very one-sided consensus in favour of growth stocks, where valuations looked stretched and against some quality businesses, with solid or improving prospects, which remain undervalued by the market,’ Wright states. Even UK companies which have benefited from the pandemic have lagged their US counterparts. There are significant differentials in the performance of comparable stocks in the UK and the US, which Wright believes offer ‘huge opportunities’ with ‘amazing upside potential’. He cites housebuilder Vistry, electronic goods retailer Dixon Carphone and premium auto dealer Inchcape as some examples of UK companies whose post-pandemic performance has trailed comparable US companies. The portfolio now holds all these names.

For Wright, the very unusual nature of the current recession is also generating opportunities. ‘We have seen significant structural shifts in consumer trends and a rise in savings rates, which has benefited specialist retailers in areas such as bike sales, sporting equipment, electronics and DIY, as consumers have more disposable income and more time,’ says Wright. Many people have also reassessed their housing requirements, as working from home has embedded itself in the culture of many businesses. FSV’s manager believes this factor, combined with low mortgage rates, a stamp duty holiday and pent-up demand, has underpinned a significant pick-up in house sales and housing-related businesses.

FSV’s managers are also excited by many other high-quality investment opportunities undervalued by the market. They see particular value in life insurers, which they believe are well-regulated, resilient companies offering an attractive combination of cheap valuations, strong supply/demand fundamentals, growing earnings and scope for strategic improvements.

However, Wright believes it is essential to be selective and he is very cautious about the prospects of businesses most affected by the pandemic. He notes that while the mass roll-out of vaccines will certainly be positive for businesses in the travel, leisure and hospitality sectors, many of these businesses have been weakened by the crisis and are likely to take some time to fully recover.

These reservations aside, Wright is convinced that ‘now is a great time to invest in UK value stocks. This sector of the market has very good upside potential and we are well-positioned to take full advantage. The portfolio is now more balanced between defensives and cyclicals, skewed to the upside and relatively highly geared, to enhance returns in the upswing,’ he concludes.

FSV’s managers aim to generate long-term capital growth from a diversified portfolio of primarily UK equities. The selection process involves rigorous analysis, supported by Fidelity’s well-resourced analyst teams, who research companies and meet their managements, suppliers, competitors and customers, to understand a business’s fundamentals thoroughly. The managers also have access to a wide range of third-party research.

They have a contrarian investment style, focusing on companies in uncertain and complex situations, that have been unduly punished by the market in valuation terms, but which should, in their assessment, see positive change and improved returns over the long term. Once this potential becomes apparent to the broader market, there can be significant share price appreciation. Limiting downside risk is a key aspect of FSV’s approach, so Wright looks for companies where investor expectations are not only low, but which also possess an important asset or business characteristic that will provide some support to their share prices.

Fidelity’s analysts consider ESG factors to be an integral part of their in-depth fundamental research, as such considerations can highlight any potential risks. FSV’s manager believes that corporate governance considerations are particularly important for contrarian strategies such as FSV’s, which focus on unloved stocks and on limiting downside. However, rather than just avoiding poor ESG performers, Wright and his team engage with company management about their concerns and the company’s plans going forward. This encourages improved practices over time and can also be a source of value creation, as any improvements in behaviour may translate into a re-rating by investors.

As an example of the value of such investor engagement, Wright cites ContourGlobal, a global power generation company which he acquired at a time when it was shunned by many ESG-conscious investors. He believes his team’s subsequent dialogue with the company contributed to a marked shift in management attitudes. The company recently announced that it had abandoned plans to build a coal-fired power station in Kosovo and committed to making no further coal plant investments globally. This stock’s subsequent re-rating by ESG conscious investors has made it one of the portfolio’s strongest performers in 2020.

Early in the coronavirus crisis, the managers sought to raise the defensiveness of the portfolio by closing several positions in airlines and highly leveraged stocks, which they deemed particularly vulnerable to the commercial and social restrictions imposed in the UK and around the world. Exposure to oil companies was also reduced due to the sharp drop in oil prices. The managers are also wary about the impact of some energy companies’ transition to renewables, which they believe will put pressure on their cash flows and their ability to distribute cash to shareholders. FSV’s holdings in Shell and BP were sold, but the portfolio retained an exposure to oil stocks (3.3% as at end December 2020, down from 8.5% a year previously) in anticipation of a rise in the oil price over time. The manager has also trimmed holdings in several stocks that have detracted from performance due to their significant exposure to sectors decimated by the pandemic, including Meggitt, an aerospace and equipment and maintenance provider, C&C, a drinks supplier, and Hammerson, a shopping centre owner. However, some exposure to the former two names has been retained based on the view that they will survive the pandemic and perform well in the post-crisis recovery.

However, as the crisis unfolded over last spring and summer, the managers also began to respond to the many opportunities the pandemic generated, adding new names that were benefiting from the pandemic but overlooked by the market, and topping up existing holdings at attractive prices. They added exposure to the consumer sector via several companies which are seeing increased demand, including retailers Dixon Carphone, Studio Retail and Frasers Group and public transport alternatives, Halfords and Inchcape. The trust also bought or added to several UK and Irish housebuilders that were benefiting from an increase in demand for larger homes. These acquisitions included Vistry, the UK housebuilder whose recovery has lagged its US counterpart. They sought exposure to the associated trend towards DIY via Kingfisher.

Consistent with the managers’ positive view on life insurers, discussed above, they also increased exposure to this sector. Three of FSV’s top 10 holdings are insurance companies, including Legal & General Group in top place and Aviva in second place. Both positions were increased during the Q120 sell-off. The trust also held a position in Phoenix Group, whose subsequent strong performance has led the manager to take some profits on this position, but it remains FSV’s ninth largest holding. Wright and Winton have also taken profits on Swiss pharmaceutical company Roche (although it is still a top 10 holding) and closed the position in Citigroup, although they have also acquired several smaller players including two Georgian banks – Bank of Georgia and TBC Bank – and Kaspi, the dominant consumer finance, e-commerce and payments platform in Kazakhstan. All of these companies are generating good returns but have been overlooked by the market. The portfolio also has a position in infrastructure company John Laing Group, which is now a top four holding.

In fact, on a sectoral basis, financials are FSV’s largest position, comprising almost 30% of the portfolio at end-December 2020, which represents a 3.5pp overweight relative to the benchmark, thanks to its holdings in life insurers and secondary banks and despite its underweight to mainstream UK banks. Industrials make up 22.4% of the portfolio and represent its heaviest overweight to the benchmark (+9.5pp). Exposure to this sector comprises a mix of aerospace, defence and support services and construction-related companies. The portfolio’s most notable underweight is in consumer goods (-5.6pp), where the manager considers companies to be too expensive, and the portfolio is also notably underweight oil and gas (-3.9pp) following its disposals of Shell and BP, discussed above. However, the portfolio still has four other positions in the energy sector.

The portfolio currently holds around 120 stocks, more than usual due to the number of opportunities the manager has been pursuing. Portfolio concentration has declined accordingly. At end December 2020, its top 10 holdings comprised 29.3% of the portfolio, down from 40.4% a year earlier. In general, in anticipation of a further improvement in UK equity markets, the managers have recently adopted a less defensive stance. In addition to purchasing more cyclical names, they have increased portfolio gearing. Net gearing stood at 16.9% at end-December 2020, compared to 4.4% in December 2019.

FSV’s value-focused style has underperformed growth and momentum strategies for some time, and this was exacerbated by the onset of the coronavirus crisis. Performance, especially that of FSV’s cyclical holdings, was disproportionately affected by the March 2020 sell-off. The portfolio fell 35.7% in NAV terms in Q120, compared to a market decline of 25.1%. However, performance began to improve thereafter as some of the portfolio’s defensive holdings showed their resilience, surprising the market with stronger than expected results. Performance was boosted further in the last months of 2020, thanks to the improvement in investor sentiment towards UK value stocks following the arrival of viable vaccines and the conclusion of a Brexit deal, which bode well for an improvement in economic activity in 2021 (Exhibit 6, LHS).

In the three months to end-January 2021, the portfolio returned 38.6% in share price terms and 24.7% in NAV terms, compared to a market return of 16.5%. This improvement in absolute and relative performance has made up for the ground lost in Q120. For the period ending 31 January 2020, on a NAV basis, the trust outperformed the broad UK market slightly over one and five years and more decisively over 10 years (Exhibit 6, RHS and Exhibit 7). It has also outperformed large-cap UK companies over five and 10 years and small-cap UK companies over 10 years.

The main contributors to the improved performance have been pharmaceutical company Roche, electricity generator ContourGlobal and fuel-to-medical products conglomerate DCC, all of which outperformed the market. FSV’s life insurance holdings have also enhanced returns, having reported solid results that attest to their low cyclicality and improved solvency levels since the financial crisis. Especially strong gains by Phoenix prompted some profit-taking to make space in the portfolio for additional cyclical names that should benefit from a recovery in economic activity. In addition, retailers Frasers Group and Halfords surprised the market with better-than-expected results, due respectively to strong demand for sportswear and bikes, bike parts and car maintenance. Serco Group, the government outsourcer, has won new contracts related to the authorities’ efforts to combat the virus and upgraded its profit expectations accordingly. Smaller, idiosyncratic positions such as SEMAFO, a gold miner which has benefited from a takeover, have also contributed to performance. On a sectoral basis, being underweight to oil and gas companies Shell and BP and two of the UK’s major banks, HSBC and Lloyds, has also assisted.

These gains were partially offset by losses on a number of holdings which were disproportionately affected by measures to contain the virus. The largest detractors from performance were Meggitt, the aerospace equipment supplier, and C&C Group, an alcoholic beverage distributor hit by the closure of pubs and restaurants. Both positions were subsequently reduced given their ongoing exposure to severe limits on travel and social interaction.

Like many other investment trusts, FSV’s valuation experienced a period of volatility following the onset of the coronavirus crisis. The share price discount to NAV widened sharply in March 2020 and, after a period of instability, the discount settled in a range around 10% over the spring and summer. However, an improvement in performance and a positive reaction to the announcement of the new fee structure saw the discount narrow towards end-2020, returning to par, and shares have since traded mainly at a small premium. Its share price is currently trading at a premium of 2.2% to NAV, which compares with average discounts of 3.9%, 0.9%, 2.8% and 5.6% over the past one, three, five and 10 years, respectively.

The board’s policy is to maintain a single-digit discount or a small premium to NAV in normal market conditions. It has the authority to purchase up to 14.99% of shares in issue, which it believes gives shareholders a level of comfort. The board can also allot up to 10% of issued share capital to satisfy demand for shares. In FY19, c 9.6m shares (c 3.6% of the end-FY18 share base) were issued and, as shown in the share buyback chart in Exhibit 1, allotments accelerated in FY20 (ended 31 August 2020) with a total of 13.9m shares issued (c 5.0% of the end-FY19 share base). So far in FY21, the board has repurchased c 1.0m shares into treasury and has subsequently issued 6.7m shares (to 5 February 2021).

FSV is a conventional investment trust with one class of share. There are currently 295.6m ordinary shares in issue. The manager has scope to use net gearing in the range of 0% to 20% in normal market conditions. Net gearing stood at 16.9% as at end December 2020.

In November 2020, the board announced that it would reduce its management fee by 25bp from 1 January 2021, as it moved to a single fee of 0.6% of net assets. This replaces the previous tiered structure of 0.85% on the first £700m of net assets, reducing to 0.75% on net assets in excess of £700m. In addition, the fixed annual fee the trust pays to Fidelity for services other than portfolio management will be removed. The board estimates the reduced management fee will save the trust around £1.6m pa. The new structure will make the trust’s fee more competitive with its peers in the AIC’s UK All Companies sector. There has been no change to the investment process as a result of the new fee arrangement.

FSV is subject to a three-year continuation vote, the next of which is due at the December 2022 AGM.

FSV pays two dividends a year in January and June, to smooth shareholders’ payment streams. For the financial year ended 31 August 2020 (FY20), FSV paid an interim dividend of 2.10p per share in June 2020, equal to the interim dividend paid in FY19. A final dividend of 3.70p per share was paid on 14 January 2021, taking the total regular dividend for FY20 to 5.80p per share, up 0.05p (a rise of 0.9%) on FY19’s regular dividend of 5.75p per share. Revenue for FY19 was substantially higher than the trust had earned in previous years, and this was distributed via the payment of a special dividend of 1.50p per share. The rise in the regular dividend in FY20 is the eleventh successive year of growth in regular dividend payments.

During FY20, the trust saw cuts to dividend payments by some of the companies in its portfolio, as they took precautionary measures to conserve cash or were compelled by regulatory pressures to reduce or suspend payments to shareholders. As a result, the trust’s revenue per share in FY20 was 4.81p per share, down from 8.65p per share in FY19. However, FSV has built up revenue reserves over several years in order to be able to smooth dividend payments if necessary. At the end of FY20, revenue reserves stood at £17.7m and the trust drew on these to partially fund FSV’s FY20 dividend. Of the 5.80p per share regular dividend paid in FY20, 0.99p per share (amounting to a total of £2.9m) was funded by revenue reserves. Based on the current share price, FSV currently offers a dividend yield of 2.4%.

FSV is the second largest fund within the AIC UK All Companies sector (Exhibit 10). The constituents of this group follow a variety of investment strategies so to provide a more meaningful comparison of the trust’s performance, Exhibit 10 also includes a selection of investment trusts which, like FSV, adopt a value-based investment approach. FSV’s recent performance has improved its ranking among its All Companies sector peers. Its total return is now ranked ninth over one year,10th over three years, ninth over five years and seventh over 10 years. The trust has also outperformed the average of its value peers over 10 years. It is one of only a few funds within its AIC sector, and within the broader value peer group, whose share price is trading at a premium to NAV. Its ongoing charge is above average for both its sector and among its value peers, but the recent fee reduction will make the charge more competitive. FSV’s gearing is somewhat higher than the average of its peers, and its yield is slightly above the average for its sector, but below the average of the value peer group.

FSV’s board comprises five independent, non-executive directors. Chairman Andy Irvine joined the board in April 2010 and assumed the chairmanship in July 2016. Nigel Forster joined the board in September 2015, followed by Dean Buckley in November 2015. Claire Boyle was appointed in June 2019 and became head of the audit committee in December 2019. As part of the board’s succession planning, Alison McGregor joined the board in January 2020. She replaced Nicky McCabe, who stepped down at the AGM in December 2020 after 16 years on the board. Between them, the board members have extensive experience in investment management, banking, accountancy, industry and real estate.