Fidelity Special Values — Increasingly positive view on UK market outlook

In its October 2018 outlook, the International Monetary Fund (IMF) maintained its expectation for a continuation in the steady expansion that has been underway since mid-2016, but lowered its projections, now seeing global growth remaining at the 2017 level of 3.7% in both 2018 and 2019. In addition, the IMF highlighted that economic growth has become less balanced and may have peaked in some major economies, indicating a rise in downside risks and less potential for upside surprises. The IMF forecasts UK economic growth at 1.4% for 2018 and 1.5% for 2019, which is below the euro area and advanced economy averages in both years. However, the modest rise in the pace of UK growth in 2019 contrasts with a slowdown in most other advanced economies.

Against a backdrop of relatively robust, but moderating, economic growth expectations, global stock markets have experienced elevated volatility throughout most of 2018, with sharp falls seen in many stock markets in the second half of the year. Share prices have been broadly affected by a number of geopolitical uncertainties, such as the US-China trade dispute, the pace of US interest rate hikes, and the UK’s negotiations on its withdrawal from the EU, which have all compounded fears of a potential sharper slowdown in the global economy.

As shown in Exhibit 2 (left-hand chart), the FTSE 250 and FTSE SmallCap indices have both significantly outperformed the FTSE 100 index over the 10 years since the 2008 global financial crisis, with all three indices declining by more than 10% from their peak in 2018. As shown in Exhibit 2 (right-hand table), the 2018 market setback has taken UK stock market valuation multiples well below 10-year average levels, and its dividend yield is considerably higher than average.

Exhibit 3 shows the valuation of the UK stock market compared with those of major regions and the world. While all regional markets are trading at discounts to their 10-year average forward P/E multiples, the UK is trading at the joint-widest discount and its 11.3x forward P/E multiple is the lowest of all the regions shown, in absolute terms.

A combination of relatively robust global economic growth and world stock market valuation multiples at below 10-year average levels suggests a broadly positive outlook for markets. Global macroeconomic concerns are weighing heavily on market sentiment and risks to global growth appear skewed to the downside. However, evidence of a path towards resolution of the US-China trade conflict or some clarity on the UK’s withdrawal from the EU could trigger an improvement in sentiment. Markets could also take cheer from any further slowdown in the projected pace of US interest rate rises, even if this is in response to weaker economic data. While the investment outlook in the UK is relatively subdued due to continuing economic and political uncertainty, any resolution of negotiations with the EU and accompanying improvement in sentiment, combined with the current relatively low market valuation, has potential to reverse the market downtrend. In the current uncertain market environment, investors may find appeal in a fund with a more discriminating investment approach and strong attention to limiting downside risk.

FSV is an LSE-listed investment trust with the objective to achieve long-term capital growth primarily through investment in UK equities (and related financial instruments) that the investment manager believes to be undervalued or where future potential has not been widely recognised. The trust’s investment objective was previously to achieve long-term capital growth predominantly through investment in UK-listed companies; this was rephrased at end-October 2018 to align it better with new regulatory reporting requirements introduced at the start of the year. There has been no change to the portfolio manager’s investment approach, and he continues to seek to fulfil FSV’s objective by investing in special situations, adopting an active contrarian approach, seeking out undervalued opportunities and taking advantage of volatility and market uncertainty.

Managed by Anthony Bolton from its launch in November 1994 until December 2007, then Sanjeev Shah from January 2008 to August 2012, FSV has been managed by Alex Wright since September 2012. Wright has 17 years’ investment experience, having worked as a pan-European sector analyst at Fidelity from 2001 to 2008, and has managed the £370m Fidelity UK Smaller Companies open-ended fund since its launch in February 2008 (co-manager since February 2013). He has also managed the £2.9bn Fidelity Special Situations open-ended fund since January 2014.

Wright’s approach is similar to those of both previous managers, referred to as value contrarian investing, which involves identifying companies whose potential for share price growth and recovery has been overlooked by other investors, then holding the shares of these companies until their value is recognised by the wider market. Additionally, Wright only invests after making a thorough assessment of potential downside risk, in order to limit the possibility of losses.

FSV’s portfolio typically comprises 80-120 holdings (96 at 31 August 2018; 107 at 31 August 2017) and 0-10 short positions (four at 31 August 2018; 10 at 31 August 2017). The investment approach is flexible and portfolio construction is driven by bottom-up stock selection, with positions held in large, medium and smaller-sized companies, across all industries. Performance is benchmarked against the FTSE All-Share index but sector allocations are not constrained by index weightings. FSV may invest up to 20% of the portfolio in companies outside of the UK in order to enhance shareholder returns. Gearing is permitted up to a maximum 40% of net assets, with the manager having flexibility to adjust net gearing within the current 0% to 20% range set by the board.

Portfolio manager Alex Wright emphasises that his investment process continues to target unloved stocks where companies are undergoing positive change, which has not yet been recognised by the market. Finding a plentiful supply of unloved companies in the UK stock market today, he sees his task as identifying those with the strongest margin of safety and the best chances of positive change. Given the high number of small- and medium-sized listed UK companies, and the lower levels of investor scrutiny that these are subjected to, he expects the portfolio will retain significant exposure to small and mid-cap companies. However, he points out that portfolio weightings are influenced by relative valuations between different size categories, as well as the outlook for different industries and companies, noting the significant increase in FSV’s exposure to FTSE 100 stocks over the last year (31.7% at end-November 2018 versus 24.4% at end-November 2017).

While acknowledging that the uncertainty surrounding Brexit has led to a de-rating of the UK stock market, Wright counters the strong consensus view – reinforced by fund manager surveys and press coverage – that UK small- and medium-sized companies are deeply out of favour and are under-owned compared with their larger and more international FTSE 100 peers. He highlights that since the UK’s EU referendum in June 2016, small- and medium-sized companies have outperformed the FTSE 100, continuing the trend of previous years. He also observes that the FTSE 100 is now cheaper on forward earnings estimates than the more domestically-oriented FTSE 250 and comments that he has incrementally been finding more interesting opportunities in larger companies, rather than among apparently unloved UK small- and medium-sized companies.

At end-August 2018, Wright cautioned that, over his six-year tenure as FSV’s portfolio manager, the UK stock market had delivered an annualised return close to 10%, which is well above long-term historical averages, and regarded it unwise to expect such unusually high returns to continue. However, he now has an increasingly positive view on the outlook for the UK market – particularly relative to other markets – mainly due to the negativity of other investors, who mostly appear to be underweight in UK stocks, with many global investors entirely avoiding UK exposure. In his view, the Brexit narrative has led to UK assets becoming deeply unloved, and therefore interesting from a contrarian perspective. He believes that whatever the outcome of UK negotiations with the EU, any clarity over the future relationship should lead to a period of stronger performance for the UK stock market. He expects any agreement to act as a catalyst for investors to revisit UK equities and sees potential for significant fund inflows due to the many good quality companies trading at discounts to peers in other developed markets, such as the US, where valuations are much higher.

Wright’s experience suggests not to wait for the good news to become obvious before investing, but to buy stocks when all the bad news is ‘in the price’ and no good news is expected. Accordingly, he took advantage of market weakness in the second half of 2018 to add to portfolio holdings and increased FSV’s net gearing (0.0% at end-May 2018 versus 16.9% at end-November 2018). He stresses that a selective approach remains important, highlighting that there are many domestic businesses being unfairly ignored, but there are also companies that are structurally compromised or financially unsound and therefore best avoided. Most recently, he has found attractive valuations among more defensive and larger-cap stocks, although he also notes that the financials sector has remained a fertile source of ideas.

Among the leading contributors to FSV’s performance over the last year, Wright highlights Ladbrokes, which was acquired by GVC Holdings. He explains that Ladbrokes was a deeply unloved UK domestic consumer stock that the market fundamentally misunderstood, but where due diligence and scenario analysis by Fidelity’s analyst uncovered significant value and limited downside, which was ultimately recognised by a corporate buyer. Another positive contributor was pharmaceutical company Shire, which received a bid from Japanese group Takeda Pharmaceutical, following a protracted period of underperformance. Royal Dutch Shell made a strong contribution, benefiting from rising oil prices as well as improved cash generation, and FSV retains its holding in the company as Wright believes its valuation continues to look attractive. Pearson performed well in 2018, but remains deeply unloved, despite what Wright sees as an exciting future for the company, and he has added to FSV’s holding. Significant detractors from performance over the last year include BT Group and Italian defence contractor Leonardo, which have both been sold.

Financials is FSV’s largest sector exposure (accounting for c 35% of the portfolio compared to 26% for the benchmark), spread across banks, financial services and diversified financials. Wright comments that within banks, FSV holds Citigroup, Lloyds Banking Group, Bank of Ireland Group and RBS Group, which are all trading on cheap valuations. While these banks have seen a strong pick-up in earnings and have been steadily rebuilding their balance sheets following the global financial crisis, he believes this is not fully reflected in their share prices. FSV also holds positions in insurers such as Phoenix Group Holdings and Aviva, which Wright observes are more defensive businesses than banks but also trading at very attractive valuations.

Wright indicates that FSV’s investments in the oil and banking sectors are based on a combination of stock-specific and industry changes, whereas portfolio investments in defensive sectors are more stock-specific. The trust remains underweight in consumer goods, but invested c 1% of NAV in Imperial Brands following the dramatic sell-off in the tobacco sector. Wright points to the company’s attractive risk/reward profile, emphasising its low valuation, with the stock trading on a 7% dividend yield, comfortably covered by free cash flow, but says it is unlikely to become a large position, given the negative structural trends in the tobacco industry and the company’s high leverage. FSV also bought a new position in Irish brewer C&C Group following its acquisition of distributor Matthew Clark, which Wright believes transforms its previously struggling UK business.

The manager seeks to meet FSV’s capital growth objective through investing in a diversified portfolio of predominantly UK-listed equities. While portfolio exposures versus the benchmark FTSE All-Share index are monitored, stock selection is not constrained by benchmark sector weightings. Opportunities are found across the market capitalisation spectrum and the proportions of portfolio investments in large, medium and small companies may vary over time, as this is the outcome of the research-driven, bottom-up stock selection process. The portfolio manager has a contrarian style and focuses on significant valuation anomalies in stocks which are out of favour with other investors, yet show potential for change.

FSV’s portfolio investments typically have the following two characteristics:

The investment process is designed to deliver an asymmetric return profile for the portfolio, which means that some winners should see outsize returns, while downside from losers should be minimised. This return profile is reflected in Fidelity’s analysis of FSV’s returns for the five years to end-September 2017. The analysis shows that the portfolio had a larger proportion of winners than losers over this period, with the largest positive stock contribution to performance more than three times the size of the largest negative stock contribution.

There are three main sources of investment ideas:

Once identified as a potential portfolio investment, all candidate companies are studied in detail by Fidelity’s sector-specialist analyst to validate the investment thesis. This involves talking to competitors, suppliers, customers and industry experts, as well as the company management and the level of due diligence conducted is seen as a key differentiating feature of Fidelity’s approach. The final stage of the investment process is portfolio construction, with stock weightings determined by the portfolio manager’s level of conviction in the investment case. A number of factors influence the level of conviction, including the number of aspects to the positive change story, stock liquidity and downside risk. An initial position in a new holding will typically be started at 25-100bp, then increased to 2-3% of the portfolio, with a full weighting usually reached within 12 months.

Up to 20% of FSV’s portfolio may be invested in companies listed on overseas exchanges. While not actively seeking non-UK investments, the manager frequently finds alternatives to UK stocks with similar but stronger investment cases, supported by the research of Fidelity’s European or global sector-specialist analysts. An example of this is FSV’s third largest holding Citigroup, which has similar global exposures and broadly similar risk characteristics to FTSE 100 constituent HSBC. The portfolio manager believes Citigroup is more attractively valued than HSBC, with higher profitability and its share price supported by a share buyback programme, while HSBC has greater property exposure, which is considered to present higher risks. Other examples of overseas alternative portfolio holdings are Sanofi and Roche, which are held in preference to FTSE 100 constituent GlaxoSmithKline. FSV can also invest in overseas companies, where there is no equivalent UK-listed stock and Fidelity’s analyst has a particularly high-conviction investment case. An example of this is former portfolio holding Electronic Arts, where the potential was seen in 2012 for a new games console cycle to drive growth in a depressed sector.

FSV may invest directly in shares or indirectly, via contracts for difference (CFDs), warrants or convertible bonds. Debt securities may also be held and up to 5% of gross assets may be invested in unquoted securities. Single company exposure is limited to 10% of the portfolio at the time of investment. Derivatives, including CFDs, futures and options, are used for three main purposes:

The portfolio manager is also permitted to reduce currency exposure through the use of CFDs when investments are made in stocks in foreign currencies.

Short exposure typically equates to 2-3% of FSV’s portfolio, with up to 10 individual short positions being held. The portfolio manager looks for stocks that he considers are clearly overvalued and where he sees a catalyst for the share to de-rate. An example of this was funeral services provider Dignity in 2017, where the company was pricing aggressively and seemingly out of kilter with its competition. Market risks are generally hedged using a FTSE 250 index future, representing up to c 10% of net assets (4.0% at end-November 2018).

FSV’s portfolio includes c 100 long positions, but exposure is relatively concentrated in the top 10 holdings, which accounted for 38.3% of the portfolio at end-November 2018, compared with 35.4% a year earlier (Exhibit 1). Portfolio turnover could be considered relatively high at 50.6% for FY18 and 54.2% in FY17, but this partly reflects the portfolio manager’s active approach to topping up or trimming existing holdings, rather than investments being short term in nature. There are three changes to the top 10 holdings compared with a year earlier, including new positions in BP and Swiss healthcare company Roche, while John Laing Group was previously a top 20 holding.

Exhibit 4 (left-hand chart) shows that the portfolio manager continues to take advantage of FSV’s flexibility to invest up to 20% of the portfolio outside of the UK market – with Irish-domiciled holdings largely being UK-listed, such as FSV’s top 10 holding CRH. Exhibit 4 (right-hand chart) shows that FSV’s portfolio is significantly overweight in FTSE 250 and FTSE SmallCap stocks, which together account for only c 19% of the benchmark FTSE All-Share index. Non-FTSE portfolio exposure includes stocks listed outside the UK as well as CFD positions.

As shown in Exhibit 5, FSV’s largest sector exposures at end-November 2018 were financials and industrials, which together accounted for c 60% of the portfolio, and these sectors also represented the portfolio’s most significant overweight exposures. While there is a similar spread of exposures compared with a year earlier, there have been notable reductions in consumer services and financials, while portfolio weightings in healthcare, consumer goods and oil & gas have been increased. The new holding in Roche accounts for a near doubling in the healthcare weighting, although FSV remains underweight this sector, while telecommunications exposure has been cut to zero following the sale of BT Group. The portfolio’s most significant sector underweight position is in consumer goods, while increased exposure to oil & gas from FSV’s new holding in BP has reduced the underweight in this sector.

As illustrated in Exhibit 6, FSV’s one-year share price and NAV total returns were clearly affected by the market declines in January, October and December 2018. The share price conspicuously outperformed both the NAV and benchmark FTSE All-Share index during January 2018, when it moved from a c 5% discount to NAV (including income) to parity, and this outperformance has been retained through to end-December 2018, when the share price stood at a 1.5% premium to NAV.

As shown in Exhibit 7, while FSV’s NAV total return has lagged the benchmark over one and three years, this reflects a short period of underperformance over the three months to end-December 2018, and the trust has outperformed its benchmark over five and 10 years. The contrarian nature of the manager’s investment selection process means performance may diverge appreciably from the benchmark over shorter time periods, particularly during periods of elevated market volatility, and this may not reflect the portfolio’s potential to outperform significantly over the longer term.

Exhibit 8 illustrates that, apart from several shorter periods of relative weakness, FSV has achieved a reasonably consistent outperformance of its benchmark since December 2011.

The board monitors the discount/premium closely and pursues an active management policy, taking action when it feels it will be effective and in the best interests of shareholders. When the shares are trading at a discount, the board seeks to maintain the discount in single digits in normal market conditions by buying back shares, either for cancellation or to be held in treasury. The board will reissue shares from treasury when the premium is sufficient to ensure that the issue is not dilutive.

As illustrated in Exhibit 9, over the last five years, FSV’s share price has ranged between a 13.3% discount and a 2.9% premium to NAV (including income), with a broadly narrowing trend evident since October 2016. The shares are currently trading at a modest 1.0% premium, which compares to average discounts of 0.0%, 3.8% and 4.4% over the last one, three and five years, respectively.

FSV is a conventional investment trust with a single share class. At 4 January 2019, FSV had 269.1m ordinary shares in issue, with a further 1.6m shares held in treasury. FSV has annually renewed authority to repurchase up to 14.99% of its outstanding shares at a discount to NAV, and to increase its issued share capital by up to 10% through the allotment of new or existing shares at a premium to NAV. Only one minor share repurchase has been made since November 2016, when the discount last stood wider than 10%, while a total of 4.6m shares (1.7% of issued capital) have been allotted from treasury since March 2018, when the shares started to trade regularly at a premium to NAV.

A five-for-one sub-division of the shares took place in June 2015 to address the substantial rise in share price (from 100p at launch in 1994 to 925p as at 22 April 2015), which was hindering smaller investors and those participating in monthly saving plans or dividend reinvestment schemes.

FSV’s maximum permitted gross gearing is 40%, and the board has currently set a 0% to 20% range within which the portfolio manager should maintain net gearing in normal market conditions. Within these restrictions, the board allows the manager to raise and lower gearing according to the availability of attractive investment opportunities. The board views the use of gearing as a structural advantage for FSV over its open-ended counterparts, and expects it to continue to add value for shareholders over the long term. FSV uses long CFDs to add gearing, normally at lower financing costs than the equivalent bank loans or bonds. Net gearing was increased during weaker market performance, rising from 0.0% at end-May 2018 to 16.9% as at end-November 2018.

On 1 September 2018, a tiered annual management fee structure was introduced, with a charge of 0.85% on the first £700m of net assets and 0.75% thereafter, which compares to the previous flat rate of 0.875% on net assets. The fee for non-portfolio management services (including company secretarial, fund accounting, taxation, promotional and corporate advisory services) was reduced from £0.6m per annum to £0.1m, also with effect from 1 September 2018. The FY18 ongoing charge was 1.04%, which was slightly lower than the 1.06% reported for FY17.

FSV is subject to a three-yearly continuation vote, with the next vote due at the 2019 AGM.

Since 2015, the board’s distribution policy has been to pay dividends twice yearly in order to smooth the dividend payment for the reporting year. In order to provide shareholders with a more balanced interim and final dividend than those previously paid, the interim dividend was increased by 80% to 1.80p per share in 2017, while the final dividend was increased from 2.70p to 2.80p per share, translating into a 24.3% increase in the FY17 total dividend to 4.60p. The FY18 interim dividend was increased to 1.85p, with the final dividend (to be paid on 16 January 2019) increased to 3.15p. The total 5.00p dividend for FY18 represents an increase of 8.7% over FY17.

FSV’s portfolio is managed actively in pursuit of capital growth and the dividend paid in each financial year will vary according to the level of dividend income received from investments. However, as an investment trust, FSV distributes at least 85% of its net income and the total dividend has been increased in each financial year since 2009 (the 2008 dividend was boosted by a one-off repayment of VAT on management fees). FSV’s revenue return for FY18 was 5.70p per share, making the FY18 total dividend 114% covered and adding 0.70p per share to revenue reserves. Adjusting for payment of the FY18 final dividend of 3.15p per share, FSV has revenue reserves equating to 2.55p per share, which can be used to smooth future dividend distributions.

Exhibit 10 shows a comparison of the trusts in the AIC UK All Companies sector that have a market cap over £100m. FSV is one of two larger trusts in this peer group that have a track record of more than five years. While performance is negative over one year, reflecting the recent UK market sell-off, and also lower than the peer group average, FSV’s NAV total return is similar to the peer group average over three years and ahead of the average over five and 10 years. The trust’s ongoing charge is at the higher end of the peer group range but it does not charge a performance fee, unlike many of its peers, and management and administrative fees have been reduced from September 2018. FSV has the highest level of gearing in the peer group, although the figure shown includes short exposure and net market gearing is c 17%. Reflecting its capital growth objective, FSV’s dividend yield is moderately lower than the peer group average.

FSV’s board comprises five non-executive directors, four of whom are considered to be independent of the manager. Chairman Andy Irvine (appointed director April 2010, chairman July 2016) has over 30 years’ experience in commercial property development and investment and is a director of BlackRock North American Income Trust. Senior independent director Sharon Brown (appointed April 2010) was finance director of Dobbies Garden Centres from 1998 to 2013 and is a director of BMO Capital and Income Investment Trust. Nigel Foster (appointed September 2015) has over 35 years’ experience in the investment management industry, including 27 years as global head of derivatives at BlackRock and predecessor firms. Dean Buckley (appointed November 2015) was previously the CEO of Scottish Widows Investment Partnership, and is a director of JPMorgan Asian Investment Trust. Nicky McCabe (appointed December 2004) was Fidelity’s head of investment trusts until December 2017 and so is deemed not to be independent. She is a director of Artemis Fund Managers and Aberdeen Asian Income Fund.